Retirement Plans: An Overview

When Congress created the Individual Retirement Account (“IRA”), the “401K Plan”, the tax-qualified pension plan, and similar types of accounts which anticipate retirement, it obviously touched a major nerve in our collective psyche. The response has been overwhelming, and if the Congressional intent was to encourage us to create nest-eggs to supplement Social Security, it has succeeded probably beyond its rosiest expectations.

Good as they are, these plans require your attention, and you owe it to those who survive you to be aware of the consequences of your participation. How enticing it is to know that a contribution to a plan from your ordinary earnings is deposited without income taxes first being deducted; as if that weren’t enough, as the fund you create generates its own income, such income bears no income tax as it is earned — in effect, a double “bonus”. (And in a sense it is a triple bonus since your fund is earning money on the portion of your contribution which would have been taxed had you not put it into the fund!)

But know this: the income taxes are not permanently saved; they are only deferred, and one day either you or your heirs will have to pay them as the money is withdrawn, though the goal ultimately is to reduce the total tax amount. Simply put, in the prime earning years your income usually will push you into higher tax brackets than you will be in during retirement when your income diminishes. So, your rate should be lower when in retirement you withdraw funds.

And, while the rule is that you may not withdraw cash from these funds prior to age 59; without paying a penalty, at age 70; you must begin to withdraw annually a certain percentage of what is in the fund or be penalized. Further, if you are not careful in designating the beneficiaries of a plan, your heirs may find themselves with a very steep tax bill that could result in a major depletion of the fund.

As a general rule these tax qualified plans are assets of the estate of the owner, and that means that in addition to the payment by your survivors of the state and federal income taxes (which have been deferred), the estate will be liable to pay state inheritance taxes and, if the estate is sufficiently large, federal estate taxes. (The current federal exemption for an individual is approximately $700,000.) The rates of these taxes vary with circumstances, but a poorly planned estate can be seriously depleted by taxes; in this respect a properly designated beneficiary of a tax-deferred retirement fund together with other estate planning devices can reduce death taxes to the benefit of your heirs.

A very practical problem incidentally can arise with the custodian of the account (the bank, trust company, mutual fund, etc.); they often have beneficiary designation forms which are woefully inadequate. To compound the problem, on occasion the person who assists you in completing these forms at these institutions will not be properly aware of the law or your particular estate planning needs and may dispense flawed advice.

By dangling the tax-deferred carrot, Congress effectively has enticed Americans to save trillions of dollars which otherwise would have been spent as they were earned. But sticks often accompany carrots, and unless you plan carefully, watch out for a resounding thump!

– Ken Butera
Posted in Finance / Taxes  |  Leave a comment

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