Can a Retirement Fund Be Taxed?

Saving money for retirement helps you build that lump sum of money you'll need to live on when you get too old to work. Retirement savings plans help you build that savings quickly and efficiently. Depending on where you are in the process, your retirement savings may or may not be taxable.

Accumulation Phase

When you begin saving money, you have many choices. You may choose a traditional 401(k) plan, IRA or any number of other retirement plans qualified by the Employee Retirement Income Security Act. You may also choose non-qualified plans like annuities. Traditional retirement accounts allow you to defer income tax on all money you contribute to the plan. The retirement account then defers all investment income you earn inside the plan. This has the effect of making your retirement savings "tax-free." The actual deferral only lasts, however, for as long as you keep the money inside of the account. Non-qualified plans do not allow you to make pretax contributions to the plan. All contributions are after-tax.

Distribution Phase

When you retire, it's time to take the money out of your retirement account. Distribution of retirement funds normally comes with an income tax liability. You're taxed on all investment gains from non-qualified accounts and all distribution amounts of qualified accounts. The income from your qualified retirement accounts normally has to be withdrawn after age 70 1/2, using table III in the appendix of IRS publication 590 as a guideline for withdrawals.

Exceptions

There is one exception to the rule for qualified accounts. Roth IRAs only allow after-tax contributions but do not tax distributions made from the account. This tax-free distribution is only valid when you make your withdrawals after age 59 1/2 and have held the account open for at least five years.

Consideration

Outside of qualified and non-qualified retirement accounts, you have few options to save money for retirement. Life insurance is commonly used as a retirement planning tool, even though the policy itself is not considered a retirement account. Supplemental Life Insurance Retirement Planning is a concept used in the insurance industry to signify a process whereby a cash value life insurance policy is purchased with the intention of using the policy's cash value to later supplement a person's retirement income. This strategy should be carefully coordinated with a life insurance agent or financial planner skilled in this process, since your life insurance policy must be set up to handle cash distributions during retirement which provide a meaningful income to you. Distributions are normally handled through low cost or zero percent net interest policy loans which are income tax-free as long as the policy remains in force.

References

• IRS.gov: Publication 590 (starting on page 38)
• IRS.gov: Topic 558 - Tax on Early Distributions from Retirement Plans, Other Than IRAs
• IRS.gov: Retirement Plans FAQs regarding Required Minimum Distributions
• IRS.gov: 401(k) Resource Guide - Plan Sponsors - General Distribution Rules
• IRS.gov: Publication 525