What to Know About Tax Advantages of a Retirement Program

While there are a variety of different retirement vehicles available, the retirement tax advantages are limited to two varieties. While both offer incentives, the benefits of one may be more advantageous to some groups than others.


There are now Roth 401k's provided by an employer and Roth IRA's setup and funded by an individual. These are "after tax" plans, meaning they are funded with dollars after FICA taxes have been withheld on your paycheck. The advantage to these comes, as once a plan is funded, the individual will never pay taxes on the earnings (capital gains, dividends or interest) again (assuming they do not withdraw the proceeds before age 59 ½).

There are also tax deferred retirement programs such as a 401k, 403b, Simple IRA (employer supplied) and Traditional IRA. Essentially, the advantage to these retirement plans is that the money invested in the plan comes out of your paycheck before taxes do.

Here is an example of how this works, assume that someone makes $1,000 a week and that they are in the 25% tax bracket. As such they will pay $250 in taxes, and ordinarily take home $750. Now let's assume instead that this individual contributed 10% of their earnings ($100) to a deferred plan, it would lower the amount of income that is taxable to $900 and instead leave them with $675 in take-home plus $100 in their retirement account. This is a total of $775 an additional $25 per pay check ($1,300 per year). Note - for simplicity, in this example we've used a flat tax rate, not progressive.

As an individual's tax rate increases the saving in using a deferred account becomes greater. Also, since many states also exempt these contributions from state taxes, it is possible to benefit even more than what is shown in this example.

As long as the withdrawal occurs after age 59 ½, the money will be subjected to ordinary income tax rates. Anything taken before this age, may include a penalty on any withdrawal. If your financial circumstances require an early withdrawal or distribution before you reach age 59½, you must be aware that retirement tax penalties will apply.

In addition to having to include the distribution as part of your taxable income, you will have to pay a 10 percent penalty unless you qualify for one of many exceptions including these four common ones:

  • The distribution is going to a beneficiary after your death.
  • You are permanently disabled.
  • The money is going to pay deductible medical expenses that total more of than 10 percent of your annual income.
  • The withdrawal occurred as a result of an IRS levy on the retirement plan.

Furthermore, there are temporary changes to the withdrawal rules under the CARES Act in 2020. If you have become unemployed and need to withdraw some or all of your retirement savings, you may be able to make an emergency withdrawal from your IRA. The CARES Act eliminates the 10 percent penalty for early withdrawal if you are under the age of 59 and a half. The Act also allows you to pay back the money you withdrew.

One of the other benefits, in either type of plan an employer-sponsored account often includes an employer match of some sort. Matches, go straight to the employee's retirement account and are typically given as a percentage of the employee's salary (up to a certain amount, provided the employee contributes that same amount). There are guidelines specifying how much the employer may offer and how they can offer it. The important part is this is free money to the employee, all they have to do is participate.

Q&A: What is The Form 1099-R?

Form 1099-R is generally used to report income that you received from a retirement account. This income could have been from a pension, an annuity, a retirement or profit-sharing plan, an IRA, or an insurance contract.

The Form 1099-R will usually contain the distribution, the taxable amount, withholding, and a distribution code. See the corresponding boxes below:

Box 1 - Distributions received during the tax year.
Box 2a - Taxable amount (box 2a). Note, if no amount is listed here, it can indicate that the payer did not have sufficient information to determine if funds are taxable.
Box 4 - Federal income tax withheld.
Box 7 – Distribution code (why you received the distribution). If this code indicates early distribution, additional 10% tax may apply.
Box 10 – Roth Rollover.
Box 12-17 - State or local income taxes withheld.

For more on 1099-R forms and distribution codes please see: https://www.irs.gov/pub/irs-prior/i1099r--2020.pdf

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