When your retirement accounts are growing, it’s great to see the numbers climb. But when you retire and start taking money out of your IRA and 401k, the taxes you owe can take a surprisingly big chunk out of your total. Hopefully you’re taking advantage of the tax breaks that come with contributing to most retirement accounts, but are you ready for the taxes and penalties that you’ll deal with when you retire?
The general rule for retirement accounts is that you must either pay taxes on the money before you put it into the account, or when the money comes out. Determining which is better for your situation or what to expect with existing accounts begins with an understanding of the tax implications of various retirement accounts.
Types of Retirement Accounts
Individual Retirement Accounts (IRAs)
You’re allowed to put up to $5,500 (or $6,500 if you’re 50 or older) into your traditional or Roth IRA for 2014 and 2015 if you meet eligibility requirements. Even if you have multiple IRAs, you can’t go over that limit for all accounts combined. There are two types of IRAs: traditional and Roth. Depending on which type you use, you’ll face different tax implications for contributions and withdrawals.
- Traditional IRA. You can deduct the total amount you contribute to a traditional IRA, netting you a tax break for the year. Funds within the account will grow on a tax-deferred basis – meaning, you don’t need to pay capital gains tax on the growth. However, when you start making withdrawals in retirement, you’ll pay income tax on the total amount withdrawn. Most withdrawals made prior to turning 59 1/2 will be taxed and penalized a 10% early withdrawal penalty.
- Roth IRA. A Roth IRA is essentially the opposite of a traditional IRA. You won’t get the immediate tax break when you contribute (you can’t deduct contributions), but when you reach retirement, withdrawals are tax-free. Funds also grow on a tax-free basis while in the account (no capital gains). You can withdraw your contributions to a Roth IRA at any time without paying a tax penalty. However, you generally will have to pay tax and a 10% penalty on earnings withdrawn before you turn 59 1/2.
There are a few exceptions to the early withdrawal penalty for Roth and Traditional IRAs (see below).
Many employers set up a 401k plan for their employees, and make it easy to use payroll deductions for employee contributions. Contributions you make into a 401k reduce your adjusted gross income, lowering your overall tax liability. Employers often also provide a match up to a certain percentage of your salary. The maximum annual employee contribution is $17,500 for 2014 ($18,000 for 2015). Some employees 50 or older may be able to make an additional annual “catch-up” contribution up to $5,500 ($6,000 for 2015). When you eventually make withdrawals, you’ll have to pay taxes on your original contributions and on the account’s earnings. If you withdraw the money early (before you’re 59 1/2 years old), you’ll owe a penalty of 10% of the amount withdrawn, plus taxes.
Some workplaces are now offering Roth 401k plans, which let you determine what portion of your contributions will be made pre-tax or post-tax, and those contributions generally follow the same rules as contributions to a traditional (pre-tax) or Roth (post-tax) IRA.
A 403b account basically has the same rules as a 401k and is a common option for government employees and those working for non-profit organizations. The maximum annual contribution is also $17,500 for 2014 ($18,000 for 2015). In these accounts, you use payroll deductions to make pre-tax contributions and then pay taxes upon withdrawal. Just like with a 401k, you face a 10% penalty for early withdrawal.
A Savings Incentive Match Plan for Employees, or SIMPLE IRA, is an option that many small businesses use because they’re less expensive to maintain. These accounts are similar to 401ks in that you contribute money pre-tax and then pay tax when you withdraw. Employees are allowed to contribute up to $12,000 annually for 2014 ($12,500 for 2015), and employers are generally required to match each dollar of an employee’s contribution up to 3% of salary. But if you need to withdraw money early and your account hasn’t been open for more than two years, your penalty is 25% instead of 10% (in addition to income tax on the withdrawal amount).
A SEP-IRA is a low-cost, easy-to-manage way to set money aside for retirement if you’re self employed or run a business with a small group of employees. These accounts follow similar rules and withdrawal penalties as a traditional IRA. However, as an employer, you’re able to contribute up to 25% of your income (or your employee’s income) to a SEP – the dollar amount cannot exceed $52,000 for 2014 ($53,000 for 2015).
Exemptions to the Withdrawal Penalty
Warnings about withdrawal penalties are all over retirement account paperwork, so the fees should be no surprise. Fortunately, however, there are a few exceptions that allow you to avoid the 10% (or in some cases 25%) penalty hit. The rules differ depending on the account type. What follows are situations in which you could be exempt from any tax penalties.
IRA/SEP-IRA/SIMPLE IRA Withdrawal Exemptions
If you have a Roth IRA, you’re in luck – you can withdraw your contributions to a Roth IRA at any time without paying taxes or penalty fees. However, if you want to withdraw earnings from a Roth (you’ve already withdrawn the total contributions amount) or make withdrawals from a traditional type IRA, you’ll likely pay a penalty unless you also meet one of the conditions below.
- IRA Rollover. You won’t be liable for taxes or penalties in completing a direct rollover to another IRA – transferring some or all of the money from one IRA account to another without taking possession of the money. As of January 1, 2015, however, the IRS only allows taxpayers to make one rollover per year.
- Payout and Deposit. A lump sum payout from an IRA that you deposit into another IRA within 60 days won’t result in penalties or taxes.
- Disability. Withdrawals made if you’re permanently or totally disabled won’t result in penalties.
- Health Premiums. Paying health insurance premiums with withdrawals during unemployment won’t result in penalties.
- Specified College Expenses. Paying for college expenses for yourself or a dependent (only qualified expenses are eligible) with withdrawals may not result in penalties.
- New Home Purchase. You won’t be penalized if you use up to $10,000 to purchase a home, if you haven’t owned a home over the past two years. There is a $10,000 lifetime maximum for this exception.
- Specified Medical Expenses. Using a distribution to cover medical expenses that exceed 10% of your adjusted gross income (7.5% if you or your spouse were born before January 2, 1949) won’t trigger the penalty.
- IRS Levies. Funds withdrawn to pay levies by the IRS to pay off your tax debts won’t be penalized.
401k/403b Withdrawal Exemptions
If you want to withdraw money from a 401k or 403b without penalty, determine whether you meet any of the following exemptions:
- IRA Rollover or Deposit. A direct rollover to an IRA, or a lump sum payout that you deposit into an IRA within 60 days won’t be penalized or taxed.
- Disability. Withdrawals made if you’re disabled won’t be penalized.
- Death. Amounts withdrawn by your beneficiary or estate after your death won’t be assessed a penalty.
- Retirement. Retiring at age 55 or older and withdrawing funds won’t trigger the penalty.
- Specified Medical Expenses. Using withdrawals to pay for medical expenses that exceed 10% (7.5% if you or your spouse was born before January 2, 1949) of your adjusted gross income won’t result in a penalty.
- Divorce. Withdrawals made following the rules of a divorce decree or separation agreement (also known as a qualified domestic relations court order) won’t be penalized.
Substantially Equal Periodic Payments
If you retire early or need to tap your retirement account before the penalty-free age of 59 1/2, one little-known way to avoid incurring penalties is to set up “substantially equal periodic payments.” The IRS lets you give yourself an annual salary, so to speak, without penalty. However, withdrawals must be spread over your entire life (the annual amount is determined by an actuarial formula). Under this arrangement, you withdraw amounts each year that are roughly the same, and the schedule spans your life expectancy. Each year, the IRS publishes life expectancy tables to determine the number of years you’ll need to cover. The IRS also helps you account for continued growth or decline (from investments) in your account.
Required Minimum Distributions
While drawing from your account too soon can result in penalties, the IRS also has rules that prevent you from taking distributions too late as well. Required minimum distributions (RMDs) are withdrawals you must make the year you turn 70 1/2. One exception is a Roth IRA, which doesn’t have RMDs.
Additionally, if you are still working at 70 1/2, unless you own shares in your company, you can delay RMDs from employer-sponsored accounts such as a 401k until the year in which you retire. But you can’t put off taking RMDs from an IRA. In fact, the companies that manage retirement accounts send annual reports to the IRS; if the IRS sees that you’re not taking RMDs, you can face a tax of up to 50% on the amount you should have withdrawn.
The amount of your RMD will depend on your age, marital status, and the total value of all of your retirement accounts. The IRS publishes tables annually that list the required minimums. If you have more than one retirement account, you need to determine how much you have to take from each account. You may not turn around and deposit the withdrawals into another retirement account, but you can move the funds to an interest-bearing savings account like ING Direct or Ally Bank.
In the event that you inherit an IRA, 401k, or other retirement account from someone who was not your spouse, you can choose to either withdraw the entire amount within five years of the original owner’s death, or you can take required minimum distributions over your entire lifetime. Taking the entire amount means a huge tax hit, so many people choose to take RMDs to spread out the tax burden. (When a spouse inherits, he or she can often take ownership of the account and follows different rules.)
It’s important to understand the tax implications of your accounts so that you know how much money you’ll actually have available to you when you need it. Many people focus on the account amount instead of the amount they’ll see after taxes. But the last thing you want is to realize just before retirement that taxes will set you back such that you’ll have to delay it. If you aren’t already, consider investing in Roth accounts to make tax time a lot less painful when you reach retirement age or need to withdraw funds in an emergency.
Have you started tapping your retirement accounts? How are you planning to reduce your tax burden?