Helping Participants Understand Tax Considerations for Retirement Plans

What should plan sponsors ensure that participants understand about the tax treatment of retirement savings accounts? Sources say there are a few key points that participants should readily be able to understand.

The most important tax consideration that people should understand about putting money “into a tax qualified account is that they get to avoid paying income tax on those deferrals,” says John Vento, an adviser with Avantax Wealth Management in New York. “This puts a person in the best position to accumulate wealth in a tax-efficient manner.”

He explains: “If you invested $100,000 in any type of account other than a qualified plan, you would have to first pay taxes on that money, whereas if you defer the tax by investing the money in qualified retirement plan, you will earn gains on your investment, including the money you didn’t have to give to the government. If I told you I could give you an interest-free loan throughout your working years and permit you to slowly pay me back that money in your retirement years, you would jump at that opportunity.

“That is how I like to explain the benefits of contributing to a qualified retirement plan. It is a powerful tool to help people accumulate wealth,” Vento continues. “I am a huge fan of qualified plans. They give people an opportunity to save money on taxes up front and almost double their earnings abilities going forward. For example, if a person was in a marginal tax rate of 50%, if they contributed $19,000 to a 401(k), they would have that full $19,000 working for them, whereas in a non-qualified account, that investment would be only $9,500.”

As for how gains on investments inside of a qualified plan are treated, like contributions, they, too, are tax-deferred, says Mark Astrinos, a member of the American Institute of CPAs’ Personal Financial Specialist Committee and a principal of Libra Wealth in San Francisco. “For a tax-qualified account, when an investment is sold at a gain, there are no taxes due,” Astrinos says.

“This is because all income tax is deferred in a tax-qualified account, meaning that you can sell investments at substantial gains within the account and pay no capital gains tax,” he continues. “This is one of the advantages of these types of accounts compared to standard taxable accounts where you would be subject to capital gains taxes if the investment was sold. Therefore, the deferral of capital gains allows your account to grow much more over time than if the taxes were taken out each time an investment was sold.”

David Reyes, financial adviser and chief financial architect at Reyes Financial Architecture of San Diego, says it is also important for people to understand that “[qualified defined contribution plans] are illiquid investments. If you choose to take your money out before age 59 ½, you will pay ordinary income tax [on the money] plus a 10% early withdrawal penalty—unless the money is used for higher education or medical bills.”

It is precisely because of the tax deferrals in qualified accounts that Comprehensive Wealth Management advises retirees to first withdraw money from taxable accounts. “There are required minimum distributions [RMDs] starting at age 70 ½,” Vento explains. “If a person has retired before that age and has income sources other than their [DC plan] or IRA, they are better off living on that alternate income because it gives them additional time to earn more money on their qualified accounts and keeps them in a lower tax bracket in their early retirement years.”

In addition, Reyes says: “Typically, 85% of your Social Security income is taxed as ordinary income, and if you have pension income, this is also taxed as ordinary income. Therefore, I advise clients to take money out from taxable accounts initially, which is taxed at lower capital gain rates.”

Roth IRAs and DC plan accounts work in the opposite manner of traditional versions of these accounts, Vento says. Contributions are made after taxes are withheld, meaning there is no up-front tax break, but the money grows and is withdrawn tax-free, he says. “For the right person in the right circumstance, the Roth might be a better choice,” he says. “If you are a high income tax payer right now, the Roth might be costly. If you are a lower income earner, then a Roth might look more attractive. And if you just can’t predict if you are going to be in a lower tax bracket in your retirement years, then traditional accounts are the right choice.”