Where Do You Start?
Providing for a comfortable retirement requires comprehensive planning, taking into account cash flow, income taxes, available assets, retirement plan distributions, and preferred lifestyle. The goal is to match expected expenditures to projected retirement income cash flow and provide for contingencies (such as extended illness, rapid inflation, and investment losses).
Most individuals share similar concerns when they consider their retirement years. These concerns include having enough income to live comfortably, providing security for a spouse or children, minimizing income and transfer taxes, accounting for inflation, and outliving assets.
Determining Your Retirement Income Needs
Take a serious look ahead to determine how much income you will need to maintain your current lifestyle when you retire. When you estimate how much income you will need, take into account inflation, future tax rates, and the investment returns on your retirement savings. Most retirement planning advisers say that you will need 60 percent to 80 percent of your pre retirement income to maintain your current standard of living.
To evaluate future income sources, start with Social Security. The Social Security Administration website has a retirement benefit estimator that can determine your maximum benefit at your normal retirement age (generally, age 65–67) and your maximum benefit at age 70.
Should You Have an Individual Retirement Arrangement?
Traditional individual retirement arrangements (IRAs) were first introduced to encourage taxpayers to save for retirement even if their employers did not offer retirement savings plans.
Many working Americans qualify for at least a partial income tax deduction for retirement savings. You may make a deductible IRA contribution of up to the lesser of $6,000 or 100 percent of earned income (or $7,000 for individuals age 50 or older), provided neither you nor your spouse is an active participant in an employer-sponsored plan.
Next, consider retirement distributions you can expect from your company’s qualified retirement plan. Talk to your Human Resources person or plan administrator to get an estimate of future distributions at different retirement ages.
Beyond these types of retirement income, you will have to develop resources on your own through other savings and investment strategies. Most people have to provide for at least 40 percent of their retirement income from other sources.
Other retirement instruments, such as annuities, enable tax-deferred accumulation of earnings but without the contribution restrictions of an individual retirement account. An annuity allows you to choose guaranteed life income payments or payments for a predetermined period of time, usually beginning at retirement.
A comprehensive investment program is an integral part of retirement planning, with periodic adjustment of strategies to fit your objectives as you progress toward retirement.
Your tax adviser can help you determine your retirement needs and develop a feasible retirement savings plan.
Traditional IRA's
Contributions to traditional IRAs may be deductible for taxpayers who are eligible for employer retirement plans but only up to certain limits based on income and filing status.
However, nondeductible contributions to a traditional IRA still provide tax-deferred accumulation of investment earnings that may be beneficial, especially if you expect to have a lower tax rate once you are retired, and also provide a first step for a Roth IRA conversion.
Traditional IRA contributions are generally taxable as ordinary income on distribution; if the contributions were nondeductible, only a part of the distribution may be taxable. Distributions before age 59½ may be subject to an early withdrawal penalty. At age 72 (or at age 70½, if you reached age 70½ by December 31, 2019), you would generally have to start receiving minimum required distributions from the IRA.
If you are at least age 72 (or age 70½, as applicable) and have a traditional IRA, you may be able to make a qualified charitable distribution (QCD) from your IRA to an eligible charity (up to $100,000) without having to pay tax on the amount transferred to the charity. The QCD counts toward your required minimum distribution but is not included in taxable income. It also cannot be used as a deductible charitable contribution. The QCDs reduction in AGI may have a favorable impact in cases were limitations or phase outs are based on AGI.
This rule applies to traditional IRAs. While it is possible to make a QCD from a Roth IRA, there is generally no advantage in doing so since Roth IRAs are not subject to the required minimum distribution rules (during the owner’s lifetime) and distributions are not taxable.
Roth IRAs
A Roth IRA is an IRA with a special tax structure. Contributions to a Roth IRA are not deductible, but the eventual distributions are not included in income (and thus earnings are distributed tax free). In addition, a Roth IRA is not subject to the required minimum distribution requirements that apply to an IRA, so the amounts can be left in the Roth IRA until needed. Special penalties apply to distributions from a Roth IRA before the Roth IRA has been in existence for five years and before you reach age 59½.
Note: Roth IRA contributions may not be recharacterized as a contribution to a traditional IRA. If you convert a traditional IRA to a Roth IRA and later find that the conversion was not a good strategy (for example, the investments had declined in value or you did not have the cash to pay the taxes resulting from the conversion), you cannot recharacterize the Roth IRA contribution as a contribution to a traditional IRA. Therefore, you should be very careful when you convert a traditional IRA to a Roth IRA.
Roth(k) Contributions
401(k) plan can be designed to allow plan participants to elect to defer amounts as pretax contributions (normal 401(k) elective contributions) or as post-tax Roth contributions. Post-tax Roth contributions (sometimes called Roth(k) contributions) are generally treated the same way as the pretax contributions except with respect to income tax (both are subject to Social Security and Medicare taxes on contributions and subject to the same dollar restrictions). An employee can choose to contribute partly pretax and partly through Roth(k) contributions.
Like Roth IRA contributions, Roth(k) contributions are taxable as made, and the contribution amount and accrued earnings on the contributions are not taxable on distribution so long as the Roth rules are satisfied at the time of distribution. Thus, the first Roth(k) contribution starts the five-year Roth holding period. The amounts in a Roth(k) account can be rolled over to a Roth IRA if all of the requirements are satisfied.
In-Plan Roth Conversions
Some plans now also allow “conversion” of pretax contributions (such as 401(k) elective contributions) into Roth accounts within the same plan. On conversion, the pretax amounts are not distributed to the individual and remain in the same plan, but the amounts converted are subject to ordinary tax in the year of the conversion. Once in the Roth account, the earnings accrue under the Roth rules and can eventually be rolled over to a Roth IRA if all of the Roth rules are satisfied at the time of distribution. As with other Roth accounts, there is a five-year holding period on converted amounts. There is no withholding within the plan on these conversions, so you would have to be prepared to pay the tax on the amount converted from other sources of cash.
If you need a short-term loan, under the rollover rules, you may withdraw money from an IRA temporarily and redeposit the full amount within 60 days in the same or a different IRA without tax consequences. Only one rollover of this type, however, is generally permitted in any 12-month period.
If you are divorced and receive alimony, you can make an IRA contribution even if all your income is from taxable alimony.
Other IRA and Roth IRA Issues
Contributions to an IRA in excess of the limits are subject to an annual 6 percent penalty. Also, money generally cannot be withdrawn from an IRA without a 10 percent penalty tax—except in substantially equal payments over your life expectancy (or the joint life expectancy of you and a designated beneficiary)—until after you are at least age 59½, disabled, or deceased.
Consider the gift of an IRA or a Roth IRA contribution on behalf of a working child or grandchild. By taking advantage of the annual gift tax exclusion, you can make a contribution for another person up to the lesser of his or her earned income for the year or the IRA limit for the year, generally $6,000. The contribution is treated as a gift to the account holder so be sure to also take into consideration other gifts that you may have made during the year when determining the amount of your contribution.
Retirement Savings Through an Employer's Plan
Many employers have established 401(k) plans (or 403(b) plans for certain tax-exempt organizations—because 401(k) and 403(b) plans have similar rules, they will be discussed together). If you are enrolled in a 401(k) or 403(b) plan, you can reduce your salary by making pretax plan contributions (which are still subject to Social Security and Medicare taxes).
Some 401(k)/403(b) plans permit Roth(k) contributions as well as pretax contributions. Roth(k) contributions are includable in taxable income, but distributions are not. Your employer may match a portion of your pretax or Roth(k) contributions.
Some plans allow additional after-tax contributions. These funds accumulate tax deferred, and you pay tax only on the earnings when you receive distributions at retirement or later.
Consider making some Roth(k) contributions to the 401(k) plan. Roth(k) contributions are taxed as contributed, but related earnings are never taxed if they’re held in a Roth(k) for at least five years and distributed only after age 59½. The amounts can be rolled over from a Roth(k) into a Roth IRA at distribution and held until needed. As noted above, Roth IRAs do not have required minimum distributions during the owner’s lifetime.
Make maximum contributions to your 401(k). For contributions made with pretax dollars, you save taxes now and accumulate tax-deferred retirement savings. If the plan allows, you may withdraw contributions to a 401(k) plan when you terminate your employment or if you face financial hardship, as defined in stringent IRS regulations. If you withdraw funds before age 59½, you generally will be subject to a 10 percent penalty tax in addition to ordinary income tax. On termination, you can direct the plan administrator to roll over the amount to an IRA or a new employer’s plan without paying any tax at the time of the rollover, allowing further tax deferral until you need to take distributions.
If you need a loan and have money invested in your company’s 401(k) or 403(b) plan, you may be able to borrow against your savings. Although loan conditions vary according to plans, the interest rates tend to be lower than for other consumer loans, and the interest you pay goes back into your account in the retirement plan. In most cases, the interest you pay is nondeductible.
Nonqualified Deferred Compensation
Your employer may provide additional opportunities to defer your income by establishing a nonqualified deferred compensation plan. Such plans have no mandatory contribution limits, and employers generally may use their discretion as to who will participate. You generally get the benefit of deferring income tax on these amounts until they are distributed. As with all deferred compensation (other than Roth IRAs and Roth 401(k) accounts), you receive compensation (taxed at ordinary income rates) on amounts deferred once distributions are made under the plan. You may, however, be subject to Social Security and Medicare taxes in the year of vesting if the amounts are vested prior to the year of distribution. Unlike qualified retirement plans, your employer cannot deduct the promised compensation until the year in which the distribution is made.
Remember, however, that you are a general creditor of the corporation with regard to this deferred compensation; therefore, in bankruptcy, the corporation’s secured creditors will be paid before you. In many cases, there is nothing left with which to pay the nonqualified deferred compensation. Another consideration with respect to a nonqualified deferred compensation plan is that distributions will be taxed as ordinary income and may be subject to Social Security and Medicare withholding.
Planning for Retirement Distributions
Retirement planning involves determining future needs and how your resources will satisfy those needs. Penalty taxes apply to early distributions, late distributions, excess distributions, and distributions of less than the required minimums with respect to tax-qualified plans. You also must consider the effect penalties will have on undistributed retirement plan balances that are part of your estate. To avoid incurring these penalties, you should review your retirement plans and applicable rules to determine the optimum method of taking distributions.
The most advantageous way to receive retirement distributions from an employer’s plan or an IRA depends not only on penalty taxes and your need for income but also the extent to which the amounts are taxable on distribution.
Minimum Annual Distributions
You generally are required to take minimum annual distributions from most qualified retirement plans no later than April 1 of the year following the year in which you reach age 72 (or age 70½ if you reached age 70½ by the end of 2019) or once you retire, if you are not at least a 5 percent owner. Distributions for subsequent years must be made by December 31 of each year. For example, if you reach age 72 in 2022, you must begin receiving distributions by April 1, 2023. However, delaying the required 2022 distribution until 2023 will force you to include in your 2023 taxable income required distributions for both 2022 and 2023.
The minimum annual distribution amounts are determined by calculating the amount necessary to distribute the retirement plan interest over your life or over your life and that of a designated beneficiary. The minimum annual distribution rules allow you to avoid depletion of your retirement savings through annual recalculation of your life expectancy (and the life expectancy of your designated beneficiary if that person is your spouse).
If minimum distributions are required, the amounts must be taken out timely. Otherwise, you will be subject to a penalty totaling half the amount you should have withdrawn.
IRA distributions must begin by April 1 of the year after you turn age 72 (or age 70½, if you reached age 70½ by the end of 2019). If you keep money in your employer’s plan (if permitted), you can avoid required minimum distributions while you are still working as an employee of that employer (provided you are not a 5 percent owner of the company).
Roth IRAs do not have required minimum distribution requirements.
For individuals other than at-least-5 percent owners, as long as you are working at least part-time as an employee, amounts held in your employer’s 401(k)/403(b) plan do not have to be distributed as required minimum distributions starting at age 72 (or age 70½, as applicable). Some companies allow you to roll over IRA amounts so you can prevent required minimum distributions until you are ready to stop working. Consider designating a younger beneficiary in order to minimize the required minimum annual distributions and delay them as long as possible. If the beneficiary is your spouse, you can recalculate your and your spouse’s life expectancies. However, this is not a decision to be made lightly. If you elect to recalculate life expectancy, the distribution is treated as a single life annuity when one of you dies. If either of you is not in good health, recalculation may not defer distributions.
Taxation of Distributions
A 10 percent penalty tax generally applies if you receive tax- deferred retirement savings from your 401(k) or qualified pension plan or from your IRA before you reach age 59½, die, or become disabled.
The penalty does not apply to the extent you rollover amounts to an IRA or another qualified plan. Distributions that are made in substantially equal payments over your life expectancy (or the joint lives of you and your beneficiary) are also exempt from the penalty. If the payment schedule is modified for reasons other than death or disability, the taxable amount will be calculated by applying the 10 percent early withdrawal penalty retroactively if you are not age 59½ and have not been receiving payments for at least five years.
You can defer taxes on a lump-sum distribution and certain partial distributions by rolling the distribution amounts into an IRA or, when permitted, to another qualified plan. The plan administrator can usually do a “direct rollover” or trustee-to-trustee transfer to another plan or IRA. Otherwise, you need to move the money within 60 days.
If you receive your distributions in the form of a life annuity, you will pay tax in the year in which you receive each payment.
Beneficiary Designations
Consider reviewing your beneficiary designations and elections each year or as warranted by other significant life events. The SECURE Act made more restrictive rules that generally require that IRA and retirement plan accounts be fully distributed within 10 years of the account owner’s death, with a few exceptions including for a surviving spouse and minor children.
Keep in mind that spousal consent may be required in some cases when changing the beneficiary designation on certain plans or accounts.
Witholding Requirement
If you do not elect to have your qualified plan (e.g., 401(k), 403(b) or defined benefit plan) distribution transferred or rolled over directly to an IRA or another qualified plan, you will receive only 80 percent of your distribution. The remaining 20 percent will be withheld to pay income taxes. This is the case even if you plan to roll the funds into an IRA within 60 days of receiving the distribution. Of course, you will not owe tax on the amount you roll over. But if you only receive 80 percent of your distribution and only roll over that 80 percent, you will be taxed on the 20 percent withheld. Also remember that any portion of the distribution not rolled over may be subject to the 10 percent penalty on early distributions in addition to ordinary income taxes if you are under age 59½ and do not meet certain other exceptions.
Elect a direct transfer from your plan to an IRA or another qualified plan to avoid the withholding rule. You can withdraw the funds from the IRA with no withholding.
If you do not do a direct rollover, contribute the 80 percent distribution plus out-of-pocket cash equal to the 20 percent withheld within 60 days of distribution. You will receive a refund for the withheld amount (adjusted for your other ordinary income taxes due, if any) after you file your income tax return for the year.
To determine the optimum method of taking distributions and the timing of those distributions, evaluate your retirement plans in conjunction with such factors as your age, health, beneficiaries, and cash flow requirements. Work closely with your tax adviser to consider the complex rules that govern distributions.
Social Security Benefits
If you are under your normal retirement age (between age 65 and age 67, depending on your birth year) and are still employed but are taking Social Security benefits, your Social Security benefits will be reduced if your current earnings exceed a prescribed limit.
You should review the Social Security Administration (SSA) report on earnings and confirm that it is a correct record of your earnings. To correct an error, you must notify the SSA within three years, three months, and 15 days after the year in which your wages were paid or your self employment income was derived. In some circumstances, your earnings record may be corrected even after this time limit has expired. You can check the SSA website (https://www.ssa.gov/) to obtain this information and model payments at various ages.
If you are newly eligible for Social Security benefits and would be subject to tax on the Social Security payments, you may want to delay applying for those benefits. Doing so will increase the monthly benefits you are eligible to receive. However, you should sign up for Medicare at your normal retirement age, as medical insurance may cost more if you delay application.
Cross-Border Benefits Considerations
If you have performed services outside the United States during the course of your career, your retirement and other benefits may be subject to taxation in more than one country. All of the relevant facts should be considered along with relevant sourcing rules and applicable treaty provisions in analyzing the proper tax treatment of the benefits or any distributions you may receive in retirement. Careful consideration of the tax treatment may be necessary prior to any decision to take a distribution or transfer amounts.
