Bucket 3: Tax Me Never
Your retirement accounts are taxed differently from one another, which can become confusing quickly. To more easily understand the tax implications on your money, we use the three- bucket concept to demonstrate the difference in taxation when you distribute funds from one of the three buckets. In the last couple of blogs, we’ve learned;
• Bucket 1, the taxable bucket, includes assets that you pay taxes in the year any investment gains have been realized.
• Bucket 2, the tax-me later bucket, also called the Tax-Deferred bucket, includes vehicles that are taxed at the time the funds are distributed. These include such accounts as 401(k)s, 403(b)s, and traditional IRAs.
Inside Bucket 3
In this blog, we will discuss the third bucket.... one of our favorite’s – the Tax Me Never bucket. Vehicles in this bucket include:
• Roth IRA
• Roth 401(k)
• Interest from municipal bonds
• Cash value life insurance
In this bucket, the profit or gains realized in these accounts can be withdrawn without incurring any tax! The most common investment strategy used in this bucket is Roth IRA’s and Roth 401(k)’s. So, here’s how they work.... Unlike Tax deferred accounts such as 401k’s and Traditional IRA’s, a contribution to a Roth or Roth 401(k) does not reduce your taxable income in the year it’s made. However, so long as certain conditions are met, your earnings can be withdrawn tax free. In order to have the earnings be exempt from tax, the individual must be age 59 1⁄2 (or as young as 55 under certain circumstances) and the account must have been open for a minimum of five years.
There are exceptions to the qualified distribution rule. If the account owner is under 59.5 and held the account at least 5 years, the withdrawals are tax free if: Permanently disabled, First home purchase ($10K max), or Beneficiary inheriting the Roth. It is important to understand taking a non-qualified distribution may count as taxable income and may incur a penalty. Non- qualified distributions may also impact ones modified adjusted gross income (MAGI), which the IRS uses to determine eligibility to contribute to a Roth IRA.
Tax Free!
Let's take a look at an example. John, age 55, purchases shares of Disney Company stock in his Roth account, amounting to $6,000. He allows the investment to grow, and at age 60 decides to sell the shares and take a distribution. Hypothetically, let’s say the value has grown to $10,000. John has met both requirements; namely he is over age 59 1⁄2 and the account has been open for at least five years. As a result, the $4,000 gain in the account ($10,000 sale price less $6,000 investment) is tax free! Let’s take a look at how this gain would be taxed in the other buckets discussed earlier; In Bucket 1 (The Taxable Bucket), the gain would be subject to long term capital gain (determined by the household taxable income), and in bucket 2, the Tax Deferred Bucket, the entire $10,000 distribution would be taxed as ordinary income, which would also be determined by the taxable income for the household.
Other limitations and restrictions may apply. The amount you can contribute to a Roth may be reduced or entirely eliminated depending on your income. This is a conversation you’ll want to have with a financial advisor. Schedule a call with an experienced advisor at Archstone Financial today.
Neither Voya Financial Advisors nor its representatives offer tax or legal advice. Please consult with your tax and legal advisors regarding your individual situation.
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