WADDY

7001 Johnnycake Road
Suite 208
Catonsville, Maryland 21244
Phone: (410) 298-0300

Understanding Taxes on Retirement Accounts

August 1, 2015adminBlog0

You’ve heard over and over about how important it is to save for retirement… and hopefully you are heeding that advice or have done so to be able to enjoy your golden years, reaping the benefit of years of hard work.

The first thing to understand is the various accounts you can use to save for retirement. Company-sponsored pensions are a rarity, having now been replaced by the 401(k) account or similar vehicle, depending on the industry in which you work (e.g. those working for tax exempt or nonprofit organizations may have 403(b) plans, etc.).

401(k) Accounts
In a 401(k) plan, often referred to as defined contribution plans, you contribute to the account on a tax-deferred basis. The contribution comes from your paycheck before taxes on your wages are calculated. The good news for the defined contribution is that it lowers your immediate tax liability.

Your eligibility to participate in your company’s 401(k) plan depends on the rules set by your employer. You may have to wait a month or even a year before you can begin participating in the plan. Likewise, your company may or may not make contributions to your account. These contributions are not required by law and the amount can range from 0 percent to 100 percent of your contributions, typically set as a match against what you are personally contributing. It’s also important to keep in mind that whatever monies you contribute to the account are yours; however, contributions made by your employer may have stipulations attached (e.g. not vested until you’ve reached a certain service level [years of employment] with the company, etc.).

IRA Accounts: Traditional and Roth
Traditional IRA accounts have been around since 1975 and allow saving for retirement outside of or in addition to a 401(k) account. The Roth IRA was created as part of the Taxpayer Relief Act of 1997. There is a critical difference between the two, and it hinges on when taxes are paid on the contributions. Very simply, contributions to a traditional IRA are deferred: You get to deduct contributions from your current tax return (thereby lowering your immediate tax liability), and the taxes are levied when you remove money from the account at retirement.

On the other hand, the Roth IRA does not offer an immediate tax break. You pay taxes on the money, thencontribute it to the Roth IRA. Because the money has already been taxed, it is not taxable upon distribution. The benefit of this type of IRA is that any interest or investment increase that occurs is also tax free once you reach retirement age.

Contribution Limits
There are limits on how much money you can contribute to any retirement plan, whether it’s a 401(k) or either of the IRA plans. If your company offers a 401(k) plan and offers to contribute to it, by all means, take full advantage of it and maximize your employer’s contribution. This is as close to “free money” as you will ever get. For 2015, taxpayers may contribute up to $18,000.00 to their 401(k) plans, according to the IRS.

You may be limited to how much you can contribute to either a traditional or Roth IRA if you are also contributing to a 401(k), depending on your total income. For 2015, the limit is $5,500.00 ($6,500.00 if you are 50 or older). Click here to learn more about IRA contribution limits and regulations.

Taking Your Retirement Money

The majority of questions about retirement accounts arise when it’s time to actually remove the money. People always ask, “Why do I have to pay taxes on my own money?” The answer is pretty straightforward: Because you never paid tax on the money in the first place. This is true of a 401(k) account because the money was contributed as “pre-tax dollars.” And it is true for a traditional IRA because you subtracted your contribution every year on your tax return and took the benefit at that time.

On the other hand, Roth IRA distributions can be taken tax free because the money has already been taxed: You contributed it without taking a tax reduction at the time (i.e. “post tax dollars”). And remember, one of the huge benefits of the Roth IRA is that interest and investment increases are also tax free!

The next common question is: “I already paid taxes when I requested my distribution, so why do I owe tax now that I’m completing my tax return?” This occurs because the mandatory 20 percent that is withheld when you take a distribution is generally not enough to cover most people’s tax bracket (i.e. the tax bracket falls above 20 percent).

In addition to owing taxes on distributions (from 401(k) plans and traditional IRAs), there is a ten percent penalty for withdrawing from a retirement account early (before reaching age 59½). There are some exclusions to the penalty when withdrawing the money so it is very important to contact us to see if you qualify.

Required Minimum Distributions (RMD)
So you can’t take your money out too early (before age 59½) and you can’t leave it in your account too long either. Once you reach age 70½, you must begin taking money out of traditional IRAs (including SIMPLE and SEP IRAs) and 401(k)s. These distributions will then be calculated as income and taxed accordingly when you complete your annual tax return. If you do not take any distributions, or if the distributions are not large enough, you may have to pay a 50 percent excise tax on the amount not distributed as required!

The only account that doesn’t require an RMD is a Roth IRA. Money in a Roth IRA can continue to grow until the death of the account holder.

The date by which you must take your first RMD depends on when you reach age 70½ (calculated as six calendar months after your 70th birthday). Subsequent RMDs must then be taken by December 31st each year. Learn more about IRS details regarding RMDs.

Navigating Retirement Contributions and Distributions
In general, it’s better to pay taxes on the “seed” rather than on the “harvest.” In other words, take the tax hit early if possible, so less of your money is taxable in your retirement.

The only way to access your retirement money without paying taxes is to ensure that your beneficiary forms for your retirement accounts are set up properly. We are currently offering free reviews to make sure they are correct. Contact us to set up your appointment for this important free review.

Saving for retirement is critical. However, there is no shortage on rules and regulations on making contributions while you are working or on taking distributions once you retire. Waddy Accounting Services is here to help you make the right decisions no matter where you are in the process.

Leave a reply

Your email address will not be published. Required fields are marked *

*