I received a text message from my 24 year old son Luke the other day. Luke graduated from college earlier this year. For the first time in his life, Luke has signed up to participate in a retirement program, his employer’s 401(k) plan. In his text message, Luke wanted to know how his contributions would be taxed when with withdrawn out of the 401(k); would they be taxed as wages, capital gains, or both?
Well, the answer to that question was a little bit longer than could be answered by a text. That evening when I saw Luke, we had an interesting discussion about the tax effects of 401(k)s and other qualified employer retirement plans, traditional and Roth IRAs, life insurance and annuities. These are the most common tax advantaged assets I see on a regular basis.
All of these investment vehicles have some sort of tax advantage, either a deferral or an exemption. After my discussion with Luke, I thought the information would be a good topic for a column. If Luke, who was just starting a retirement plan, wanted to know about withdrawals from these investment vehicles, then others probably would too. Today, we will do an overview. So here goes:
401(k)s and Other Qualified Employer Retirement Plans. Withdrawals from qualified employer retirement plans, like 401(k)s or 403(b)s, are taxed to you consistent with the contributions to the plan. Employer contributions to the plans are not generally taxed to you when the contributions are made. Your own employee contributions can be pre-tax deferrals of your wages, which reduce your taxable income, or can be after-tax contributions for which income taxes have already been paid.
If you have made any after-tax contributions to the plan, when you make withdrawals, a portion of the amounts taken out will be considered tax-free return of those after-tax contributions. All other withdrawals, consisting of your employer’s contributions, your pre-tax contributions and the earnings on all contributions, are taxed as ordinary income, just like interest.
For your pre-tax contributions, it’s basically wages in, interest out. Also, any withdrawals made before you are 59½ are subject to an additional 10% tax, unless you meet certain exceptions. And once you reach age 70½, you must start taking minimum distributions each year.
Traditional IRAs. Traditional IRAs are generally treated like employee pre-tax contributions to a qualified employer retirement plan. Your contributions to your IRA are reductions of your taxable income. When the contributions and earnings come out, it is all taxable as ordinary income. The age 59½ and the age 70½ rules also apply.
Roth IRAs. Your contributions to your Roth IRA are made with non-deductible after-tax dollars which do not reduce your taxable income. However, generally, if your withdrawals out of your Roth IRA occur after age 59½ and at least 5 years after your first contribution to your Roth IRA, all withdrawals are income tax free. You pay no income taxes not only on your after-tax contributions, but on all your Roth IRA earnings. You are not required to make any minimum distributions from your Roth IRA during your lifetime. Minimum distributions are only required after your death.
Life Insurance. After your death, the proceeds of your life insurance policies are usually payable to your beneficiaries income tax free. If you sold a policy to someone, such as your child, the proceeds over and above the purchase price and any subsequent premiums paid, would be fully taxable as capital gain income to your beneficiary. Note to self: Do not sell the life insurance policy to the kids, give it to them.
Annuities. The taxability of payouts from annuities is determined by whether the annuity is a qualified or non-qualified annuity. Qualified annuities are basically annuities that are purchased within an IRA or employer qualified employer retirement plan wrapper. Because of this, all withdrawals out of qualified annuities are taxed like traditional IRAs, as ordinary income.
Since non-qualified annuities are purchased with after-tax dollars, only a portion of the withdrawals are considered taxable. Just like after-tax contributions to qualified employer retirement plans, a portion of the proceeds are considered income tax free return of your investment and remainder as taxable ordinary interest income.
Be on guard for annuities with “life insurance” benefits. These death benefits are generally not income tax free like life insurance. Since these death benefits are typically in excess of your investment in the contract, they are 100% income taxable to your beneficiaries as ordinary interest income. This has shocked many individuals who come to us after the death of a spouse; they were told by the annuity peddler that this death benefit was “just like life insurance”.
If you really want to purchase an annuity, instead of purchasing an annuity with death benefits, you (or your survivors) may be further ahead if you purchase an annuity with no death benefits and purchasing a separate life insurance policy. Choose an annuity which has lower internal management charges, lower surrender charge penalties and a shorter surrender charge penalty period. The annuity peddler may not like it because his or her commission is lower, but you end up keeping more of your investment dollar. Instead of paying your hard earned savings to the annuity peddler as commissions, the annuity company as management fees or the IRS as income taxes, you are keeping it for yourself and your loved ones.
Estate Tax Liability. Although life insurance proceeds are income tax free and these other tax advantaged investments are income tax deferred, they are generally all included in your taxable estate for Federal estate tax purposes. This is no big deal if your estate is less than $5 million in 2012 ($1 million in 2013 and thereafter). However, if you have a taxable estate and have not planned ahead, not only would income taxes have to be paid on these investments, up to 55% of your investment’s value on your date of death would also have to be sent to the IRS.
There are a number of other tax advantaged investment vehicles out there. We have only touched upon the most common ones that I see on a regular basis in our practice. There are also many special rules and exceptions to the general rules that we have not covered today. In addition, certain circumstances allow you to roll-over, convert or re-characterize one type of tax advantaged investment vehicle into another. When you are contemplating these types of investments, please consult with knowledgeable investment and/or tax advisor.
By Matthew M. Wallace, CPA, JD
Published edited September 23, 2012 in The Times Herald newspaper, Port Huron, Michigan as: Building your nest egg