Holding Court is a series by retired Rye City Court Judge Joe Latwin. Latwin retired from the court in December 2022 after thirteen years of service to the City.
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By Joe Latwin
Congress created several financial vehicles intended to help citizens in their retirement. These vehicles travel under several names – CODAs, or Cash or deferred arrangements (otherwise known as 401ks), Individual Retirement Accounts (IRAs), Simplified Employment Pensions (SEP IRAs), Tax Sheltered Annuities (403b), and deferred compensation plans (457). The main thrust of these vehicles is to allow people to set aside certain amounts of their income.
The funds go into special accounts and the taxpayer does not count the deferred funds in the computation of their income tax for the year the funds are earned. If the taxpayer funds the account with $1,000, that $1,000 will not be taxable as income for that year. If the taxpayer had $100,000 in salary and made the $1,000 deposit into the deferred account, the taxpayer’s reportable income for that year will be $99,000. Assuming a 25% tax rate, the taxpayer’s tax would be reduced from $25,000 to $24,750 saving the taxpayer $250 in current tax savings. Also, while the funds are in the account, the income and growth in the account are not taxable in the year earned. Thus, the fund grows tax free. The longer the funds are in the vehicle, the more they can grow tax free, whether it’s through the benefits of compound interest or the time for the investments to grow.
The withdrawals from the funds become taxable when made. If you withdraw $10,000 from the account, that $10,000 will be considered income for the year of the withdrawal and added to your other income to determine your taxes. When you reach the age of 73, you must make annual distributions, called Required Minimum Distributions (RMDs). Your RMDs are determined by IRS tables based on your life expectancy by dividing the account balance by the tabled age factor. A 75-year-old has a distribution period of 22.9 years. If you take an early distribution, there is not only a tax on the withdrawal, but a penalty as well. There are special rules that grant a surviving spouse advantages to rollover the funds into “rollover IRAs”. For all other beneficiaries who take control after death, the funds must be distributed in 10 years.
Is it worth it? While you are savings taxes now, you do not know the cost in the future. Congress can always increase the tax rate. Market forces and inflation can eat away at the investments of the fund. It was presumed that when you made the investment in the fund, you were at the highest tax rate since you were working and presumed to be near the peak of your career and after you retired or reached 73, you would have less income and be in a lower tax bracket. That may or not be the case. It’s a good deal when you aren’t paying taxes early on, but it stinks when you have to pay the piper.
Then, there are other similar investments where you pay the taxes currently, but don’t pay when you withdraw them – Roth IRAs. Some people are converting their IRAs to Roth IRAs paying the taxes now so they can receive the funds tax free when distributed if the qualifications are met.
