Personal Finance Essentials
Retirement Plans and Taxes
Borrowing $10,000 from Your 401(k)
Could Cost You $100,000 at Retirement
Retirement plans exist specifically to give you a way to save for the future on a tax-advantaged basis. Understanding how they work – and how the tax rules affect them – is essential to making the most of them.
The 401(k): How It Works
The 401(k) plan was created in 1981 when a benefits consultant named Ted Benna noticed a new provision in the tax code that allowed workers to set aside a portion of their paycheck into a separate account. When he asked the IRS whether those contributions could be made on a pretax basis, the agency confirmed they could. He created the country’s first 401(k) plan for his own company, and the idea spread quickly. By 1983, nearly half of the Fortune 500 were either offering 401(k) plans or developing them.
When you contribute to a 401(k), you do not pay income taxes on that contribution in the year it is made. Your taxable income is reduced by the amount you contribute. The money then grows tax-deferred – meaning no taxes are owed on dividends, interest or gains along the way. You pay income taxes only when you withdraw the money, typically in retirement.
Most employers add to your contribution as well. Nearly 80% of employers that offer retirement plans match employee contributions, commonly providing an amount equal to 3% of your pay. If you contribute $100 and your employer matches it dollar for dollar, you effectively receive a 100% instant return on your investment before any market gains. Combined with the tax deduction on your contribution, this is one of the most powerful wealth-building tools available.
Roth 401(k), 403(b) and 457 Plans
Some employers offer both a traditional 401(k) and a Roth 401(k). The plans work the same way, but the tax treatment is reversed: with a Roth 401(k), you contribute after-tax dollars, and withdrawals in retirement are tax-free.
If you work for a nonprofit organization such as a hospital or school, or for a municipal government, your retirement plan is likely based on Section 403(b) or 457 of the tax code. These plans function similarly to 401(k) plans and offer comparable tax advantages. Within a 403(b) plan, participants can typically choose between annuities and mutual funds. Because all 403(b) plans already grow on a tax-deferred basis, annuities inside a 403(b) provide no additional tax benefit. Since mutual funds in these plans generally cost less than annuities, mutual funds are usually the better choice.
IRAs: Types and Tax Treatment
Individual Retirement Account
Deductible IRA
Roth IRA
Nondeductible IRA
Deductible IRA vs. Roth IRA: Which Is Better?
This is one of the most frequently asked questions in personal finance, and the answer is less dramatic than most people expect. Both types actually produce the same after-tax wealth as long as your tax rate is the same today as it will be in retirement. Suppose you are in the 30% bracket and earn $100. In a deductible IRA, the full $100 goes in, doubles to $200 and you net $140 after tax. In a Roth, you pay $30 in taxes first, invest $70, it doubles to $140 and you withdraw it tax-free. Same result.
The relevant variable is whether your tax rate will be higher or lower in retirement than it is today. No one can reliably predict future tax rates. A practical rule: if you are currently in a low bracket (12% or less), choose the Roth IRA – you are not getting much current benefit from the deduction, and you are likely to be in a higher bracket as your wealth grows. If you are in a higher bracket now, choose the deductible IRA.
Converting to a Roth IRA
You can convert an existing traditional IRA or 401(k) to a Roth IRA at any time, but doing so comes with an immediate cost: you must pay income taxes on the full amount converted in the year you convert. If you have $250,000 in a traditional IRA and convert it, you could owe $100,000 or more in taxes. If the conversion pushes you into a higher bracket, you may owe even more than anticipated.
There are additional complications. Medicare Part B premiums are based on your income, so a large conversion in one year could increase your healthcare costs. And if all of your retirement income becomes tax-free, certain deductions – such as those for mortgage interest, property taxes and charitable contributions – lose their value. You might actually be better off financially having some taxable income in retirement rather than none at all. Consult a tax advisor before converting; the decision is highly dependent on your individual circumstances.
Net Unrealized Appreciation: A Tax Strategy for Company Stock
If you own stock in your employer inside your 401(k), you may be eligible for a tax break called net unrealized appreciation, or NUA. This strategy applies only if the stock has appreciated significantly.
NUA is the difference between what you originally paid for the stock (your cost basis) and its current market value. Under ordinary circumstances, withdrawing money from a 401(k) triggers ordinary income taxes on the full amount. But if you take the company stock out as actual shares rather than converting to cash first, the NUA portion is taxed at the lower long-term capital gains rate, not at ordinary income rates.
To qualify, you must distribute all the money in your 401(k) within one tax year, take the company stock as actual shares and have experienced a triggering event such as separation from employment or reaching age 59½. The potential tax savings can be substantial, but the calculations are complex. Consult a tax advisor before proceeding.
Why You Should Never Borrow from Your Retirement Plan
Borrowing from your 401(k) carries serious tax risks that most people underestimate. Most plans charge a flat origination fee – commonly $75 – that goes to the plan administrator, not back to your account. You also pay interest, and while the interest returns to your account, it is money you could otherwise have invested for potentially higher returns.
When you leave a job – whether you quit, are laid off or are fired – you typically must repay the entire outstanding loan balance within 90 days. If you can’t repay it, the outstanding balance is treated as a taxable distribution. You’ll owe income taxes on the full amount plus a 10% penalty if you’re under age 59½. There is also a double-tax problem: you repay the loan with after-tax dollars, and then pay taxes again when you withdraw that same money in retirement.
Research has found that borrowing $10,000 from a retirement plan reduces your account balance at retirement by approximately $100,000. And once you borrow, you tend to borrow again. Among plan participants who have taken loans, two-thirds borrowed more than once and 20% borrowed five times or more. Each loan compounds the damage to your long-term savings. Never borrow from your retirement plan.
If you must withdraw from a retirement account before age 59½, you can avoid the 10% IRS penalty if you meet one of several qualifying tests – being totally disabled, having unreimbursed medical expenses above 7.5% of your adjusted gross income, being ordered by a court to transfer money to a divorced spouse or dependent or being at least 55 and separated from employment. Approved uses include preventing eviction or foreclosure on a primary residence, college costs for yourself or a dependent and funeral expenses. Income taxes are still due even when the penalty is avoided. You can also take substantially equal periodic payments under Section 72(t) of the tax code, which allows penalty-free early withdrawals as long as you take them regularly over a set number of years.
Required Minimum Distributions
The IRS requires you to begin withdrawing money from traditional IRAs and retirement accounts at a certain age. These mandatory withdrawals are called Required Minimum Distributions (RMDs). You must take your first RMD by April 1 of the year following the year you turn 73, and by December 31 of every year after that.
One important nuance: if you delay your first RMD to April 1, you will have to take two RMDs in the same year – one for the prior year and one for the current year. That can push you into a higher tax bracket, increase your Medicare premiums and reduce other deductions. Failing to take your RMD carries a severe penalty: you will owe income taxes on the amount you were required to withdraw, plus a 25% excise tax on the missed amount (reduced to 10% if corrected within two years). Do not try to manage RMD compliance on your own; hire a tax or financial advisor to perform the calculations.
Dividing Retirement Assets in a Divorce
Retirement accounts held in employer-sponsored plans require a special court order – a Qualified Domestic Relations Order (QDRO) – to divide during divorce. This document gives the other spouse the legal right to receive a portion of the retirement account without triggering taxes or penalties on the account holder.
The QDRO must be approved by a court and submitted to the plan administrator. Generally, you need a separate QDRO for each qualified account. If you are the spouse receiving money via a QDRO, the cleanest approach is to transfer the funds into your own IRA, allowing them to continue growing tax-deferred. Liquidating the entire amount triggers immediate income taxes and, if you are under 59½, a 10% penalty. For non-employer plans such as IRAs, a similar tax-free transfer can be arranged pursuant to a divorce decree.