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Tax-Deferred Retirement Accounts Part I
See Also:
Tax Deferred Retirement Accounts: An Overview – Part I
Note: This is part one, please see part two here.
Through its tax policy, the federal
government encourages people to save money for retirement. It does so by
providing substantial tax benefits for qualified retirement accounts. The
central principle behind most qualified retirement accounts is that
contributions to the accounts are income tax deductible (and so are funded with
“pre-tax” money), while withdrawals from the accounts are subject to income
tax. Essentially, tax on that money is deferred until after it is
withdrawn, which may be several decades after it is contributed. Moreover,
unlike regular interest and dividend income in an ordinary brokerage account,
which is taxable on yearly basis, income earned on money in a qualified
retirement account is not subject to income tax in the given year.
This principle applies to most types of
qualified retirement accounts, though we will discuss the differences between
the types of accounts a bit later. The Roth IRA is a different kind of
qualified account, and we will look at that in Part 2 of this presentation.
Advantages of Tax Deferral
Because money in qualified accounts
grows tax-free and because retired people are usually in lower tax brackets
than mid-career professionals, qualified retirement accounts present
substantial economic benefits for most people. Let’s look at an example.
Diane is a single 40-year-old
attorney who earns $100,000 per year, putting her marginal income in the 28% federal
income tax bracket. She plans to retire at age 65. If she earns an additional
$10,000 this year, she will pay $2,800 in federal income tax (plus, depending
on where she lives, possibly state and local income tax as well). Let’s say she
invests the remaining $7,200 in a vehicle that gives her a 5% annual return.
Because she’s paying 28% of the income each year in federal income tax, she’s
effectively earning 3.6% per year (even without considering state income tax).
On her $7,200 investment, at 3.6% growth per year, by the time she is 65, her
investment will have grown to $17,431.
Let’s assume, instead, that she
takes the $10,000 and puts it into a qualified retirement account. First, she
does not have to pay income tax on it, so she gets to invest the full 10,000.
Second, she doesn’t have to pay income tax on its growth because it’s in a
qualified account, so she earns the full 5% growth each year. When she’s 65,
her account will be worth $33,863, or almost double what it would have been had
she not contributed it to a qualified account. It’s true that it will be
subject to income tax when withdrawn, but once retired, Diane’s federal income
tax bracket may only be 15%. She is paying 15% now in exchange for having
almost doubled her money through the benefits of the qualified account.
Clearly, this option is best for Diane in the long run.
Early Withdrawals
The benefits of tax deferral do some
with some costs, principally relating to flexibility. With some exceptions,
withdrawals from qualified accounts before age 59 ½ are subject to a 10%
penalty in addition to standard income tax on withdrawals. The reason for this
penalty is that the policy behind the tax benefits is to encourage people to
save for retirement. Allowing account holders to make mid-career withdrawals
without penalty could defeat this purpose.
Required Minimum
Distributions
While the early withdrawal penalty
forces people to keep money in their retirement accounts, the required minimum
distributions rule requires people to take it out. Because money in these
accounts is tax-deferred, the government has an interest in ensuring that they
are not held in the account ad infinitum.
Instead, once a person reaches age 70 ½, he must begin withdrawing money from
the account. The amount of the required minimum distribution is one divided by
the person’s life expectancy, based on her age. The IRS publishes tables under
which life expectancy is calculated, so individual factors such as health are irrelevant.
For example, according to IRS tables, a person age 78 has a distribution period
of about 20 years. Thus, she must withdraw about 1/20 of the account during
that year, which is subject to income tax. Failure to withdraw the required
minimum distribution results in a whopping 50% penalty!
Types of Qualified Accounts
Qualified retirement accounts can
take the form of traditional IRAs, Simplified Employee Pension (also called
“SEP”) IRAs, employer-sponsored retirement plans and Roth IRAs.
Traditional IRAs
Anybody can contribute to a
traditional IRA up to $5,500 per year if the contributor is under 50, or up to
$6,500 per year if she is over 50. The full contribution is tax-deductible if
the contributor is not covered by another retirement plan at work. If the
contributor is covered by another retirement plan at work, contributions to the
traditional IRA are only fully tax-deductible for people making up to, as of
2017, $62,000 per year or, for married couples, up to $99,000. Above those
income levels, for people covered by retirement plans at work, the tax
deductions phase out, making the IRA a much less attractive option.
Withdrawals from traditional IRAs
are subject to the age limitations we discussed earlier, including the penalty
for money withdrawn before age 59 ½. There are, however, exceptions that allow
withdrawals prior to that age without penalty (though not without income taxes
on the distributions). These include withdrawals:
-
needed
due to disability of the owner,
-
to
satisfy a qualified domestic relations order,
-
needed
for certain qualified higher education expenses,
-
to
purchase a first home, up to a $10,000 withdrawal,
-
to satisfy
certain tax debts,
-
to
pay for some high-cost unreimbursed medical expenses, and
-
to
pay for health insurance premiums while unemployed.
SEP IRAs
The SEP IRA is a form of
employer-sponsored qualified plan that is less complex than other
employer-sponsored retirement plans, such as the 401(k). It allows a small
business owner to set up a qualified retirement plan for himself or his
employees without having to go through the hassle and expense of setting up a
401(k). SEP IRAs are commonly used by business owners to fund their own
retirements because their contribution deduction allowances are much broader
than those of the traditional IRA. While contributions to traditional IRAs are
limited to $5500 (or $6500, for those over age 50), SEP IRA contributions can
be as high as $54,000 (as of 2017).
However, employees’ contributions are limited to 25% of their income,
while employers’ contributions are limited to 20%. Moreover, when the business
owner uses a SEP IRA for herself, it must be funded with self-employment
income, even if she has another job.
The withdrawal, penalty and tax rules
are substantially the same as those for Traditional IRAs.
A similar device, called the Savings
Incentive Match Plan for Employees or “SIMPLE” IRA, despite its name, is a
little more complex than the SEP, though it’s not as complex as setting up a
qualified retirement plan. While it’s nuances are different than the SEP’s,
it’s essential function and most of its rules are similar.
In our continuation presentation, we
will look at qualified retirement plans, Roth IRAs and rollover, spousal and
inherited IRAs.
References:
https://www.fidelity.com/retirement-ira/contribution-limits-deadlines
http://www.bankrate.com/finance/money-guides/ira-minimum-distributions-table.aspx