Retirement plans are designed to pave the way for a smooth retirement, covering some or all of your living expenses when you’re no longer working. However, how much of your retirement savings and earnings you get to keep depends on how much in taxes, if any, you need to pay on those funds.
Types of Retirement Accounts
Whether, and how a retirement account is taxed depends on the type of retirement account and the circumstances surrounding contributions and distributions to that account.
Traditional IRA Contributions
Contributions to a traditional IRA are typically tax-deductible. If you or your spouse contribute to a traditional IRA and a retirement plan covers neither of you through your job, you can take the full deduction on those contributions. The amount of that deduction depends on your modified adjusted gross income (MAGI), representing your taxable income minus any qualifying deductions you’ve taken.
If, however, you’re married and a workplace retirement plan covers either you or your spouse, you may not be able to take the full deduction on your traditional IRA contributions. Check with your tax accountant to determine the current deduction limits based on your MAGI.
There are two exceptions, however, to these MAGI limits. If you’re married and you and your spouse file as Married Filing Jointly and your spouse doesn’t have a retirement plan covered through work, you can take the full tax deduction on your traditional IRA contributions regardless of your MAGI. The same applies if you’re a qualified widower or widow or you file as single or head of household and a retirement plan at work doesn’t cover you.
If you take an early withdrawal from your traditional IRA before you turn 59½, you may have to pay the IRS a 10-percent penalty. There are exceptions to this rule, such as withdrawing money early in order to buy your first home.
Roth IRA Contributions
Because you make contributions to a Roth IRA on a post-tax basis, in other words, on taxed income, those contributions are not tax-deductible. Instead, the money you earn in that account and your qualified withdrawals are tax-free and penalty-free.
Any early withdrawals you make before you’re 59½ years old will be taxable. And, as with traditional IRAs, unless you’re withdrawing the funds early to make your first home purchase, you’ll also incur a 10-percent penalty.
The money you contribute to a 401(k) is not considered taxable income and, therefore, is ineligible for a tax deduction.
Similarly to IRAs, you could incur a 10-percent IRA penalty if you’re under 59½ and take a withdrawal from your 401(k). Also, as with IRAs, there are exceptions to this rule, such as if you withdraw the funds after you’ve become completely and permanently disabled. Once you’re 59½ or older, all your withdrawals from a 401(k) are penalty-free.
Whether or not you have to pay taxes on 401(k) withdrawals after you turn 59½ depends on the type of 401(k). If it is a Roth 401(k), you don’t; if it is a traditional 401(k), you do. When taking a distribution from a traditional 401(k), you must report that amount as taxable income on your Form 1040.
Traditional Pension Plan Contributions
Contributions to a traditional pension plan are typically tax-free.
If your employer sponsors your traditional pension plan and you withdraw funds before you turn 59½ year old, you may incur a 10-percent IRS penalty. If, however, you take that early withdrawal because you’ve become completely and permanently disabled, you are exempt from this requirement.
After you retire, chances are you’ll need to pay federal income tax on any monthly payments or lump-sum payments you take from your pension. However, some of that might already be covered by tax withholdings the pension plan’s sponsor takes before issuing any pension checks. There are 14 states that don’t tax pensions; however North Carolina is not one of them.
There are several other considerations to make when determining the tax implications of your retirement accounts.
The Saver’s Credit
If you contribute to an IRA or a retirement plan your employer sponsors, you could qualify for a tax credit on those contributions. You must be at least 18 years old and not a full-time student to qualify.
The amount of the credit is either 10 percent, 20 percent, or 50 percent of your contributions based on your adjusted gross income and tax-filing status. You can earn the Saver’s Credit on up to $4,000 in contributions per tax year.
Pandemic Relief and Taxes
The federal CARES Act grants certain additional benefits to people saving for retirement.
If, for example, you’re under 59½, you can take out as much as $100,000 for eligible retirement plans penalty-free. Any federal taxes payments you may need to make on retirement plan withdrawals you can spread out over three years.
To find out any other CARES Act tax benefits still in effect, ask your tax accountant in Charlotte.
Tips for Managing Retirement and Taxes
While you’re still working, take advantage of whatever pre-tax deductions you can get on retirement plan contributions. If you have a 401(k), consider making the maximum contribution, as long as you can afford to. If your employer offers any pre-tax payroll deductions, such as for supplemental insurance, transportation, or a flexible spending account, be sure to take advantage of those too.
Determine which of your retirement assets could be considered long-term gains. These are any assets you’ve held for more than a year. Long-term gains are taxed at the long-term capital gains rate, which is lower than the tax rates on ordinary income or short-term capital gains. However, if your income, including realized gains, is below a certain threshold, you may not need to pay long-term capital gains tax.
If you hold any retirement accounts that don’t qualify for tax deductions and have currently lost more than you invested in them, consider selling those assets. As a capital loss, they may be partly tax-deductible. However, be sure you consult with your CPA in Charlotte, NC, before taking such action so you don’t recognize a loss when no long-term capital gains tax will be due on those funds.
If you plan to donate to charity, consider which form of giving is most tax-advantageous to you. If you’ve held appreciated stock for longer than one year, for example, consider donating that instead of cash. You could claim a tax deduction on the total market value of the asset, while the charity could turn around and sell the asset without having to pay capital gains tax on the appreciated amount.
For guidance maximizing your retirement savings and earnings while minimizing your tax burden, speak with Scott Boyar, CPA, one of the top Charlotte tax accountants. Protect your retirement, and call 704-527-2725 or contact Scott Boyar online today.