What You Need to Know About Retirement Plans & Taxes

When it comes to retirement, there are several different saving plan options. While the goal of each may be similar, how they work and may be taxed can vary greatly. 
 
Retirement plans fall into one of three tax categories: 1) taxable 2) tax-deferred and 3) tax free. 
 
Below, is a breakdown of different retirement plans, based on tax-type. 
 
 
Tax-Deferred (pay taxes after withdrawal)
 
A traditional401(k) is a retirement savings plan sponsored by an employer. It lets employees save and invest a percentage of their paychecks before taxes are taken out. 

• Employers decide how much their employees can contribute (usually based on a percentage of salary), up to $18,500 per year.
• When the money is withdrawn, taxes are paid as ordinary income on both the contributions and growth.
• A 10% early withdrawal penalty may apply for withdrawals taken prior to age 59½.
• Required withdrawals begin at age 70½. 
  

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• Pros: Some employers match the contributed dollar amount, up to a maximum percentage. It’s also one of the most convenient retirement plans, as contributions are typically taken out from an individual’s paycheck and go into their account automatically. Money pulled from your take-home pay and put into a 401(k) lowers your taxable income so you pay less income tax during the year of contribution. 
• Cons: You’ll be taxed at the higher ordinary income level rather than the lower capital gains level for investments. You may have limited choices as to your investments as well as limited control. Account value affected by performance of investments. Account could lose significant value near or during retirement.

 
A Traditional IRA is a retirement savings plan that allows investment earnings such as interest or dividends to accumulate tax deferred until the time of withdrawal.

• Penalty-free withdrawals for first home purchase and certain college expenses.
• A 10% early withdrawal penalty may apply for other withdrawals taken prior to age 59½.
  

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• Pros: You do not need to pay the taxes up front. 
• Cons: All taxes are paid during the time of withdrawal. Even with the lower rate (if minimum age is met after employment), the total amount of taxes could be significant. Contributions are limited to $5,500/year or $6,500/year if aged 50 or older. Account value affected by market performance of investments. Account could lose significant value near or during retirement.

 
Other retirement plans that fit in this tax deferred category include 403(b), 457, SEP IRA and Simple IRA plans.
 
Tax-Free 
 
With a Roth IRA andRoth 401 (k), you make contributions with money you’ve already paid taxes on, and your money will grow tax-free, with tax-free withdrawals in retirement, so long as certain conditions are met.

• Individuals can contribute up to $5,500 per year if under 50, or $6,500 per year if 50 or over (Roth IRA).
• You may only contribute to a Roth IRA if you make less than a certain amount of money: $135,000 for single filers and $199,000 for married couples filing jointly in 2018.

• For Roth 401 (k) plans, employers decide how much their employees can contribute (usually based on a percent of salary), up to $18,500 per year.
• A 10% early withdrawal penalty may apply for withdrawals taken prior to age 59½. For a Roth IRA, if over 59½, you must have begun contributing to the account at least 5 years prior to withdrawal to avoid a 10% penalty. 
• There are no required minimum distributions during the lifetime of the original owner.
• Penalty-free withdrawals may be made for first-time home purchases and for unreimbursed medical expenses or health insurance if you’re unemployed.
• Minimum age to avoid penalty withdrawals (if not meeting certain exceptions) is 59½.
  

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• Pros: No taxes on investment earnings or at time of withdrawal.
• Cons: Being taxed upfront means less money being contributed to account (less to grow).

 
An Indexed Universal Life Plan, which can also serve as a retirement plan, is considered tax-free because you pay with “after tax dollars”, it grows tax deferred, and money may be taken out tax-free. 

• Limitations on contributions (premiums) are dependent on the amount of life insurance.

• You can have access to your cash value at any age, any time, for any reason, without paying taxes or penalties.
• Death benefit is tax-free for beneficiaries
  

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• Pros: No penalty or taxes are paid, regardless of the individual’s age or the reason that money is withdrawn. Once dividends are credited to account they cannot be lost as a result of market volatility if Indexed Universal Life. At time of death heirs receive life insurance plus account value tax free.
• Cons: In the event of policy cancelation, gains become taxable as income. You must qualify medically for the life insurance. Roth products subject to stock market volatility. 

The following example compares the results of investing in a 401(k), a Traditional IRA, and an Indexed Universal Life Policy. The following sonario will be used: A 30 year old employee, earning $80,000/year who is in average health, works for a company who will match an employee’s contribution with a “match” of ½ of the contribution up to 5%. The employee wants to contribute 5% of his/her salary to retirement. So he/she wants to compare the overall effect of the different types of plans. We will estimate that the employee will pay a total of 30% in combined State and Federal income taxes.

​Regardless of your age, I can help you start, modify or add a retirement plan that best supports your current financial situation and will help meet your future financial goals. 

For a free retirement and financial consultation, please contact me at 909-714-1830 or at russ@russmorrisfinancial.com.