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Tax-Deferred Retirement Accounts Part II

See Also:

Tax Deferred Retirement Accounts: An Overview – Part 2

               Note: This is part two, please see part one here.

            Qualified retirement accounts provide tax benefits to encourage people to save money for retirement. In the first of this two-part presentation, we focused on explaining the advantages of tax deferral, some of the rules that apply to most qualified retirement accounts and on the Traditional and SEP IRAs. Our continuation will focus on qualified retirement plans, Roth IRAs and then what happens when IRAs are transferred.

Qualified Retirement Plans

            While there are a variety of qualified retirement plans, most employers use the “defined contribution” plan under section 401(k) of the Internal Revenue Code. Not-for-profits have a parallel option under section 403(b). Setting up a 401(k) is complex and its rules are nuanced, but fundamentally, a 401(k) is a lot like a Traditional IRA. Unlike an IRA, though, it is set up by an employer for the company and its employees rather than by the individual contributor.

            Contributions to a 401(k) are withheld from the employee’s salary and paid by the employer directly to the employee’s qualified account. The employer may also “match” the employee’s contributions, and certain 401(k) rules incentivize the employer to do so up to 4% of the employee’s salary.

            The big advantage of the 401(k) over the Traditional IRA is that contribution limits are much higher. As of 2017, up to $18,500 could be contributed to a 401(k) annually. Moreover, there are no income limitations on contributors, nor is the employee prejudiced by having other retirement accounts.

            The distribution rules for 401(k)s are virtually identical to those of the traditional and SEP IRA, except that there are fewer exceptions to the 10% early withdrawal penalty. For example, a penalty free early withdrawal cannot be made from a 401(k) for a first-time home purchase or to pay health insurance premiums while unemployed.

Roth IRA

            The Roth IRA, introduced in 1997 and named for Delaware Senator William Roth, is a very different device from the other qualified plans. Unlike other qualified accounts, contributions to Roth IRAs are not tax-deductible, which means that the contributors contribute “post-tax” dollars. The good news is that when money is withdrawn from the Roth IRA, it is not subject to income tax, regardless of how much it has grown. The chance for completely tax-free asset growth makes the Roth IRA a useful and popular device.

            Like the Traditional IRA, the Roth is subject to annual contribution limits of $5,500 for contributors under 50 years old and $6500 for contributors over that age. Unlike the traditional IRA, the Roth has income limitations for the contributors irrespective of whether the contributors are covered by other qualified plans. As a 2017, individual filers who make over $117,000 per year cannot contribute the full amount to a Roth, and the ability to contribute phases out completely at $132,000 of income. For a married couple, the phaseout begins at $184,000, while couples with over $194,000 of income cannot contribute at all to Roth IRAs.

            It must be noted also that the $5,500 or $6,500 contribution limitations are on combined traditional IRA and Roth IRA contributions. For example, a 45-year-old who has already contributed $3,000 to a traditional IRA this year may only contribute $2,500 to a Roth.

            Withdrawal rules are similar to other IRAs, except for a major difference that the amount of one’s contributions may be withdrawn free of taxes or penalties. So, for example, if you contribute $50,000 over the course of 10 years to a Roth IRA and the account balance is now $90,000 (due to interest, dividends and capital gains), you can withdraw up to $50,000 without penalty even if you are under age 59 ½. Note, of course, that there is no income tax on this money because income taxes were already paid on this money, as contributions to a Roth are post-tax dollars. 

            Beyond the amount of the contribution (the additional $40,000 in our example), withdrawals prior to age 59 ½ are subject to income tax and the same 10% penalty as are other IRAs. Early withdrawals without penalty before age 59 ½ are allowed in substantially the same cases as for a Traditional IRA (first time home buyer, education expenses, etc.), discussed in part one. Even such withdrawals are, however, subject to income tax.

            There are no minimum required distributions from a Roth IRA during the lifetime of the account holder.

Transfers of IRAs

            It is axiomatic that IRAs cannot be transferred, as they have rules that are defined by the age of the holder and have specific withdrawal and contribution limitations. If assets in an IRA are transferred to another person, that is tantamount to a withdrawal, with all the taxes and penalties that go along with it. However, as with virtually every tax-related set of rules, there are exceptions.

            An IRA “rollover” is a transfer of assets from one qualified account to another. This often happens when 401(k) participants leave their jobs. They are no longer able to participate in their erstwhile employers’ 401(k) plans, but they certainly don’t want to withdraw their moneys at once and face taxes and penalties. The contributor can instead roll over the 401(k) assets into a Traditional IRA or to a new employer’s 401(k). Because the withdrawal and distribution rules are substantially similar across these plans, this is allowed from a tax perspective. One can also do a rollover from a 401(k), Traditional or SEP IRA to a Roth IRA. However, the contributor or must pay income tax on that money at the time of the rollover, because a Roth is funded with post-tax dollars only.

            If an IRA holder dies and is survived by a spouse, the account can be transferred to the spouse and it will be treated as though it were the spouse’s retirement account. This is known as a “spousal rollover.” The surviving spouse can withdraw the money in the deceased spouse’s IRA and put it in her own qualified account or she can re-title the account in her own name. Once done, she can treat the retirement account as her own qualified plan. If she’s over age 59 ½, she can withdraw money without penalty and her required minimum distributions start at age 70 ½, as with her own qualified account.

            If the IRA holder dies without a spouse or the spouse is not the beneficiary (such as, for example, where the spouse waives the right to be the beneficiary or disclaims beneficial interest in the account), the recipient (usually, the child of the deceased IRA holder) may take the entire amount at once (which would be subject to income tax, unless the account is a Roth) or may continue to hold the IRA as an “Inherited IRA.”

            An inherited IRA is treated similarly to a regular IRA, with two important exceptions:

1.    There is no penalty for withdrawal prior to age 59 ½.

2.    The beneficiary must begin taking required minimum distributions immediately instead of being allowed to wait until age 70 ½. As with a regular IRA, the required minimum distribution is the fraction of the account that is one divided by the holder’s life expectancy. Withdrawals from an inherited IRA are subject to income tax, unless the inherited IRA was a Roth. Note that inherited Roth IRAs do have required minimum distributions even though they don’t have required distributions during the lifetimes of the initial holders.

Note that a surviving spouse can choose an inherited IRA instead of a spousal rollover if, for example, she wants to withdraw money before age 59 ½.

Qualified retirement accounts offer tremendous tax advantages to encourage people to save for their retirements. While the nuances and minutiae of tax law pertaining to retirement accounts are complicated, these presentations should give you an overview of the various available qualified retirement account devices.