Are you setting yourself up for a tax problem caused by your retirement savings? Too often, people hear the tax-deductible and tax-deferred side of the story and assume that means tax-free. Not so, unfortunately. Recently a new client shared that she had made a withdrawal after age 59 ½ and found herself owing a tax bill she couldn’t pay. This can also be an issue for beneficiaries who inherit IRAs and 401(k)s only to find themselves owing taxes.
Looking at paychecks, which are pretty transparent, can help us understand retirement savings, which are more opaque. While you are paid a gross amount, a net amount actually hits your checking account. You pay taxes for federal, state, Social Security and Medicare. You probably don’t call the money that hits your checking account your after-tax money, but you could. Similarly, if you make a Roth IRA contribution, you should view it as after-tax retirement savings. That is, if you save in a Roth-style account using dollars from your checking account, you could potentially never pay taxes on any of the earnings on your contribution.
Non-Tax-Advantaged Retirement Savings
I believe that part of the confusion starts with tax terminology for non-tax-advantaged retirement savings and tax-advantaged retirement savings. Let’s start with non-tax advantaged savings. Just as it sounds, the earnings on non-tax-advantaged retirement savings are taxed at your personal income tax rate (which is also the short-term gains tax rate or the long-term capital gains tax rate). Many don’t realize that the interest paid on checking accounts and savings accounts is taxable. It’s added to your income for the year and subject to income tax. If you have a brokerage account or something that is held for more than a year, those earnings are considered long-term capital gains. It will be charged at zero, 10 or 20% depending on your overall income.
Tax-Advantaged Retirement Savings
Now, let’s move on to tax-advantaged retirement savings: tax deductible, tax deferred, tax free and taxable. Let’s assume that you participate in your company’s traditional 401(k) plan. By traditional, I mean that it does not have a Roth savings option. Your company’s payroll provider adjusts your taxes to reflect your workplace retirement plan contributions. In this case what is usually referred to as tax-deductible is now called a pretax contribution. In other words, your retirement plan contribution is taken out of your gross income before taxes are calculated, so you aren’t paying any taxes on your contribution.
A traditional IRA works a little differently. In that case, you write the check from your checking account using money you’ve already paid taxes on. When you file your taxes, an adjustment is made that essentially refunds the taxes you paid on the savings. The tax deduction is not a dollar-for-dollar pass-through, of course. If you make a $5,000 contribution, the taxes you pay are not reduced by $5,000. Rather, they are reduced by the income tax you paid on that $5,000. If you contribute to a Roth IRA (using already taxed dollars from your checking account), you receive nothing back on your savings at the time you file your taxes.
The advantage all these tax-advantaged retirement savings have in common is that they feature tax deferral on the growth, investment returns or interest. Because of that, your savings grow faster than in non-tax advantaged savings where you’re paying taxes on the growth on an ongoing basis.
Withdrawals From Tax-Advantaged Retirement Savings
Now, let’s move on to what happens when you withdraw or take a distribution from your tax-advantaged accounts. Let’s start with the Roth IRA. You will pay no taxes if you meet all the requirements, such as the five-year holding period and attaining age 59 1/2.
For the traditional IRA, your tax deferral stops no later than the time when required minimum distribution rules kick in, currently age 72 if you aren’t grandfathered in for age 70 1/2. When you make a distribution, also called a withdrawal, the money is added to your gross income for that year, and you pay taxes based on that amount. For example, if your income is $100,000, and you take a $100,000 withdrawal, your gross income subject to taxes is now $200,000.
For an IRA, 403(B) or 401(k) funded with tax-deductible savings and earning tax-deferred growth, the savings along with all its growth will be taxed in the future at an unknown tax rate. Many people assume their taxes will be lower when they retire. While that is hopeful thinking, it may not be true and therefore warrants thoughtful evaluation.
Many people judge their 401(k) balance based on its size. If you are looking at a summary of your accounts, such as checking, savings brokerage and 401(k), on a balance sheet, it’s easy just to see them as all being the same. In fact, however, the 401(k) and IRA represent inflated values because no taxes have been paid on that money. Most of us see our checking account as available money. We don’t think that if I pull out $100, I will actually get, say, $70 because taxes need to be paid. But that’s exactly how we should think about our 401(k) and IRA balances. The amount on the account balance sheet isn’t really what’s available because taxes still have to be deducted.
Comparing Taxes Across Tax-Advantaged Retirement Savings
Let’s try to put this all together through a couple of examples. Let’s say you and your spouse each open a Roth IRA for $5,000, totaling $10,000 in savings as a couple. Further, hypothetically, let’s assume that, over the next 30 years, your money doubles every 10 years. That means that $10,000 grows to $20,000, $20,000 grows to $40,000 and $40,000 grows to $80,000. You can withdraw all that money tax-free. Since you created the savings with already-taxed dollars, you do not have to pay taxes on the growth.
Now, let’s say that instead of opening a Roth IRA, you and your spouse each decide to reduce your taxable income and open a traditional IRA. Let’s assume that each account has $5,000 in it by the end of the year and that, by using pre-taxed income to set up the accounts, each of you saved $1,000 on your 2020 taxes. Let’s also assume you get the same hypothetical growth we saw earlier—your money doubles every 10 years over the next 30 years, so, after 30 years, you, as a couple, have $80,000. If you withdraw all of that money at once, you will pay taxes on the entire $80,000 at whatever your tax rate is 30 years from now. If the $80,000 is taxed in the 25% tax bracket, you will pay $20,000 in taxes. That leaves you with $60,000. Would you feel that the $2,000 you saved in 2020 was worth it in 2050?
What we don’t know, of course, is what tax rates will be in the future. We are currently at historically low tax rates, but we also have the largest budget deficits we have seen. And we don’t know how we’re going to pay for the coronavirus relief packages. While I have no crystal ball, it seems likely that tax rates will be higher in the future.
Hopefully understanding how retirement savings accounts are taxed will help you avoid some nasty tax surprises in the future. If talking through your options would be helpful, consider consulting a financial planner, certified public accountant or enrolled accountant.