Retirement Tax Planning: The Three Tax Wallets
Note: While some information in this article is specific to BP employees, the points about the three tax wallets may be useful for anyone saving for retirement.
To understand the myriad types of retirement accounts and their complex tax treatments requires a certain depth of knowledge and expertise in retirement tax planning, more than can be adequately discussed within the confines of this article. However, we can simplify things by focusing on the three most common tax treatments, which I will refer to as the three tax wallets. They are:
- Non-qualified accounts
- Traditional qualified accounts
- Roth qualified accounts
1) Non-qualified accounts. These accounts do not qualify for favored tax treatment, thus the name. They can be identified by the receipt of a 1099 tax form. The 1099 lists the interest, dividends, and realized capital gains over the tax year, to be reported on the tax return. Tax is paid each year on these items of income. The most common account types in this wallet include Individual and Joint accounts; most commonly held in brokerage or bank accounts.
2) Traditional qualified accounts. These retirement accounts qualify for favored tax treatment if used for a qualified purpose. They can be identified by the tax deductibility of contributions. The account is not subject to taxation on any current income or gains. Withdrawals are taxed, and a 1099R form is used to report those withdrawals. Penalties may be assessed if the withdrawals are not used for the intended purpose, or if certain IRS rules are not followed. The most common account types in this wallet include before-tax 401k plans, cash balance pension plans, and traditional IRA plans. Specific to BP employees: Your before-tax BP ESP (401k) plan and your RAP pension are both examples of accounts in this tax wallet.
3) Roth qualified accounts. These retirement accounts also qualify for special tax treatment. Unlike traditional qualified accounts, the contributions are not deductible. As with a traditional qualified retirement account, income and gains are not taxable, but in addition the withdrawals are tax free if certain rules are met. The most common account types in this wallet include Roth 401(k) plans and Roth IRA accounts.
Addressing Retirement Tax Challenges for BP Employees
BP provides excellent retirement benefits, making large contributions to both the ESP 401(k) and the RAP pension. These employer contributions are all pre-tax. In addition, most employee 401(k) contributions are pre-tax. BP employees realize that if they maximize their 401(k) contributions, after a long career they will be able to successfully retire without saving money into any other accounts outside of BP. At retirement, they end up with a nice nest egg, all in traditional (pre-tax) qualified accounts. BP employees with a high letter grade are helped in this regard by the various non-qualified excess benefit plans and stock plans.
In the context of retirement tax planning, having everything in traditional qualified accounts is less than desirable. Remember that income tax has not yet been paid on these accounts. This can be viewed as a tax debt owed to the IRS. The IRS is a horrible creditor: consider that with any other debt, the borrower knows the terms of loan, such as the payment amount and interest rate. The IRS, on the other hand, will charge you whatever future tax rate is in existence at the time funds are withdrawn! It is very plausible that due to the mountain of Federal debt, it will be necessary for the Federal Government to raise future tax brackets. No one will be happy with a traditional qualified account that had contributions which were deducted in a 22% or 24% bracket, but withdrawals that will be taxed at 50% or higher! In that scenario, your pretax 401(k) and RAP plan will have been a tax trap.
Retirement Tax Planning Solutions for BP Employees and Beyond
As part of a comprehensive retirement tax planning strategy, the BP 401(k) offers a Roth option for contributions. It also offers an after-tax option, which can be rolled into a Roth IRA. These Roth (and after-tax to Roth) options are often your best choices, especially for younger employees who are not yet in their peak earning years. By choosing the Roth option, you pay tax in today’s known bracket, and by so doing avoid paying tax later in an unknown (and perhaps higher) bracket. The difference between making the right and wrong choice can be impactful.
The nine CFP®s at Financial Plan are thought leaders regarding the topic of Roth IRAs and Roth IRA conversions. Consult with your Financial Plan advisor before making any changes to your current elections.
