What triggers a tax liability for an individual or a trust? What can I expect to pay in taxes and when can I expect it? How can I prepare myself to pay the least amount of taxes in my retirement?
In this article, we will answer some of these questions and help you understand some of the taxable events you can expect in your future.
When you distribute, sell, or receive assets from a retirement account, taxes usually follow. It is true for individuals; it is true for trusts. These decisions represent taxable events.
Many retirement accounts are tax-deferred, but not tax-exempt. So, at some point, a “day of reckoning” arrives for these accounts, and taxes are due. The tax liability may differ greatly, depending on account ownership. This point in time can make it or break it for many people’s nest eggs. Often the amount of money you saved in the short-term by deferring taxes is drastically less than what you will pay when receiving income from your retirement account.
Trust income is now taxed much more than individual income. This is a result of the Tax Cuts and Jobs Act of 2017. As an example, in 2019, a trust could earn up to $2,650 in taxable income without federal taxes on its qualified dividends or capital gains. That threshold was almost 15 times higher ($39,375) for an individual. Factor in a $12,200 standard deduction in that same year, and an individual could potentially have up to $51,575 in qualified dividends to manage their federal income tax liability. Additionally, an individual has to have net investment income or modified adjusted gross income in excess of $200,000 per year to face the 3.8% net investment income tax (NIIT). Compare that with a trust: the threshold is just $12,750. Using a trust involves a complex set of tax rules and regulations. Before moving forward with a trust, consider working with a professional who is familiar with the rules and regulations.
Say an investment in your retirement account is sold for a capital gain. If it has been held in your account for less than a year, that capital gain is short term; short-term capital gains are usually taxed at the same rate as earned income. If those shares have been in your account for more than a year, then long-term capital gains tax rates likely apply, which are either 0% or 15% for most individuals. A trust also faces the possibility of capital gains tax in this situation whether it distributes the gain or it doesn’t. Both trusts and individuals can use capital losses to offset capital gains.
Suppose you receive dividends in a retirement account. In an ordinary brokerage account, qualified dividends are taxable annually whether the money is distributed, reinvested, or left in cash. The threshold for taxation of qualified dividends is much lower for a trust than for an individual. Reinvested dividends in an Individual Retirement Account (IRA) are not taxed. Regarding IRAs, it is important to note that distributions from traditional IRAs must generally begin once you reach age 72. The money distributed to you is taxed as ordinary income. When such distributions are taken before age 59½, they may be subject to a 10% federal income tax penalty, although the CARES Act allows some exceptions to the penalties for 2020. (You may continue to contribute to a Traditional IRA past age 70½ under the SECURE Act as long as you meet the earned-income requirement.)6
How are taxable events in retirement accounts reported, and when are taxes withheld? Each tax year, Form 1099s tell the story. The 1099-DIV tracks dividends, the 1099-INT displays interest income, and the 1099-R shows distributions out of pensions, IRAs, retirement plans, and insurance contracts. Now to withholding. Distributions from employee retirement plans have taxes withheld unless a trustee-to-trustee transfer occurs (i.e., the invested assets go seamlessly from one retirement plan to another, with the individual or trust never taking possession of them). The withholding rate in such instances is 20%. An IRA owner can choose not to withhold tax from an IRA distribution; otherwise, the withholding rate is 10%. There is no withholding at all, of course, on investment income from a taxable brokerage account or capital gains and losses. Keep in mind that this article is for informational purposes only and not a replacement for real-life advice. Also, tax rules are constantly changing, and there is no guarantee that the tax treatment of IRAs and other qualified retirement plans will remain the same in years ahead, for individual taxpayers or trusts.
To boil it down, you need to know what the future holds for your taxation structure. While the retirement accounts that you have may be saving you thousands now, when you start withdrawing, the taxes you pay could be in the tens if not hundreds of thousands. There are strategies to save you from this future headache, and seeking professional perspective is always a good choice.
Citations.
1. The Tax Adviser, April 25, 2019
2. Internal Revenue Service, May 28, 2020
3. Tax Policy Center, May 2020
4. CRRCPA.com, August 27, 2019
5. Investopedia, January 21, 2020
6. TheStreet, May 13, 2020
7. Nolo.com, August 12, 2020
8. The Balance, July 14, 2020