Tax-Deferred Retirement Accounts Part I
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 Essentially, tax on that money is deferred until after it is withdrawn, which may be several decades after it is contributed.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.
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.
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.
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.