Financial Questions that Count: Choosing the Right Retirement Accounts. Is Tax Deferral Important?Submitted by Miller Financial Group, Inc on July 10th, 2019
Today, I want to look at the various choices we have when deciding how to save for retirement. Which type of, or collection of accounts, is right for what you are trying to accomplish? In last month’s blog we discussed the concept of the “3-Legged Stool” which included what I consider to be the three key pieces to a strong retirement income stream.
The third key piece, or “leg on that stool” are the “Defined Contribution Plans,” aka your own retirement savings accounts. Which type of account, or accounts, you should use is going to depend on several factors. That is where I want to dive into today.
One of the first considerations is going to be your tax situation. Taxes should never be your only consideration when choosing which type of account to use, but it should and will play into the decision. Why? Because the IRS looks uniquely at every type of account and the tax rules attached to it. For instance, if your goal is to keep your current taxable income as low as possible while still contributing for the future, tax deferred accounts such as what we are discussing today may be the best choice. If you don’t mind paying taxes today to help ensure tax-free income in the future, you may want to consider the ROTH. Or, if you do not mind paying some taxes as you go, but also realizing that you may potentially face future capital gains taxes as well, then there are even more options to consider such as taxable non-qualified accounts.
Today I want to break down tax deferred accounts. There are two broad types of tax deferred accounts, IRS tax qualified accounts and non-qualified tax deferred accounts. IRS tax qualified accounts include Traditional IRAs, SEP IRAs, SIMPLE IRAs, Traditional 401k plans, SOLO 401k plans, 403B plans and additional categories of tax qualified deferred accounts such as the Thrift Savings Account utilized by Federal Employees. There are several commonalities among these accounts. The first is tax-deductibility. All contributions are made to these accounts with pre-tax dollars and the amount of contributions into these accounts will not be included in current year taxable income. The second is tax-deferral. As long as monies are held in each of these accounts neither the original amount contributed, nor the earnings, are taxed.
The third common trait is that they are all subject to two distinct age-based tax rules. The first is that you must leave the funds in the account until age 59 ½ to be able to withdraw without penalty. There are exceptions to this rule but that is beyond the scope of this blog today. The second age-based rule is that at age 70 ½ you must start taking money out of the accounts which will now be included in your taxable income. These are referred to as Required Minimum Distributions. The amount of these distributions are determined by a formula based upon the age of the IRA owner and the balance in the account on December 31st of the previous year.
Each one of the aforementioned tax-deferred tax-qualified accounts also have account specific rules that apply to each one. Traditional, 401ks, SEP IRAs, SIMPLE IRAs, SOLO 401k plans and 401b plans are all employer sponsored plans. Traditional IRAs are funded by individual contributions or from rollovers from tax-deferred tax qualified employer sponsored plans. I recommend that you speak to a financial advisor to see exactly which type of tax-qualified tax-deferred account is right for you.
In addition to tax-qualified tax deferred accounts there are also non-qualified tax-deferred accounts such as annuities. Annuities come in many shapes and sizes and may be opened with either tax qualified (IRA type) monies or after-tax money. The unique thing about all annuity contracts is that regardless of the tax qualification going into the account, while funds are invested in the annuity contract, they will grow tax deferred. If money is put into the account with after-tax dollars, that is referred to as basis. Your basis will be able to be returned to the owner free of additional taxes. Only the earnings on the basis is potentially taxable when withdrawn. If the annuity is funded with tax-qualified money, all money withdrawn from the contract is potentially taxable.
Another less common type of tax-deferred account is the 457 Deferred Compensation account. The 457 account is unique in that money withdrawn from these accounts are not subject to the 10% early withdrawal penalties like all the other tax-qualified tax deferred accounts listed previously. The account does grow tax-deferred and may also be rolled over to a Traditional IRA and withdrawals are counted in taxable income, but you can get to these funds prior to age 59 ½ without penalty once separating service from the sponsoring employer.
There are many other rules and nuances that must be considered when deciding if tax-deferral is important for you regarding your retirement savings. I recommend that you speak to a financial advisor and your tax advisor regarding which type of tax-qualified tax-deferred account is right for you. None of the information presented today was intended as tax advice.
Next time, we will look at retirement accounts designed to provide tax free growth for the future. And the ROTH is not the only way you may be able to do it!
Daniel S. Miller, CFP®
Miller Financial Group, Inc.