Taxation of Retirement Plans: The 3 Buckets
Taxation of Retirement Plans: The 3 Buckets
February 8, 2019

In the United States, there are really only two places you can put your retirement money: either in a Non-Qualified Plan or in a Qualified Plan.

The main difference between the two is Non-Qualified Plans use after-tax money and with Qualified Plans use pre-tax money. Both plans typically invest in the same type of investment vehicles, stocks, bonds, mutual funds, life insurance, and annuities.

There are three phases, or buckets, of money for every retirement plan: the contribution bucket, the accumulation bucket, and the benefit bucket. Uncle Sam doesn’t care which bucket of money you pay taxes on (small, medium, or large), but you must choose at least one. When deciding on a type of retirement plan or retirement vehicle, it’s important you understand how it’s taxed.

First, let’s take a look at Non-Qualified Plans and the most common investment vehicles used.

Mutual Funds (Stocks & Bonds): Give you the privilege of being taxed on all three buckets (contribution, accumulation, and benefit buckets). Gains from mutual funds are distributed every year (whether or not you sold shares). Typically, the gains distributed are both long-term and short-term gains. The tax you pay on mutual funds each year is typically between 15% – 50%* (federal and state taxes).

Annuities (Fixed, Indexed, and Variable): Annuities are taxed on two buckets (contribution and benefit buckets). Annuities are one of only two investments that turn capital gains into ordinary income. Annuities illustrate best if you don’t use the money and don’t die (both are taxable events). The tax you pay on annuities is typically between 15% – 50%* (federal and state taxes).

Qualified Plans (401-K, Pension, Money Purchase, Profit Sharing, etc.): Qualified plans are taxed only on one bucket (the big benefit bucket). Qualified plans are really shells that allow you to invest into stocks, bonds, mutual funds, annuities, and life insurance using pre-tax money. The theory behind qualified plans is you put money in them when you are in a high tax bracket and pull money out at retirement when you are in a low tax bracket. This might work for some people but typically the tax bracket you are in mirrors your life style. Historically, we are currently in a low tax environment (37% top federal tax bracket). It might be better to pay taxes now rather than to roll the dice to see what your tax bracket might be 20 or 30 years. Would you like to pay taxes on the $10,000 you invest today or pay taxes on the $1,000,000 you withdraw 20 years from now?

Qualified Plans are great, but they’re not always the best retirement solution for all people. And as a business owner, you get a new partner when you set up a Qualified Plan. Your new partner: Uncle Sam. He’s going to tell who can be in the plan (you can’t discriminate). He is also going to tell how much you can put into the plan. The most you can put in yourself each year is approximately $55,000 (it might take a couple of plans to do that). But if you put in $55,000 a year for yourself you will need to match somewhere between $15,000 – $20,000 for your employees.

Your employees need to be vested in 5 – 7 years so you will eventually lose that money. Uncle Sam also tells you when you can pull money out of the plan. If you pull it out before age 59 ½ you get hit with a 10% penalty tax, and CA adds on an additional 2.5% (this is on top of income taxes). At age 70 ½ if you don’t pull out the minimum out of your plan you get hit with a 50% excise tax. You also have administration costs that can range between $300 – $8,000 a year, and about every 3 – 5 years Uncle Sam changes the rules with qualified plans. The rule changes typically reduce the advantages of qualified plans for higher income earners. Lastly, you always have the potential to be audited with a qualified plan.

* 2018 maximum contributions to Qualified Plan: 55,000 (Profit Sharing Plan), 18,500 (401-k Plan)

So where else can you put your money?

Life Insurance (Index Universal Life or Variable Universal Life): Life insurance is a Non-Qualified Plan, so you are using after-tax money. Life insurance is taxed only on one bucket (the small contribution bucket). Life insurance allows your money to grow tax-free; you can withdraw money out completely tax-free and your beneficiaries can receive an income tax-free death benefit. Using Index Universal Life (IUL), you can get the upside of an index like the S&P 500 and a guarantee to never have a negative return. Life insurance is very similar to a Roth IRA, with the exception of allowing you to put in as much money as you want (a Roth IRA* has a $5,500 a year limit).

Life insurance offers several additional advantages over qualified plans, especially if you’re a business owner:

  • No contribution limits
  • No discrimination rules (you can select whoever you want or just yourself)
  • No matching requirements for employees
  • No vesting requirements for employees
  • No penalties for withdrawals prior to age 59 ½
  • No minimum withdrawals required at age 70 ½
  • No annual administration cost (qualified plan costs are $300 to $8,000 a year)
  • No rule changes every 3 – 5 years (there have been 15 tax code changes regarding qualified plans since 1974)
  • No potential audits

There are two ways you can pull money out of a life insurance policy: withdrawal or a loan. Withdrawals are a tax-free recovery of your cost basis in the policy and are always tax-free. The way to beat Uncle Sam when you pull the gains out of the policy is to call it a loan. This is a loan you never have to pay back. Many insurance companies have loans (that may charge you 5% and credit you 5% on the loan). As long as you die with the policy in force, all the loans are completely income tax-free.

* Your income must be less than $189,000 to be able to contribute $5,500 into a Roth IRA

Short Term Gains (Ordinary Income) Federal Top Tax Bracket37%
Short Term Gains (Ordinary Income), State (CA) Top Tax Bracket13.3% Federal and CA Income Tax - Top Brackets 2018
Medicare Surtax (Obamacare) 3.8%

Federal and CA Capital Gain / Dividend Tax - Top Brackets 2018

Dividends & Long-Term Gains, Federal Top Tax Bracket20%
Dividends & Long-Term Gains, State (CA) Top Tax Bracket13.3%
Medicare Surtax (Obamacare) 3.8%

History of U.S. Federal Income Tax Rates

YearsRange of Rates (%)Highest Amount Over ($)
1913 – 19151 – 7
1919 - 19243 - 731,000,000
1930 – 19351 – 631,000,000
1942 – 195316 – 92
1954 – 196320 – 91 400,000
1965 – 197114 – 75
1972 – 198014 – 70212,000
1982 – 198612 – 50171,580
1988 – 199215 – 31
1993 – 2000
15 – 39.6
2001 – 200210 – 38.6
2004 – 201210 – 35
2013 – 201710 – 39.6
2018 -10 – 37
Average Top Tax Bracket:57.31%