In consultations and in my everyday life, I’ve met more than a few people who aren’t really sure about what a retirement account is and the benefits it gives them. I get it: details sometimes get lost in the balance between work, family, and personal goals. But it’s important information that’s helpful to know. Here are the basics.
Retirement accounts (IRAs, 401(k)s, 403(b)s, etc.) are accounts designed to be funded during a person’s working life, with the accountholder withdrawing money during retirement to augment his or her Social Security income. With the exception of ROTH IRAs (discussed later in this post), the following rules apply.
- Contributions to retirement accounts are made with pre-tax dollars – you don’t pay income tax the year you earn the income you deposit to the account.
- Retirement account balances aren’t taxed immediately, either: money earned in the account isn’t taxed as it grows. However, this tax deferral ends when money is withdrawn from the account.
- Withdrawals from accounts are included in the accountholder’s taxable income the year the withdrawal is made. Since your income tax bracket in retirement likely will be lower than during your working life, it’s likely you’ll pay less tax per dollar withdrawn from the account than you would have had you paid tax when you originally earned the income.
To ensure that retirement accounts are used to save for retirement, rather than as a rainy day fund, most withdrawals made before the accountholder is 59.5 years old are subject to an “early withdrawal” penalty, which is an additional 10% tax paid on top of the income tax already due upon withdrawal. For example, a withdrawal of $40,000 would incur an early withdrawal penalty of $4,000 in addition to the income tax assessed on the $40,000 of income. For a link to an early withdrawal calculator and a discussion of how much people lose by making early withdrawals, see my blog post, Early Withdrawals: Usually A Bad Idea.
To ensure that money in a retirement account isn’t allowed to grow tax free indefinitely, retirement accounts have a “required beginning date” (RBD) at which the accountholder must start withdrawing money. Beginning with the RBD, there is an annual “required minimum distribution” (RMD), the amount of which is recalculated each year based on the accountholder’s life expectancy. The idea of RMDs is to require that you use the balance of your account over your lifetime. Withdrawals are not limited to the amount of the RMD: once your RBD has started, you can withdraw as much per year as you like. However, whatever you withdraw will be included in your taxable income.
ROTH IRAs operate differently. Money contributed to a ROTH IRA is included in the accountholder’s taxable income when earned (so contributions to a ROTH IRA do not lower income tax liability when made). Income earned within the account is not taxed, and distributions from a ROTH IRA are not income taxable to the accountholder.
Since ROTH IRAs are funded with post-tax dollars, distributions from ROTH IRAs are not taxable income when made. ROTH IRAs also do not have RMDs during the accountholder’s life (however, inherited ROTH IRA accounts do have RMDs as discussed below). Early withdrawals from a ROTH IRA are subject to the early withdrawal penalty.
If a person dies before his or her retirement account is exhausted, the account passes according to the account contract or to the beneficiary the owner appointed in the retirement account documents. Ordinarily, it is not paid to the accountholder’s estate.
The rules for how inherited retirement assets (including ROTH IRAs) can be managed and what distributions must be made are complicated and have changed with passage of the SECURE Act on December 20, 2019. The options vary depending on who the beneficiary is and, sometimes, his or her age. Who to name as beneficiary(ies) and how best to make the gift depends on various factors and is a legal decision people should make in consultation with their financial advisor and attorney (👋).
In some cases, the RMDs for an inherited retirement account can be calculated according to the inheriting beneficiary’s life expectancy. This is called “the stretch.” The stretch benefits the beneficiary of the inherited account because money remaining in the account grows tax-free until it is withdrawn. In exchange for more flexibility in using retirement accounts; the SECURE Act limited availability of the stretch for the majority of non-spouse beneficiaries. However, the stretch still is available for some beneficiaries, including surviving spouses, the accountholder’s minor children (during their minority), beneficiaries less than 10 years younger than the accountholder, and beneficiaries with qualifying disabilities and chronic impairments. See my post, SECURE Act Changes Retirement Account Rules, for more information.