Understanding Retirement Account Taxation

It’s important to start saving for your golden years as soon as you are able, so that your money has time to grow into a nest egg by the time you need access to it in retirement. Once you have earned income, you can contribute to an IRA, and once you have an employer that offers one, you can start to take advantage of an employer-sponsored retirement account. If you work for the military or federal government, this account comes in the form of the Thrift Savings Plan, and if you work for a civilian employer, you’re likely to be offered a 401(k). Some employers offer a 403(b) or a 457 plan, but these are less common.

While not an account per se, retirement pensions, like those offered by the military, are another source of income that can be accessed by qualified individuals upon their retirement. Most pension plans do not permit employee contributions and there are tax implications for pension funds paid out in retirement.

Essentially, when it comes to retirement, you have two choices: you can pay taxes now, at the time of deposit, or you can pay taxes when you receive the funds in retirement.

IRAs

Individual Retirement Accounts (IRAs) are taxed differently depending on which type of IRA you have: traditional or Roth. Individuals must have earned income to open an IRA.

Contributions to Roth IRAs are taxed at the time of deposit, but all withdrawals are completely tax-free (on both the principal and earned amounts) provided that you are at least 59 ½ years old and the account is at least five years old. This makes them an exceptional savings vehicle for individuals who expect to be in a higher tax bracket in retirement than during their working years. Withdrawals made prior to age 59 ½ are subject to an IRS penalty.

Note that Roth IRAs have income limits set by the IRS that prevent people with income above a certain level from contributing funds to a Roth IRA.

Contributions to Traditional IRAs may be tax deductible at the time of deposit (depending on your income level), but withdrawals increase your taxable income and are taxed as such. As with Roth IRAs, any withdrawal that occurs before age 59 ½ is penalized by the IRS – and the penalty is steep: 10%.

Further, traditional IRAs are subject to required minimum distributions (RMDs). Once you reach 73 years old, you must withdraw funds from your account and pay the associated taxes. If you fail to withdraw the RMD amount specified by the IRS, you will be required to pay an additional penalty: 25% of the amount you were supposed to withdraw.

Traditional IRAs have no income limits and individuals with any amount of earned income can contribute funds to an IRA account. However, there are limits to who can receive tax deductions at the time of deposit. These limitations are based on annual gross income and whether or not the account owner (or their spouse) contributes to an employer-sponsored retirement account.

• There are situations in which you may be able to make a qualified withdrawal from either a traditional or Roth IRA prior to age 59 ½ and avoid the 10% penalty. These include a first-time home purchase, qualified educational or medical expenses, and if you become permanently disabled.

Employer-Sponsored Retirement Accounts

A 401(k) plan is an employer-sponsored retirement plan offered primarily by private corporations that allows employees to contribute a portion of their income to their retirement fund before payroll taxes are taken out – deferring part of their salary until they withdraw the funds in retirement. Many employers “match” a percentage of what the employee contributes to their 401(k), and some may pay the fees associated with the account – though many leave that to the employees.

Workplace contributions to 401(k)s typically default to being made with pre-tax dollars (meaning that you would pay taxes on the full amount of the withdrawal in retirement). However, you are usually able to switch the allocation of your retirement deposit from a traditional IRA subaccount to a Roth subaccount, allowing you to pay taxes on the deposits now and receive retirement distributions tax-free in the future.

The Thrift Savings Plan, or TSP, is a defined-contribution retirement plan that is accessible only to federal employees and members of the uniformed services. It is similar to a 401(k) plan that may be offered by civilian employers and provides low-expense retirement investment options.

TSPs have both traditional and Roth components.

• Money put into a traditional TSP account will have taxes deferred, meaning you will not pay any taxes on that income when it is contributed to your TSP account. When the money is withdrawn after you reach age 59 ½, however, you will be required to pay taxes on both the contributions and the earnings.
• When money is contributed to a Roth TSP account, it will be taxed during the year of the contribution. However, this money grows tax-free and there will be no taxes paid on any earnings withdrawn in retirement.

You may elect to put money into both a traditional and Roth TSP account, with each taxed as described.

With both 401(k) and TSP accounts, matching contributions provided by a civilian employer or the military are deposited into a traditional subaccount, meaning that they are not taxed at the time of deposit. When distributions are initiated in retirement, any matching funds pulled from the traditional subaccount are taxed as ordinary income.

All employer-sponsored retirement accounts are subject to required minimum distributions on both the traditional and Roth subaccounts once the account holder reaches age 73. Failure to take the appropriate RMD will result in a 10% penalty. That said, TSP account holders are protected in that should an account holder fail to take the appropriate RMD amount during the year, TSP will send a check in the amount of the difference to prevent the need for the penalty.

Similar to IRAs, both 401(k) and TSP accounts prevent withdrawals prior to age 59 ½ unless the account holder meets specific eligibility criteria, as described above.

Pensions

Typically, you are required to pay taxes on funds received from a pension plan during retirement. If you elected to contribute any money to the plan (if you were given the opportunity) and paid taxes on it during the year of your contribution, the funds you receive in retirement are partly taxable – you would pay taxes on the portion of your distributions that was originally paid into the pension by your employer, but not on your contributions. While the federal government does charge taxes on pension funds, you may not have to pay state income taxes on funds received, depending on where you live.

The following states do not tax pension distributions: Alabama, Alaska, Florida, Hawaii, Illinois, Mississippi, Nevada, New Hampshire, Pennsylvania, South Dakota, Tennessee, Texas, Washington, and Wyoming.

Further, the following states do not tax military retirement income: Alabama, Alaska, Arkansas, Connecticut, Florida, Hawaii, Illinois, Iowa, Kansas, Louisiana, Maine, Massachusetts, Michigan, Minnesota, Missouri, Nevada, New Hampshire, New Jersey, New York, North Dakota, Ohio, Pennsylvania, South Dakota, Tennessee, Texas, Washington, West Virginia, Wisconsin, and Wyoming.

Note that you normally cannot take early withdrawals from your pension; you must wait until you retire to receive any of the benefits.

The Navy Mutual blog is meant to provide basic information that generally applies to most situations and should not be construed as legal or tax advice. It is not meant to replace the services of a financial planner, insurance counselor, attorney, or tax adviser. Information contained in this blog post may change on occasion.