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How Do Taxes on Retirement Income Work?



Question: Can my cashed out retirement be taxed more than once? Christopher G. in California

Mandi Woodruff, executive editor at MagnifyMoney, responds…

Without much detail on the type of retirement account you’re concerned with or your reasons for cashing out, it’s hard to know exactly how to answer your question. So let’s start by covering the tax basics for some of the most popular retirement accounts: Individual Retirement Accounts (IRAs) and 401(k)s.

Taxes on Roth retirement accounts

When you make contributions to a Roth IRA or Roth 401(k), contributions are made with after-tax dollars. In other words, pay taxes upfront but withdrawals are tax-free in retirement. Roth accounts can be a great way for people who believe they’ll face higher tax rates in the future to create a tax-free income stream in retirement.

The trouble with Roth IRAs is that not everyone can use them. For 2019, if you are single and have income over $137,000 (or married filing jointly with income of $203,000 or more) you cannot contribute to a Roth IRA. There’s no income limit for Roth 401(k) contributions, but you’ll only be able to contribute to this type of account if your employer offers a Roth option in their 401(k) plan.

Taxes on traditional retirement accounts

If you’d rather get the tax break now, you can contribute to a Traditional IRA or 401(k). With these accounts, contributions are made with pre-tax dollars — you receive a tax break in the year you make the contributions, but when you take the money out in retirement, the distributions are considered taxable income. For 2019, you can contribute up to $6,000 to an IRA and up to $19,000 in a 401(k). People aged 50 or older can also take advantage of “catch-up” contributions which allow them to contribute an extra $1,000 to an IRA and $6,000 to a 401(k).

Two ways you could end up paying taxes twice on retirement funds

1. The trouble with traditional IRAs is, if you’re covered by a retirement plan at work, you might not get to deduct your contributions. For 2019, a single taxpayer with a modified adjusted gross income (MAGI) of $64,000 or less can take a full deduction for their contributions to a traditional IRA. If your MAGI is more than $64,000 but less than $74,000, you’ll receive a partial deduction, and if your MAGI is $74,000 or more, you’ll receive no deduction. For a married couple filing jointly, you need to make less than $103,000 to get the full deduction and get no deduction at all if your income is $123,000 or more.

Now, this doesn’t necessarily mean you’ll lose out on your tax break now and have to pay taxes on withdrawals in retirement. Any contributions to a traditional IRA for which you don’t receive a deduction in the year it was made are considered “basis” in your IRA. When “basis” is withdrawn, that portion of your withdrawal is not taxable.

It’s up to you — not the IRS and not the bank or brokerage that holds your IRA — to keep track of your basis. When you make a non-deductible contribution to your IRA, you are required to file Form 8606 with your tax return to report the non-deductible contribution. You should hold on to a copy of that Form 8606 — and any more 8606s you might file in the future for additional non-deductible contributions — basically forever. Don’t shred them along with your other tax documents a few years later, or you’ll lose your only record of your basis.

That’s one way in which you actually might have to pay taxes twice on your retirement. Without proof of basis, you get no deduction for the money going into the account and have to include it in your taxable income when you withdraw the money later.

2. There’s another scenario in which it might appear that you’re being taxed twice on your cashed out retirement. In this case, we’re talking about early withdrawals from an IRA or 401(k). Generally, if you withdraw money from an IRA or 401(k) before age 59½ (or the normal retirement age as defined by your 401(k) plan), the money you withdraw is taxable income and you may have to pay a 10 percent additional tax penalty.

There are a few exceptions to the 10 percent penalty. For example, you can withdraw money from an IRA to cover college education expenses or health insurance premiums while you are unemployed. The IRS has a complete list of exceptions to the penalty on early distributions.

If at all possible, try not to withdraw your retirement savings until you’re at least 59½. Unless you qualify for an exception, the taxes and penalties can eat up a big portion of the money you cash out.

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