It seems like many folks we talk to would prefer to pay as little in taxes as possible. Which frankly is understandable. Any dollars that go to pay taxes are dollars that cannot be put to use elsewhere. Many folks would rather direct those dollars toward the things that are most important to them. While that may vary from person to person or from couple to couple, a dollar lost to avoidable taxes is a lost experience. One that would have resulted from applying the money to something or someone you enjoy most.

The fear of loss however often prevents people from taking action that would greatly improve their circumstances. We find that folks are often confused by what triggers a taxable event. They may stay in an account or investments that are not serving them well because they are fearful of making move and losing precious resources to taxes. Whether the fear is justified or not, it is real nonetheless and the impact may be tragic.

What actions trigger a taxable event, and at what tax rate?

Many folks understand that distributions from the pretax accounts like IRAs and 401Ks trigger a taxable event. More specifically, these distributions are treated as ordinary income, and taxed at your next highest marginal tax bracket. If your next highest marginal tax rate is 22%, and you withdrawal a dollar from a pre-tax account you will get to keep only $0.78. Distribute $10,000 and you get to keep $7,800. Where does the other $2,200 go? Is there anything you can do about it?

On the other hand, many folks are unaware of the difference between a transfer, a rollover, and a distribution. Lack of understanding may prevent someone from repositioning their retirement account dollars to a more advantageous position because of the concern of being taxed on the transaction.

Rollover

A rollover happens when you transfer money out of one eligible workplace retirement plan like a 401(k), to another eligible workplace retirement plan or an individual retirement arrangement, known commonly as an IRA.

A direct rollover occurs when money transfers from one custodian to another custodian. A custodian is the financial institution holding, or having custody over, your assets. A direct rollover is a tax-free transaction. Your current custodian will send the money directly to the new custodian for your benefit. The money is never “distributed” to you, therefore no taxable event has occurred.

On the other hand, an indirect rollover is when money is distributed to you from your current custodian, and then you deposit your assets into a new custodian within the 60-day allowable time frame. When money is distributed to you, the check is made out payable to you, not a financial institution. You are deemed to have “taken constructive receipt” of the funds. Failure to deposit the assets within in 60 days triggers a taxable event on the entire amount distributed.

Furthermore, a 20% mandatory federal tax withholding is required on distributions from a workplace retirement plan to ensure the government receives their tax revenue if you fail to deposit the money within 60 days.

The 20% may be refunded at tax time so long as you successfully deposited the qualified plan distributions, plus an additional deposit equal to the 20% withheld, into a new custodian account within 60 days.

Indirect rollovers can be quite complex and challenging with potential for costly mistakes. For this reason, it often makes sense for folks to opt for a direct rollover instead of an indirect rollover.

Transfers

Transfers take place when you move one IRA held at your current custodian to an new IRA at the same or different custodian. For example, you may have an IRA at financial institution A, but you wish to establish an IRA with financial institution B because they are giving away a free toaster.

You can conduct a direct transfer of assets. This transaction moves money from one custodian to another, and you never take constructive receipt of the funds. The check is made out to the new financial institution for your benefit, and the money is transferred from one institution to the other directly. You receive your free toaster while avoiding a taxable event.

You can also conduct an indirect transfer from financial institution A to financial institution B without any taxable consequences. However, in this case the money is “distributed” to you. Like we discussed before with an indirect rollover, the check is made payable to you. You take constructive receipt of the funds, and have 60 days to deposit the money into a different IRA account.

Unlike with an indirect rollover, there’s no mandatory 20% federal tax withholding on an indirect transfer of an IRA. However, you are limited to one indirect transfer per year across all of your IRA accounts. More than one indirect transfer made in a single year may result in a taxable distribution on all indirect transfers made during that tax year. That could be a very costly mistake!

Indirect IRA transfers can be quite complex and challenging with potential for costly mistakes. For this reason, it often makes sense for folks to opt for a direct transfer instead.

While A free toaster may be a poor reason to move an IRA from one custodian to another, there are many reasons why you may want to consider it. However, the manner in which you do so could potentially trigger a taxable event. Therefore, proceed with caution and seek guidance from a professional who handles these types transaction on a regular basis.

Tax Triggers On Interest, Capital Gains and Dividends

For folks that have money in after-tax accounts like non-retirement bank accounts, or brokerage accounts taxes due annually vary based on many factors. Things can get tricky fast.

Are you earning interest from a bank account? Don’t laugh. There are some that still pay an interest rate even if it is not much. It is taxed as ordinary income, and taxed at you next highest margin rate.

Did you receive dividends from investments? Ordinary dividends are taxed as income, but qualified dividends are taxed at capital gains rates. What makes a dividend ordinary or qualified? That’s a great question, and the answer can be confusing.

Furthermore, rules applying to capital gains triggered by the sale of investments vary as well. The type of investment, how long you have owned it, your adjusted gross income, and many other factors can affect taxes on capital gains.  

Interest Bearing Accounts

Interest earned on after-tax bank accounts is considered 1099 income. For example, if you earn 2% on a $100,000 CD you will gross $2,000. However, assuming you are in the 22% federal tax bracket, your interest earned after federal taxes is only $1,560. The interest earned is also added to your total taxable income for the year which could potentially push you into a higher tax bracket, or open you up to a whole host of other potential tax traps like Medicare surcharges, or increased taxation of your social security.

Bond Interest

Interest earned on individual bonds is also considered income. It too is taxed like the interest described in the previous paragraph, and can trigger similar tax related complications. However, what if you bought an individual bond yielding 4%, but now sell it in an environment where the going interest rate is only 3%. Someone is willing to pay you more for the bond than what you bought it for. That is a capital gain, and therefore taxed at capital gains tax rates.

Bond funds on the other hand are made up of many investments. Income generated from bonds within the fund are taxed as income, while the sale and purchase of bonds within the fund triggers capital gains and potentially capital losses. Therefore, if you own bond funds it is likely that you will receive both income and capital gains from these types of investment.

Even if you reinvest the income generated from your bonds or bond funds, taxes are due annually.

Taxes On Dividends  

If you own shares of company stock you may earn dividends. Ordinary dividends are considered income and are taxed at income tax rates. However, qualified dividends are taxed at capital gains rates.

Qualified dividends are dividends issued by:

  1. A U.S. corporation, or a foreign corporation that regularly trades on a major US exchange.
  2. The shares must have been owned by you for more than 60 days of the “holding period” — which is defined as the 121-day period that begins 60 days before the ex-dividend date, or the day on which the stock trades without the dividend priced in.

Taxes On Capital Gains

Capital gains (or capital losses) refer to profits from an investment. Investments held in an after-tax brokerage account are taxed differently depending on how long you have held the investment. Gains on investments held longer than 12 months are taxed at long-term capital gains rate. Depending on your income you could end up paying 0% capital gains, 15% capital gains, or 20% long-term capital gains. In order to pay 0% capital gains, your income must stay below a specific threshold. Capital gains on investments held less than 12 months are taxed at ordinary income tax rates.

Tax Avoidance Is Legal

Tax avoidance is legal, but tax evasion may get you up to 5 years in a federal prison. Knowing the tax laws and applying them to your specific circumstances is your responsibility. If you don’t know the rules, make sure you are working with professionals who do. Do not expect the IRS to help you strategize, or alert you when you have overpaid because you didn’t know the rules.

Understanding how to manage unavoidable taxes, and how to avoid unnecessary ones, is one of the greatest challenges many folks will face as they charge to and through their retirement years.

Paying more than you are required to by law could result in tens of thousands if not hundreds of thousands of dollars lost over a 25 to 30-year retirement. Knowing how and when to distribute money from specific accounts in order to minimize taxes on distributions is a critical factor in maximizing your resources for your enjoyment and that of your family.

Every dollar that you send to the IRS unnecessarily is a dollar that you will not be able to use to make the memories. It’s a dollar that can’t be used to make life worth living. Each dollar eroded by taxes that could be avoided could mean one less vacation, or one less unforgettable experience with your children or grandkids. Perhaps it’s one less day enjoying your favorite hobby or pastime.

The rules are vast, and complex, and it’s up to you and your team of professionals to apply them effectively. Slow down, take you time, and get educated. Find a team of professionals who understand how various taxes work and how they interact with each. Make certain to incorporate tax planning into you overall written retirement income plan. Your future self will thank you for it.

“Investment Adviser Representative of and advisory services offered through Royal Fund Management, LLC, a SEC registered investment adviser.”

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