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Effects of Retirement Savings and Home Ownership

March 23, 2020

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UPDATE: On March 21, 2020, The Treasury Department and Internal Revenue Service announced that the federal income tax filing due date is automatically extended from April 15, 2020, to July 15, 2020.

Taxpayers can also defer federal income tax payments due on April 15, 2020, to July 15, 2020, without penalties and interest, regardless of the amount owed. This deferment applies to all taxpayers, including individuals, trusts and estates, corporations and other non-corporate tax filers as well as those who pay self-employment tax.

Retirement savings and homeownership are two of the largest financial investments for many taxpayers. In this post we discuss the income tax implications for both.

RETIREMENT

Over the years, Congress has devised a variety of ways to incentivize Americans to save for retirement. Below, we describe some of the more common options, and we also discuss a few relevant options for those working at GGC. As a preliminary matter, most plans are broken down into two broad categories.

Defined Benefit Plans

First, there are defined benefit plans (i.e., pensions). Typically, these promise an employee an income stream after retirement, which is based on how long the employee works with their employer and on the amount of salary the employee earns over the years. For 2019, a retiring employee could not receive a benefit in excess of 100% of the average of their three highest years of salary (and in no case higher than $225,000). Employees are not vested (i.e., entitled to receive the benefit) until they have worked a certain number of years for their employer.

USG has such a plan for its employees known as the Teachers Retirement System (TRS) of Georgia. This plan vests with employees after they have worked 10 years in the system. Employees are eligible to receive this benefit when they turn 60 and have at least 10 years of service (or once they have worked 30 years in the system). Once the employee retires, this income stream will last for the rest of their life. Finally, note that some or all of each payment is subject to income tax.

Defined Contribution Plans

Second, there are defined contribution plans. With these plans, employers agree to contribute a certain amount to an employee’s retirement. Often, the employer will match the employee’s contribution up to a certain annual amount. This plan allows employees to have control over these contributions and invest them into the market. This also means that employees bear the risk of making investments.

The best-known plan is the 401(k), which is very similar to USG’s Optional Retirement Plan (ORP). With the USG plan, employees contribute 6% of their yearly salary, and USG contributes a little over 9%. There is no vesting period, and employees have wide latitude in where to invest the funds. The USG also offers two supplemental plans—the 403(b) plan and the 457(b) plan—which work much the same way except only the employee makes contributions. With some exceptions, employees can take distributions from most of these accounts once they turn 59½ (or 55 if they have retired). Otherwise, they are assessed a 10% penalty from the Internal Revenue Service (IRS).

For all plans, there are annual contribution limits. For instance, traditional 401(k) plans limit employee contributions to $19,000 in 2019 and $19,500 in 2020. For employees 50 and over, the total contribution limit goes up to $25,000 in 2019 and $26,000 in 2020. The ORP comes with higher limits (up to 100% of an employee’s salary, but not over $56,000 in 2019 and $57,000 in 2020).

From a tax planning perspective, the biggest thing to remember is that many defined contribution plans come in two types—traditional and Roth. For traditional, an employee can exempt the amount of their annual contributions from gross income (and they do not have to include the amount of their employer’s contribution). On the flipside, the employee must report the amount of their annual distributions as gross income after they retire. This means paying tax on the amount of your original investment plus all its market growth over the years. For Roth accounts, employees do not get any tax deduction up front for their contributions. However, they may take distributions tax free once they retire. Of course, the big benefit here is that all the market growth the account has experienced over the years will be always and forever tax free.

In closing, it should be noted that this is a highly technical area of the law, and the above summary is just that—a general overview. For example, there are various ways to “roll” some types of retirement accounts into other types, and there are specific rules on when a taxpayer must start taking withdrawals from their account(s) to avoid penalties.

HOME OWNERSHIP

In addition to trying to incentivize Americans to save for retirement, the tax code also sees fit to encourage Americans to purchase and own a home. While not trying to undersell the nuances, this discussion is much easier than the former one. Mainly because we’ve already discussed the big advantages of homeownership in a previous blog post.

Recall, taxpayers may deduct interest payments they pay on their mortgage(s) each year. Taxpayers may also generally deduct points paid on their mortgage loan (if the points were bought in order to bring the interest rate on the loan down). Recall also that property taxes paid on all kinds of real estate owned by a taxpayer are eligible for itemized deductions (up to $10,000 for all taxes paid).

One other area where home ownership is beneficial from a tax standpoint occurs when the home is sold. Normally, when a taxpayer sells an asset, taxes must be paid on the gain. For homeowners, this could potentially add up to a large tax burden if the property has increased in value over the years. However, for a home that a taxpayer has owned and used as their principal residence for at least two of the past five years, the tax code allows for up to $250,000 of gain to be excluded from gross income. For married couples who file jointly, the exclusion doubles to $500,000. In effect, this means that most taxpayers who meet the time requirements will not have to report any gain on a home sale.

Finally, while we do not discuss them here, it is also worth noting that the tax code has special implications for taxpayers who rent parts or all of their homes, and for taxpayers who run businesses out of their homes.

CONCLUSION

Retirement savings and homeownership are two of the largest financial investments for many taxpayers. Both areas of the tax code are highly complex, requiring special care for taxpayers to comply with the code and maximize the benefits afforded.

DISCLAIMER

Dr. Benjamin Akins and Dr. James A. Weisel are faculty members in the Georgia Gwinnett College School of Business. The content of this blog should not serve as a substitute for legal advice from an attorney or accountant familiar with the facts and circumstances of your specific situation. If legal or accounting assistance is needed, we recommend that you seek the services of a qualified professional.