When you receive retirement benefits from your company retirement plan, you should understand how these benefits are taxed. There are many different types of company retirement plans, depending on your employment status and your company. If you die before you are able to receive the money, your beneficiaries may have to pay tax on the proceeds.
A pension plan is fully funded by your employer. The pension is considered deferred income. You pay income tax on all of the money that is distributed from the plan. Pension plans don't have direct death benefits. Instead, if you have elected to give a portion of your pension to your spouse, your spouse will receive the remainder of your pension and will pay ordinary income tax on the distribution amount.
Qualified plans may include traditional and Roth 401k plans as well as SEP and SIMPLE IRAs. Any qualified plan that made tax deductible contributions to the account is taxed at ordinary income tax rates at your death. A Roth account is untaxed. This is because the contributions to the account were non-deductible. Because of these non-deductible contributions, your heirs don't have to worry about paying income tax on the distributions made during retirement.
Non-qualified accounts are funded with after-tax dollars. The non-qualified account will only be taxed on the investment gain at your death. This is because all contributions are already taxed. Investment growth was tax-deferred during your life. An example of this is an annuity. An annuity is an insurance policy which defers the taxation of investment income inside of the policy. All withdrawals from the policy are treated as though investment gains are being withdrawn first before principal. At your death, your heirs can take either a lump sum of money or annuity payments. Lump sum amounts are taxed in the year they are received. Only the investment gain is taxed. Alternatively, the policy may be converted to an immediate annuity payment. This means that most of the annuity payment is a return of investment principal with only a small amount of money constituting interest on the account. This, in turn, lowers the tax in any given year on the distribution amount since only a small portion of the retirement benefit is subject to income tax.
Executive Bonus Plans
An executive bonus plan is owned by the employee and funded by the employer. However, these plans typically use whole life or universal life insurance as the funding vehicle. Therefore, all distributions from the plan are tax-free income. Like all life insurance death benefits, the life insurance death benefit is tax-free to your heirs.
- "Practicing Financial Planning for Professionals (Practitioners' Edition), 10th Edition"; Sid Mittra, Anandi P. Sahu, Robert A Crane; 2007
- "Ernst & Young's Personal Financial Planning Guide, 5th Edition"; Martin Nissenbaum, Barbara J. Raasch, Charles L. Ratner; 2004
- IRS: Publication 590
- IRS: Publication 575
- IRS: Publication 525
What Is a Fully-Funded Retirement Plan?
If you have a fully-funded pension plan, you are in relatively safe hands. That means your pension plan has a sufficient amount...