At times, it may seem that options surrounding taxes are limited. Perhaps it feels a bit like this: you earn money, your check is reduced by taxes, you visit your CPA, and you either pay more or receive a refund. Sound familiar? It doesn’t always have to be so cut and dry. Options for choosing how you wish a portion of your financial life to be taxed do exist. The following is a simple explanation of two common tax models and how they can be used to maximize investment and retirement income flexibility.
Pre-tax (tax-deductible): 401(k), 403(b), 457, profit-sharing plans, deductible traditional IRAs, and most other retirement accounts receive the tax advantaged status of pre-tax contributions. Making contributions from earnings into these accounts means that the funds invested escape immediate federal and state taxation. The amount contributed reduces the taxable income reported to the IRS, and thus reduces the amount of taxes paid each year. As long as the money remains in the account, no taxes are due on growth and no losses can be claimed. Once the funds are in the account, they must be left until age 59 ½, at which time any distributions out of the account are considered ordinary taxable income. In most cases, distributions before age 59 ½ result in taxable income and a 10% excise penalty. Perhaps the simplest way to explain the value of pre-tax accounts is this: by contributing to a pre-tax account, the taxpayer is actively choosing to pay taxes in the future, rather than in the current year.
Tax Free: Roth IRAs and Roth 401(k)s share the special property of being free from taxes when distributions are made in retirement. Contributions to Roth IRAs and Roth 401(k)s are made after taxes have been paid on the funds contributed. The contributions enjoy tax-deferred status throughout the time the money remains in the account and at age 59 ½, the money may be distributed from the account without any taxes due as long as Roth funds have existed at least 5 years. The money contributed to the account has already been taxed and the growth of the money is never taxed! Roth IRAs enjoy one additional provision: contributions may be removed from the account after any length of time and at any age without triggering penalties or taxes. In comparison to pre-tax accounts, tax-free accounts can be summarized as follows: by contributing money that has already been taxed, the taxpayer is choosing to pay taxes on income today in favor of receiving tax-free growth and tax-free income in the future.
Having a pool of money available in retirement that will not be subject to taxes is a huge advantage. Consider the following example:
John retires at age 65. He draws a comfortable retirement income of $90,000 from his 401(k), which he rolled over to an IRA. All of the $90,000 is taxable income for John. As a reward to himself for his years of hard work, John decides to purchase a collectible car valued at $75,000. In order to do so, he must take a distribution from one of his accounts. These are his options:
- Distribution from his traditional IRA: if John takes the money from his IRA, he must pay taxes on the amount he receives. Because of his tax bracket, any money he receives is federally taxed at 28%. To arrive at the $75,000 he needs for the car, he must actually take $96,000 out of the account, which means his taxable income for the year is now $186,000.
- Distribution from his Roth IRA: if John takes the money from his Roth IRA, no taxes will apply to the distribution. His taxable income remains the same, at $90,000. John must take out only what he needs to purchase the car, $75,000. His taxable income for the year remains $90,000.
We encourage you to consider tax diversification when planning for retirement. We understand that tax laws can be complicated and confusing, so we’re here to help. We’re pleased to have in-house tax planning and tax preparation services available to our clients and are happy to offer education to help you better understand your taxation options.
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