Retirement Accounts and TaxesMay 01, 2023
Types of Retirement Accounts
There are several types of retirement accounts in the US, each with its own set of tax rules and benefits. Some of the most common types include:
Traditional IRA: A traditional IRA is a tax-deferred account that allows people to contribute pre-tax dollars (depending on your income). This can reduce their taxable income for the year. The money in the account grows tax-free until it is withdrawn. Once you start withdrawing funds you are taxed at your normal rate.
Roth IRA: A Roth IRA is a tax-free retirement account that allows individuals to contribute after-tax dollars. The money in the account grows tax-free and can be withdrawn tax-free in retirement.
401(k): A 401(k) is a tax-deferred retirement account that is typically offered by employers. Employees can contribute pre-tax dollars, and most employers also offer matching contributions. The money in the account grows tax-free until it is withdrawn, at which point it is taxed at your normal rate.
403(b): A 403(b) is a tax-deferred retirement account that is offered to employees of non-profit organizations, such as schools and hospitals. Like a 401(k), employees can contribute pre-tax dollars, and some employers also offer matching contributions.
- Thrift Savings Plan: A TSP is a tax-deferred retirement account that is offered to government employees. Like a 401(k), employees can contribute pre-tax dollars, and the government offers matching contributions.
SEP IRA: A Simplified Employee Pension (SEP) IRA is a tax-deferred retirement account that is typically used by self-employed individuals or small business owners. Contributions are tax-deductible, and the money in the account grows tax-free until it is withdrawn, at which point it is taxed at your normal rate.
Most of us are interested in the tax implications of Traditional and Roth IRAs so let's take a deep dive.
- Everyone can contribute to a Traditional IRA but it IS NOT Pre tax for everyone. The IRS has a special form to fill out every year where they calculate your MAGI (maximum adjusted growth income). This number determines if ALL your contribution, PART of your contribution or NONE of your IRA contribution would be a tax write off.
- If you withdraw prior to 59 1/2 years old you will pay taxes and a 10% fine to the IRS.
- If you withdraw after 59 1/2 years old you will pay taxes and this money will be treated as income. This may affect your social security or Medicare payments when you are older depending on the laws at that time.
- You are required by law to start taking disbursements starting at 72 years old.
- Contributions to a Roth IRA depends on your income and as of 2022:
Single or married filing separately making under $104,000: Full Contribution
making between $104,000 to $144,000: Partial Contribution
over $144,000: No Contribution
Married filing Jointly making under $204,000: Full Contribution
making between $204,000 to $214,000: Partial Contribution
over $214,000: No Contribution
- There is something called a Back Door Roth that makes it so everyone can take advantage of the Roth IRA.
How does this work?
1) Open a Traditional IRA account and fund it.
2) Open a Roth IRA
3) Transfer the money from the traditional IRA to the Roth IRA.
Several online brokerages make this really easy to do.
- After you have owned the Roth IRA account for 5 years you can withdraw your contributions at any time.
- If you withdraw any gains from your investments prior to 59 1/2 years old you will pay taxes on your gains and a 10% fine to the IRS.
- After 59 1/2 you can withdraw both your contributions and your gains from investments without paying any further taxes. This means it IS NOT counted as income on your tax forms.
Example: You contribute $6,000 a year for 10 years and invest it in a SP 500 index which averages a 8% return yearly. You contributed $60,000 total and your investments gained an additional $46,000. You have $106,000 in your account and when you withdraw it you do not have to pay any taxes.
- You are not required to take disbursements over 72 years old.
Keep in mind that Roth 401Ks and TSP are now available with the same tax advantages. It's worth it to check into your retirement options.