Taxation of Tax-Advantaged Accounts

My daughter Elizabeth recently graduated from college and in a couple of weeks will begin her first “real” non-temporary job. For the first time in her life, Elizabeth will be able to sign up to participate in an employer retirement program, her employer’s 401(k) plan. When Elizabeth was reviewing her future employer’s benefit booklet, she had a lot of questions about this and other retirement plans, employee benefits and about the tax ramifications of each of each of them.

Well, the answers to those questions were a little bit longer than could be answered in one sitting, so we had discussions over several evenings. We had interesting conversations 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 exclusion. After my discussions with Elizabeth, I thought the information would be a good topic for a column. If Elizabeth, who was just starting a retirement plan, wanted to know about deposits to and withdrawals from these investment vehicles, then others probably would too. Since we have discussed annuities other recent columns, today we will do an overview of the others. So here goes:

401(k)s, 403(b)s, 457(b)s and Other Qualified Employer Retirement Plans. Contributions to these plans can be made by either the employee or employer. Most contributions to these plans are not subject to income tax when the contributions are made. However, if you are deferring a portion of your wages to make these contributions, they are still subject to the 7.65% Social Security and Medicare taxes.
If a 23 year old like Elizabeth contributes $500 per month to her 401(k), 403(b) or 457(b) plan and it earns 5%, she will have more than $1 million upon retirement at age 68. If it is invested in equities like the Standard and Poor ‘s 500 and earns 9%, then that $500 per month could be more than $3.7 million at age 68.

Many financial commentators recommend that you defer 15% of your wages to these plans. I recommend and am encouraging Elizabeth to defer 20% of her wages to her 401(k). There are limits on the contributions that you make to these plans. The contribution limit for 2015 is $18,000. You may want to consider increasing your contributions to this limit to help reach your retirement savings goals.
Withdrawals from these qualified employer retirement plans, are taxed to you consistent with the contributions to the plan. If the contributions to the plan were not income taxed before they were put in the plan, they are considered to be pre-tax contributions and are subject to income taxation when withdrawals are made. Most employer contributions to the plans are pre-tax. 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 from the bank.
Generally, any withdrawals of pre-tax contribution from these plans made before you are 59½ are also subject to a 10% early withdrawal penalty tax in addition to income tax, unless you meet certain exceptions. And once you reach age 70½, you must start taking required minimum distributions each year.

Traditional IRAs. Contributions to a traditional IRA are also limited. In 2015, annual contributions are generally limited to $5,500, unless you are age 50 or older, then you can contribute up to $6,500 annually. If your annual compensation is less than this limit, your annual contributions are limited to your compensation. If you had no compensation, you still may be able to contribute to an IRA if your spouse had income and you filed a joint income tax return. The total of all your and your spouse’s IRA contributions then could not exceed your spouse’s compensation.

Your contributions to your traditional IRA may be deductible reductions of your taxable income in certain circumstances. If neither you nor your spouse are covered by an employer sponsored retirement plan, you can generally deduct on your federal individual income tax return, all your contributions to a traditional IRA. However, if either you or your spouse are covered by an employer sponsored retirement plan, then your tax deduction for your IRA contributions may be limited based upon your income.
When your contributions and earnings come out of a traditional IRA, it is all taxable as ordinary income. The age 59½ early withdrawal penalty tax and the age 70½ required minimum distribution rules also apply. In addition, other than rollover contributions, you can no longer make contributions to a traditional IRA after age 70½.

Roth IRAs. The total contributions that you can make to all traditional and Roth IRAs combined cannot exceed the $5,500, $6,500, compensation and spousal IRA limits discussed above. In addition, there are further limits on how much of these amounts that can be contributed into a Roth IRA, based upon your income.

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. And you can continue to make contributions to a Roth IRA after age 70½.
Life Insurance. Most employer provided life insurance is group-term insurance for which there is no inherent cash value or premium buildup. Some employers allow you to purchase additional life insurance with after tax payroll deduction. You can also purchase individual term policies from an insurance agent or online. After the term expires or you or your employer stop paying premiums, the insurance stops.

You can also purchase individual permanent policies, which offer cash value build up. After your death, regardless of the type of life insurance or who pays the premium, the proceeds of your life insurance policies are typically payable to your beneficiaries income tax free.

There are a number of other tax advantaged investments 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 July 26, 2015 in The Times Herald newspaper, Port Huron, Michigan as: Rules are complex
for tax-advantaged investing

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