IRS Tools: the CARROT and the STICK

Tax policy is clearly just as much a social engineering tool as it is a revenue source.  When you think of it, this makes perfect sense and is something we should probably applaud.  By driving us to be healthier (by assessing outsized taxes on cigarettes, junk food, and fossil fuels), the government is arguably reducing the amount of total taxation, by reducing the health and environmental impact associated with these items – as well as the attendant costs of care and remediation that would likely fall on the government to provide.  The premise is, obviously, that people utilize these items less if they’re taxed more.

And even as this system of ‘sticks’ is used to discourage destructive (and ultimately costly) behavior, there are ‘carrots’ that taxing authorities use to encourage certain behaviors.  Tax credits and deductions for everything from purchasing electric vehicles to sending kids to college are prime examples.

The IRS is also very interested in encouraging people to save for retirement.  It doesn’t take too much imagination to figure out why.  People who save for retirement are less dependent on tax-funded social programs for their health, maintenance and support.  Needless to say, they provide some ‘carrots’ to lure people into the good behavior of saving for retirement – but they’re at the ready with a number of ‘sticks’ as well to make sure the carrots aren’t abused!

THE CARROTS

• Tax Deductibility – Putting money into an employer retirement plan, or an individual retirement account (if you don’t have an employer retirement plan) can be done before income taxes are assessed.  As such, savers are able to put more money aside because of the tax savings than they otherwise would.
• Tax Deferral – Assets put into retirement plans are not taxed as they grow, but rather when they’re taken out, giving all of the assets time to accumulate value instead of just those that escape the Tax Man.
• Tax-Free Growth – Even better than tax-deferred growth, some retirement savers have the ability to invest in accounts whose growth is NEVER TAXED AT ALL. The most common version of this is a Roth IRA, which anyone with income can contribute to (as long as their income isn’t too high) or convert to regardless of income.
• Deductibility of Employer Contributions – Corporations get to deduct contributions made to employee retirement plan accounts from taxable income, incentivizing them to do so. They generally need to follow some stringent rules that ensure these retirement plan contributions aren’t given out in a discriminatory way (for example, they can’t just be for the ‘big wigs’ but have to also cover rank-and-file employees.)
• Actual Tax Credits – Perhaps there is no carrot more effective than just plain FREE MONEY. And that’s what the “savers credit” is about.  Taxpayers whose income is low to moderate can get up to a 50% credit for any contributions they make to a retirement plan, including an Individual Retirement Account (IRA)

Keep in mind, though, that the IRS wants to make sure that if you are offered a carrot to save for retirement, that there’s also a ‘stick’ to make sure you are actually using the money for retirement.

THE STICKS

• Early Withdrawal Penalties – Depending upon the retirement plan one is in, distributions taken prior to 59 ½ years of age result in a 10% to 25% surtax (on top of normal taxes on income). There are some exceptions to this rule.  Among them:
  • Section 457 (public employer) retirement plans don’t generally have early withdrawal penalties
  • If you work for an employer under a 401(k) or 403(b) plan, and retire after age 55, there are no early withdrawal penalties from those employer’s plans.
  • Other limited exceptions exist for first-time homebuyers, withdrawals for college tuition, disability and certain systematic distributions.
• Late Withdrawal Penalties (or Required Minimum Distributions) – Much in the same way that the IRS going want their carrot back if you take retirement assets out before what they consider to be ‘retirement age’, they also don’t want you to dilly-dally too long in taking them out (and, as you might imagine, paying taxes on them)! After all, these are ‘retirement plans’, not ‘make-your-kids-rich’ plans!  If you don’t start taking retirement distributions in the year you turn 70 ½, you’ll be hit with a whopping 50% penalty tax on what you should have taken bud did not.  Again, some exceptions apply:
  • For people who are still working, they can delay Required Minimum Distributions in their employer’s plan.
  • The first year’s Required Minimum Distribution can be delayed to April 1^st of the following year.

With retirement savings, and a large number of other things, the secret is to maximize the ‘carrots’, while avoiding the ‘sticks’.  This often takes careful planning, but that’s why we’re here!