How are you planning for retirement? Are you saving and investing enough? Some tax considerations for your retirement savings account.
Retirement accounts and retirement plans are excellent for saving money and building your wealth on a tax-deferred or tax-free basis. In fact, as of 2003, Americans held over $6.5 trillion in a combination of IRA’s, 401(k) plans and other retirement accounts. But these accounts can also be a tax trap, though, if you aren’t aware of the rules regarding transferring retirement money, inheriting retirement money or leaving the money to your children. And let’s not forget the typical 50% penalty for withdrawing money from your retirement accounts for unapproved reasons, and the often additional 10% penalty for taking the money out before you are 59 ½ years old.
In a study conducted by the Internal Revenue Service in 2003, it was estimated that 4.9 million taxpayers paid out $3.4 billion in retirement account penalties — and most of that was for taking money out before the account holders were 59 ½ years old.
Image from ABC News.
Here are a few action items you may want to consider taking, in order to avoid tax traps involving your retirement accounts. You may want to check with a tax advisor if any of these ideas and tax tips may be a fit for your specific financial situation.
Your Retirement Savings Account: How To Avoid Tax Problems
1. Consider a Roth IRA’s tax benefits.
Most people who manage an investment portfolio have retirement accounts, and know that diversification is the key to reducing investment risk. If your employer offers a 401(k) plan with a matching program, you should contribute enough to receive the maximum amount that your employer will match. (That’s free money to you!)
If you are eligible, you can also contribute to a Roth IRA and allow your earnings to grow tax free for decades — but the good news is, when faced with an emergency you can withdraw the money you’ve contributed without penalty.
Eligibility requirements for contributing to a Roth IRA are based on your income level and filing status. Your modified adjusted gross income must be less than the following, according to your tax filing status, so that you’re eligible to contribute to a Roth IRA (from the Investopedia):
- $166,000 for individuals who are married and file a joint tax return.
- $10,000 for individuals who are married, lived with their spouse at anytime during the year, and file a separate tax return.
- $114,000 for individuals who file as single, head of household, or married filing separately and did not live with his or her spouse at any time during the year.
2. Rollover your retirement funds into an IRA.
If you are leaving an employer to work for someone else or to become self-employed, most financial advisors will tell you that it’s better to roll your 401(k) balance into an IRA rather than leaving it in the plan with your previous employer, or rolling it into a new 401(k) plan through your new job. This is because an IRA will give you more flexibility — you can select your own investments with your IRA, among other benefits (like converting to a Roth IRA).
Money in an IRA can be withdrawn to pay for things like higher education, a down payment on your first home, or to pay health insurance premiums if you are unemployed — none of which you can do without penalty with a 401(k) plan.
3. Make your kids your beneficiaries.
Most married individuals list their spouses as their IRA beneficiaries. What happens if your spouse passes away before you do — or decides upon your death that he or she doesn’t need that money and wants to let it go straight to the kids?
Under IRA rules, if your children or grandchildren are named as “contingent” beneficiaries, and your spouse decides he or she doesn’t need the money — the kids will be able to stretch out the IRA payouts over their projected life spans. They’ll gain decades of extra, tax-deferred or even tax-free growth on the money, as compared to the surviving spouse.
But beware of rules for minor children and get a professional to assist you if you decide to set up a trust to leave IRA money to minor children. There are some money “traps” that exist, which may result in an older family member’s life expectancy (rather than those of the kids’) becoming the basis for distribution of IRA payouts.