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Federal Income Tax on Retirement Benefits

* Please consult your tax advisor for detailed advice on your personal situation.

Qualified Accounts

o    A “qualified” retirement account is one that is funded with pre-tax dollars. The most common examples of qualified retirement accounts are traditional IRAs and 401(k)s. Money you contribute to these accounts can be deducted from your income taxes because you did not actually take it as income during the year in which it was earned, but rather earmarked it for use during your retirement. Any earnings on your contributions inside these accounts will not result in current-year tax liabilities. No income taxes will be due on the money inside qualified retirement accounts until you actually withdraw it and take it as income. Taxes will be due on only the amount of money you actually withdraw during the year, and any remaining balance will stay tax-deferred until withdrawn.

Non-Qualified Accounts

o    A “non-qualified” retirement account is one funded with after-tax dollars. Annuities are the most common type of nonqualified retirement account. For example, accumulated funds in a money market or savings account have already been taxed, and using this money to purchase an annuity will not result in an income tax deduction. However, the earnings inside the nonqualified annuity will remain untaxed until you actually withdraw the money. The most complicated aspect of nonqualified retirement accounts is understanding how much of your withdrawal is considered the untaxed earnings and how much is your original after-tax contribution. Each type of nonqualified account may treat withdrawals differently; some use the Last-In-First-Out (LIFO) method, wherein the most recent addition of the untaxed earnings is considered withdrawn first, while others use the First-In-First-Out (FIFO) method, wherein the earliest contributions of your after-tax deposits are considered withdrawn first.

Early Withdrawal

o    The government restricts withdrawals from both qualified and nonqualified retirement accounts until you have reached the age of 59 1/2. At that time, you can freely utilize the accumulated money within your retirement accounts and will owe additional income tax on only the amount you actually withdraw during the year. If you make a withdrawal from a retirement account prior to the year in which you become 59 1/2, you will be penalized an additional 10 percent of the gross amount of your untaxed withdrawal. From a qualified account, the 10 percent penalty will apply to the entire amount you take, but from a nonqualified account, the penalty will apply to only the portion that has not been taxed yet.

Exceptions

o    There are some exceptions to the early withdrawal penalty normally imposed by the IRS for money taken from a retirement account before age 59 1/2. Your beneficiaries will not be required to pay the 10 percent penalty for withdrawing money after your death, but may owe ordinary income taxes on amounts withdrawn. If you become completely disabled, and are expected to remain permanently disabled, you may withdraw money without additional penalties. Withdrawals for qualified medical expenses that exceed 7 1/2 percent of your gross income can be made without penalty. In some cases, early withdrawals can also be made without penalty if the money is used toward the purchase of your first home.

Transfers and Rollovers

o    If done properly, moving existing retirement accounts to another provider will not result in a taxable event. For example, transferring your IRA from one mutual fund company to another, or from one bank to another, will not create a penalty because at no time did you take possession of the funds. Even if the transfer process resulted in a check being mailed to your home, no taxes or penalties will be owed if you deposit the entire amount into the new account within 60 days. Similarly, if you leave an employer and rollover your 401(k) into an IRA, no income taxes or penalties are due.

Roth Accounts

o    Roth IRAs and Roth 401(k)s can be a source of confusion regarding federal income tax treatment of retirement benefits because contributions are made with after-tax dollars, the accounts grow without taxes due, and withdrawals after age 59 1/2 are entirely income-tax free. In exchange for earmarking a portion of your earnings for retirement but still paying income taxes on that portion in the current year, the IRS will allow your account to grow without tax liability, and forfeit taxes that would otherwise be due on the growth.

Pensions and Annuity Payments

o   If you receive regular monthly payments from a pension plan or an annuitized annuity, income taxes will be due on the entire amount of the money you receive. Those payments are considered income, and you do not have access to the bulk of the account from which those payments are generated. Pension benefits come from a former employer, and taxes are due because you have yet to receive any of that money. An annuitized annuity contract, regardless of whether it began as qualified or nonqualified, has already taken into consideration the tax status of the account, and calculations have already been made to account for any disparity between pre-tax growth and original after-tax contributions.

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