How are withdrawals from tax-deferred retirement accounts taxed? Are all withdrawals taxed as ordinary income, or are you allowed to declare excess of cost basis as capital gains?
What I really need to know is whether I need to track cost basis because I have these things going back decades and my records going back that far are a little shaky.
IANATA
Based on http://www.irs.gov/publications/p590/ it is my understanding you withdraw your distribution by the end of the year and that amount is added to whatever other income you may have for the year. You pay tax on your total gross income.
What remains in your traditional IRA (including any income generated by it for the account) remains tax deferred until you withdraw it (see above).
You are required to withdrawal a defined minimum amount because your IRA is supposed to run out when you die, based on actuarial tables. You can withdraw more than the minimum requirement. However, if you live longer than the actuarial tables calculate, you could end up with no more IRA funds and still alive.
Ordinary income. That’s one reason why some brokerage firms do not even bother keeping track of your cost basis in older IRA accounts. That info is really irrelevant. Note that withdrawals from Roth IRAs are not taxable.
Note that you will have a cost basis in your IRA if any of your contributions were non-deductible and were reported as such.
Follow-up question: If your gains are taxed as ordinary income, then what is the benefit of tax-deferred accounts? Yes, you defer the tax and yes your marginal rate may be lower when you retire, but still, the capital gains rate is 15% and ordinary income over $34,500 will be taxed at a higher rate than that; the next higher bracket is 25%. I haven’t run any numbers on this but it seems that the government giveth and the government taketh away.
All your capital gains and income from within the tax-deferred account are untaxed up until the point you take a distribution. So it’s only quite as simple as you’re making it out to be if you bought, say, a savings bond that you held to your retirement date.
But any more complicated investments like an actual portfolio of investments, you’ll have a certain amount of income each year, perhaps from coupon payments on bonds or from dividends on stocks. Those will all be tax free each year. You’ll also have realized capital gains from trades of stock as you reallocate your investments from time to time. Those will be untaxed. Each year your investment return is untaxed.
It’s only at the end that your disbursements are finally taxed when you take the money out.
That said, Roth IRAs are a better choice often and for many people (most?)
Say you had a $1000 pre-tax to invest, were in the 25% tax bracket, and your investment had doubled by the time you sold.
If you put it in an IRA/401k, you put the whole $1000 in, pull out $2000 in the end, and pay $500 in taxes leaving you with $1500.
If you put it in a non-tax deferred account, you would only have $750 to invest, would pull out $1500, and pay $112 in taxes on the gain, leaving you with $1388. That is the best case, too. If you sold/bought multiple times along the way the capital gains tax would “compound” and take an even bigger bite.
Would it be even better if you only paid capital gains tax on the gains in the first case? Of course, but you still make out better than if the money was in the taxable account.
This is a common misunderstanding. You forget two very critical features of a deductible IRA( or 401k): first, your contributions do not count as taxable income in the year in which they are made, and second, your IRA pays no taxes whatsoever on any income that it makes, whether it is from capital gains, interest, dividends, or anything else. The effect of the first benefit is that if your tax rate is the same when contributing as it is in retirement, then the tax that you owe on withdrawals end up being the original tax deduction you got for the contribution plus any gains you made on the deduction. This means that you get to keep the money from the contribution that wouldn’t have been taxed, plus any gains, tax free. This is why they call it a tax deferred account. N
ote that if you have a lower tax rate in retirement, which is common, then as a bonus you get to keep some of the “government’s” money. On the other hand, if you manage to have a high tax rate in retirement, you lose. This is why the Roth accounts were created for those with low incomes.
A simple example. Suppose somebody in a 20% tax bracket saves $5000 per year for retirement. First let’s consider the scenario where they don’t use a tax-advantage account for saving. Of that $5000 per year, $1000 is paid in taxes immediately, so the saver really can only put away $4000 per year after tax. Let’s assume a 5% rate of return(the rate of return is irrelevant to the conclusion, by the way). However the return will be subject to tax. Let’s assume it will be 10% per year, which reduces the return to 4.5%. Plugging all of this into the Future Value formula we see that after 30 years our saver has accumulated $244 028.58.
Now consider the use of a deductible IRA. Now our saver gets to put away the full $5000 each year. They still make a 5% yearly return, but gains in the IRA are tax free so they keep the full 5%. After 30 years they have accumulated $332 194.25. Of course, they still owe taxes on this money. If it’s still a 20% tax rate, they are left with $265 755.39 – more than they had if they saved outside the IRA. Why the difference? Well, if we go back to the original scenario, but take taxes on gains out of the equation(so they get the full 5% per year), we see that our saver is again left with $265 755.39. The real benefit of tax deferred accounts is avoiding taxes on gains.
By the way, my third example – investing with after-tax money, paying no taxes on gains and no taxes on the final amount – is exactly how a Roth works. It should be easy to see that if we make the tax rate paid in retirement higher than 20%, then the Roth produces more money for the saver, but if the make the tax rate in retirement lower, then the deductible IRA wins.
One final note: I’ve neglected to distinguish between marginal and average tax rates because they just muddy up the discussion. To be honest, it’s never been entirely clear to me whether when I talk about your “tax rate” in retirement whether you’re supposed to be looking at average or marginal rates. I suspect that the reality of it is that it’s messier than an either/or situation and depends on what you assume about other sources of income like SS.
Just one more perspective about the follow-up question:
Even if it turned out that the tax/savings amounts were identical with and without an IRA/401k, there would be the issue of deferring taxes. Given the time value of money, you are better off with $1,000 to spend today, even if you have to pay that $1,000 back tomorrow. Someone who has deferred paying 20% tax on $250,000 is looking at $50,000 that they got to enjoy for years (even decades) before they finally had to pay it back. Since a taxpayer may have enjoyed that $50,000 when they needed to buy a home, put braces on the kids, send the kids to college, etc. they might consider the tax deferral worthwhile even without any net savings.
I do think that far too many people are putting money in 401ks when they simply aren’t aware of the advantages a Roth plan might have for them - especially young taxpayers in their 20s and 30s where even a small Roth contribution now can turn into huge amounts tax-free in retirement.
I’m not following your reasoning. You *defer *taxes on gains but you don’t *avoid *it–you pay tax on them when you withdraw it. Normally you would pay taxes when the gain is realized (realization can be deferred significantly anyway with proper management).