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Tax Planning for Retirement Plans: Understanding the Main Types of Retirement Accounts

Understanding the benefits and drawbacks of different retirement plans is crucial to long-term tax planning. Most retirement plan investment earnings are taxed at ordinary income tax rates—you receive an ordinary tax deduction for every contribution, and you pay ordinary income tax rates when you withdraw funds. However, certain types of retirement plans come with special tax exemptions and other financial benefits, which taxpayers can take advantage of with some advance planning. 

Below, we’ll review six common types of retirement plans:

  1. Defined contribution plans include 401(k) or 403(b) plans, as well as traditional, SIMPLE, and SEP IRAs. These plans are typically tax-deferred—an employee and/or employer makes contributions regularly, and the benefits are based on the contribution amounts plus any investment earnings on those contributions. The investment earnings tend to be unpredictable, since that depends on market performance. 

Defined contribution plans place limits on how much money you can put in and withdraw in a certain time period. Employer contributions are tax-deductible, and employees will not pay taxes while the money stays in the account. However, once funds are withdrawn, they will be taxed at ordinary income tax rates.

  • Defined benefit plans are pension-type plans. These accounts define the amount of retirement benefits employees will receive, so there’s less ambiguity than we see with defined contribution plans. When employees retire, they receive an annuity stream of fixed and regular payments. The only restriction is that the IRS puts a cap on the highest benefit amount the participant can receive within a year once payments begin. As with defined contribution plans, the full amount is taxable when withdrawn. 

Some governmental retirement plans may allow account owners to make additional after-tax contributions to their plan. If this is the case, those contributions would be tax-exempt when they are withdrawn.

  • Social Security is an often overlooked type of retirement plan [link to new Social Security article] with significant tax advantages. The average American will receive about a million dollars in Social Security benefits in their lifetime, but most people don’t approach Social Security as a planning opportunity. The taxable amount is calculated using a formula based on your provisional income. Once your provisional income exceeds $44,000 dollars, these benefits are taxable up to 85%. So in a best-case scenario, 15% of that $1 million in (average) benefits will be tax-free. 
  • Roth IRAs are a popular and flexible type of individual retirement account [link to new Roth IRA article] that allow for tax-free withdrawals, but contributions are not deductible. 
  • For annuities and insurance type products, the principal is tax-free, but the rest is taxable at ordinary income tax rates. Annuities can be a great investment option because the taxpayer has a certain amount that is guaranteed to be available for retirement. With this account type, the taxpayer is buying an annuity: the insurance company borrows the taxpayer’s money for a set period of time, and in exchange, the insurance company provides the taxpayer with a stream of income starting at a certain date. Though the principal is not subject to tax, the majority of the annuity is typically taxable when it is received. 

If an insurance investment or an annuity provides an opportunity for loans, that could factor into an overall tax strategy. When the insurer offers loans secured by cash value in the plan, the loan proceeds are tax-free. So the taxpayer can take a loan during retirement, which is not going to be taxable. The loan will then be paid off upon death by the death benefit of that policy, and the insurance proceeds will also be tax-free to the beneficiaries. 

  • Finally, we have this set of traditional investment types: bank accounts, stocks, bonds, and mutual funds. The interest from these investments is taxed at ordinary income tax rates, but qualified dividends, capital assets, stock transactions, and real estate all have the potential to be classified as long-term capital gains, which can lower the tax rate from 0% up to 20%.

In order to effectively plan ahead for retirement, taxpayers also need to be aware of the tax implications for their retirement plans. Learn how to guide clients through the ins-and-outs of retirement plan tax benefits by becoming a Certified Tax Planner.

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