When Two Out Of Three Ain't Bad
From a tax perspective, a dream retirement account probably would encompass three elements:
- Contributions to the account would be tax-deductible.
- Accumulation of earnings within the account would be tax-deferred.
- Distributions from the account would be tax-free.
For instance, if you establish a traditional IRA, you may be able to deduct contributions to the account, especially early in your career when your income is lower. However, deductions for contributions are phased out if you (or your spouse) participate in a retirement plan at work and your income exceeds a specified level. Nevertheless, any earnings inside the IRA will continue to grow without erosion by taxes until the money is withdrawn.
When you take distributions from a traditional IRA, the portion of the withdrawal representing deductible contributions and earnings will be taxed at ordinary income rates. You also might owe a 10% tax penalty on the taxable portion of distributions you take before age 59½. Finally, after you hit age 70½, you’ll have to take “required minimum distributions” (RMDs) each year.
Generally, your contributions to a 401(k) or another kind of “qualified” workplace retirement plan are exempt from taxes up to a specified annual maximum, and earnings inside your account continue to build up tax-deferred, just as they do with a traditional IRA. But here, too, your distributions from the plan will be taxable at ordinary income rates on a pro-rata basis—that is, you’ll be taxed on the portion of each withdrawal that represents pre-tax contributions and the earnings they generate. But if you change jobs or retire, you could make a tax-free rollover into another qualified plan or an IRA. As with traditional IRAs, distributions from workplace plans prior to age 59½ are normally subject to a 10% tax penalty, and the rules for RMDs also apply to these plans unless you’re still working full-time.
With a Roth IRA, contributions are never deductible, but any earnings in the account will grow tax-deferred. Even better, for a Roth you’ve had for at least five years, distributions after age 59½ are tax-free. If you make a withdrawal within the first five years, account earnings will be taxed at ordinary income rates but you’ll be allowed a tax-free return of contributions.
Unlike traditional IRAs and qualified plans, a Roth IRA doesn’t force you to take RMDs during your lifetime. That means you can pass along all of the account’s assets to your heirs.
Because there’s no dream plan that offers all three desirable attributes, you could choose to combine different kinds of accounts to get a blend of tax benefits.
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