Tax Series Part 3: Retirement Plans and Taxes

Tax Series Part 3: Retirement Planning and Taxes | www.TheHeavyPurse.comOne of the tax questions I get most often is about retirement plans. Our expectations to what retirement will look like varies from person-to-person, but overall most expect to lead an active life for 20-30 years in retirement, which requires a significant amount of savings.

During my 23 years in practice, I have seen fewer pension plans every year. Employers have moved from defined benefit plans (pensions) to defined contribution plans (employee contributes and employer will often match), which many of us recognize as a 401k or an equivalent plan.

Retirement in the 21st Century

The new reality is that we can no longer expect our employer to automatically reward us for years of service by taking care of us in our golden years. Nor will Social Security provide our dream retirement lifestyle. This requires a change in mindset for many, particularly for baby boomers, whose parents lived off their pension and social security in retirement and may have expected to do the same.

Bottom Line: We are now responsible for saving for our own retirement.

The good news is we have more control than ever over on how we spend our retirement years and when we can retire too. The bad news is that too few of us are saving at the rate we need to fund even a bare bones retirement, much less our dream retirement.

Bottom Line: People will need to work longer than expected (or desired) because they cannot afford to quit.

Social Security Fun Fact

In their most recent survey of consumer finances, the Fed noted the average balance in a retirement account for people ages 55-65 is $120k. This is a low number when you consider current life expectancies. I still use Social Security in my planning for clients, but it is not THE plan. The additional income helps but likely will still be inadequate for most.

Social Security Tax Fun Fact

Did you know that more money is going in than coming out? An average “high income’ American couple (defined as having a joint income of at least $125,000) planning to retire in five years in 2020 will pay $909,000 in lifetime Social Security taxes but only receive $756,000 in Social Security benefits. In other words, for every $1 paid they paid in taxes, the couple will receive $0.83 in benefits (source: Urban Institute).

I will be dedicating another series to Retirement Planning, but I want to start by first outlining the different types of retirement plans and their tax benefits.

What Are Qualified Retirement Plans?

Qualified Retirement Plans (pre-tax money) are usually made available to employees by an employer. They are typically a 403 (b), 401k, 457, SAR-SEP, Simple IRA or Simple 401k.

Tax Benefits of Qualified Retirement Plans

This money comes out of your compensation pre-tax, which lowers your taxable income for that year. It also allows the entire dollar (because it hasn’t been taxed yet) to go to work for your retirement. The taxes are deferred until you use the money or turn 70 1/2.

What Are Required Minimum Distributions

The 70 1/2 Required Minimum Distributions, often called RMDs, are required annually. They are calculated based on the balance of all your Qualified Accounts (tax deferred) on December 31st of the previous year. Then the IRS calculates how much you need to withdraw based on a uniform life expectancy table.

For example, you have $300k in qualified plans and are 70 1/2 this year. You would use the current tables, which states that you would use 27.4 years in your calculation.

$300,000 / 27.4 = $10,948.91

To calculate: Divide $300k by 27.4 which equals $10,948.91. This is the amount you need to withdraw by December 31st this year or face a 50% penalty or $5474.45. You then need to report this number on your taxes.

Safety Tip: It gets tricky when you have several accounts in different places to make sure you are taking your RMD correctly. You may want your financial advisor and/or CPA to assist you with this to avoid any penalties.

Retirement Plans for Small Business Owners

For the small business owner not all retirement plans are created equal, and each plan has a different set of rules around what you can contribute. For many of the plans, if you have employees, you will need to contribute for them as well. I would highly recommend that you consider sitting down with your financial advisor to make sure you are taking full advantage of the tax deferral and savings plans available to you as a business owner. It’s been my experience that most small business owners are so busy creating successful businesses that they miss huge opportunities to save money for their future.

What Are IRAs?

IRA stands for Individual Retirement Account, which you typically set-up yourself, rather than an employer-based program. They offer tax benefits and are commonly used to supplement a Qualified Retirement Plan.

Work with your CPA or financial to determine if you are eligible to deduct your contribution as there phase out ranges for the deductibility of contributions. A non-active participant (someone who is not earning money) can contribute and deduct an IRA if they have an active participant they file taxes with. Again, there are phase out ranges.

Did You Know: If your children earn any money, they are also eligible to contribute to an IRA. Starting their retirement savings at such a young age, gives their money plenty of time to grow and a real advantage over their peers.

Retirement Savings and You

This is a broad topic in taxes and each of your situations is unique to your family. Retirement savings, if done correctly, can save a substantial amount of taxes during your working years, while allowing you to use the whole dollar to save. The best part is you can’t miss what you don’t see (most set-up automatic contributions to Qualified Retirement Plans and IRAs), so it’s easy, painless savings that has a significant impact on achieving your retirement goals.

One important note on Qualified plans and taxes: Don’t just consider the tax impact/benefit today but also in retirement. More to come on this topic!


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March 2, 2015  •  11 Comments  •  Taxes

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  1. Monday, March 2nd, 2015
    Why is that so? (I am referring to the SSS). How come that we get less than what we paid for? This seems unfair. Thanks for this Shannon. I am gonna read all your post on retirement plans and taxes for me to answer my question and be educated more on taxes.
  2. Monday, March 2nd, 2015
    What an awesome post, Shannon! So thorough. :) The Social Security stuff is scary. I don't know how they thought it was a good idea to start a system that paid people with money they didn't pay in. It was doomed to fail from the beginning. That's government thinking for you.
  3. Monday, March 2nd, 2015
    Another excellent post on this Shannon! :) It is concerning, to say the least, to look at SS and think of what those who're counting on it are going to do if it doesn't meet what they need...especially if they didn't put away enough themselves. That said, we go the route of SEPs and a Roth for both Nicole and I. The SEP is just a no-brainer in my opinion as we get to put away a chunk of money and save on taxes. However, we're actually going to speak with our CPA this year about moving to a Solo 401(k) potentially. I know some brokers charge admin fees, which I'm not a fan of, but if it results in us being able to put away more and save more then it could be worth it.
  4. Monday, March 2nd, 2015
    Social security is so depressing to me. I know I won't get anything close to what I paid in by the time I am eligible!
  5. Monday, March 2nd, 2015
    Our retirement plan doesn't even take social security into place. I fear it will be completely gone by the time we retire. If not, great: bonus income. But we're planning for it to not be there.
  6. Monday, March 2nd, 2015
    I think a lot people don't realize that kids who earn money can contribute to an IRA. That's a great way to get them into investing. I also think it will help them manage their 20s when they are more apt to spend. If the money is tied up in an IRA that has penalties for early withdrawal, they may be less likely to use it. In other words, the restrictions serve as a barrier that makes them at least think twice about drawing money from it.
  7. Monday, March 2nd, 2015
    I think SS will still be around when it's my time to collect...still almost 30 years away, but I'm not counting on it and I have a feeling it will be reduced, or maybe even means tested...who knows. I think in government and have a pension plan. I am pretty lucky in that respect, but a small part of me prefers to have a 401k with generous employer matching. I want to have more control and the pension plan is a bit of a golden handcuff. Vesting nowadays is 10 years and if you leave early, you're severely penalized. It kind of makes leaving the job a tough decision, even though you don't necessarily enjoy all that much.
  8. Monday, March 2nd, 2015
    Great post. I like how you break down some of the information and that you pointed out how much more we are putting into social security than what we will get out of it. I can't wait to read your retirement series!
  9. Monday, March 2nd, 2015
    I have always assumed that social security will not be a part of my retirement options, so I have made retirement planning a priority. I hate to see older clients with little cushion to help them on the retirement part of their life journey. I would rather have the unexpected "surprise" of social security money than to be surprised in the opposite way.
  10. Monday, March 2nd, 2015
    I would love to opt out of social security and have DIY retirement. It's fun to dream. I do worry a bit about the pension eligible jobs that are still around (Jim has one). I can see the state changing the rules and making employees work longer or get less than originally promised. So many people don't save anything extra. You are so right that we have to be responsible for our own retirement and not depend on the government or anyone else.
  11. Wednesday, March 4th, 2015
    As someone in their mid-20s, I pretty much assume I will receive $0 in social security. It's unsustainable with current population trends. I think of the money I put into the program as "sunk costs." Also, this fact is terrifying: "the average balance in a retirement account for people ages 55-65 is $120k." I really hope the next generation saves more, but I'm not optimistic...unfortunately : /
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    "As a Certified Financial Planner, it is my passion to help individuals and families build a healthy relationship with money. I look forward to helping you raise financially confident kids.” - Shannon Ryan