Retirement plan assets are favored in our tax code. These plans include pension plans, profit-sharing plans, stock bonus plans, 401(k) plans, 403(b) plans and IRAs. Their earnings grow tax deferred, and often the contributions are made with pretax dollars. The tax favored status of these plans can enhance the size of your retirement fund substantially over time.
Let's do a quick comparison to illustrate. Judy plans to save $5,000 each year for 30 years for her retirement. She can participate in a qualified retirement plan, or she can choose taxable accounts such as an ordinary savings account or a mutual fund. Either way, we'll assume that the money is invested in assets that earn a total return of 7.5 percent per year.
If Judy puts the money in a retirement plan, so that she is not taxed on the $5,000 contributions and taxes aren't imposed on the growth, she will accumulate more than $550,000.
Instead, if Judy's investments are in a taxable account and not in the retirement plan, and her contributions and earnings are taxed each year at her 28 percent federal tax bracket, her 30-year total will be only about $270,000. This is much less than tax-free growth, and it illustrates the effect of taxes.
The flip side is that the $270,000 account can be accessed at any time without any tax consequences. On the other hand, the $550,000 account is taxable to Judy as she receives distributions from the account. Plus, IRA penalties apply if she makes a withdrawal before age 59 1/2 with limited exceptions.
When the Taxes Do Kick In
Qualified retirement plan distributions are taxed to you (normally at your ordinary income tax rate) as they are removed from the plan.
The exception to this is the Roth IRA. The Roth IRA is almost the reverse of the standard IRA. Taxpayers and their spouses are able to make nondeductible contributions of up to $5,000 in 2009, yet the distributions are typically not taxed. Catch-up contributions up to an additional $1,000 are allowed for individuals who have attained age 50.
Regardless of the type of plan, however, retirement plan assets are subject to taxation in a person's estate at death. They potentially face an estate tax and (with the exception of the Roth IRA) an income tax. This means that special planning is in order if you wish to pass the remainder of your retirement plan to heirs.
The most popular option is to name a charity as beneficiary of all or a portion of your retirement account. Whatever amount is left to charity will avoid income and estate taxes.
Another tax-smart option for some people is to arrange for a testamentary charitable remainder trust to be established upon your death using the assets in a retirement plan. The trust could pay an income stream to selected beneficiaries and after their lifetime, it pays the remaining balance to Kappa Alpha Order Educational Foundation.
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The information in this Web site is not intended as legal advice. For legal advice, please consult an attorney. Figures cited in examples are for hypothetical purposes only and are subject to change. References to estate and income tax include federal taxes only. Individual state taxes and/or state law may impact your results.
