Oct
10
2024

Guide to Rolling Over a 403(b) Into an IRA

By | invest, Investing, Preparing for Retirement | Comments Off on Guide to Rolling Over a 403(b) Into an IRA

If you have a 403(b) plan at work and you leave your employer, you could roll over some or all of your savings into an IRA. Rolling a 403(b) over to an IRA simply means moving money from one retirement account to another.

You might consider a 403(b) rollover if you’d like to gain access to a wider range of investment options. Understanding how the process works can help you decide if rollover 403(b) makes sense.

Key Points

•   A 403(b) is a retirement plan for employees of public schools, religious organizations, and certain non-profits.

•   Rolling over a 403(b) to an IRA can offer more investment options and potentially lower fees.

•   There are various types of IRAs, including traditional, Roth, SIMPLE, and SEP IRAs, each with different tax implications.

•   Consider tax implications, fees, and investment options before rolling over a 403(b) to an IRA.

•   Rolling over a 403(b) to a Roth IRA requires paying income tax on the rollover amount, but allows for tax-free withdrawals in retirement.

What Is a 403(b)?

If you don’t know what a 403(b) plan is, it’s a retirement plan that’s offered to employees of public schools, religious organizations, and certain other 501(c)(3) tax-exempt organizations.

A 403(b) plan may also be called a tax-sheltered annuity or TSA, because in some instances the organization’s 403(b) plan may include an annuity option; in other cases the plan can be structured more like an investment account, similar to a 401(k).

Like a 401(k), these plans allow you to defer (i.e., contribute) part of your salary each year to the 403(b) plan, and pay no tax on the money until you begin taking distributions.

In many cases you can choose to make your 403(b) a Roth-designated account, in which case you’d make contributions using after-tax dollars and withdraw them tax-free in retirement, similar to a Roth IRA.

How a 403(b) Works

Eligible employers can establish a 403(b) plan on behalf of their employees. IRS rules define eligible employers as:

•   Public schools, including public colleges and universities

•   Churches

•   Charitable entities that are tax-exempt under Section 501(c)(3)

Elementary school teachers, college professors, and ministers are all examples of employees who may be eligible to contribute to a 403(b) plan. Contributions reduce taxable income in the year they’re made, and are taxed as ordinary income when withdrawn.

The maximum contribution limit is $23,000 for 2024. Employees age 50 or older can make catch-up contributions of up to $7,500 per year, for a total of $30,500. There are special catch-up rules for workers who have at least 15 years of service, who may be eligible to contribute an additional $3,000 per year if they meet certain criteria.

Combined contributions from the employee and the employer — employers can also make matching contributions — may not exceed the lesser of 100% of the employee’s most recent yearly compensation or $69,000, in 2024.

Like most other types of employer-sponsored retirement plans, 403(b) accounts are subject to required minimum distribution rules (RMDs), which require plan participants to start withdrawing a certain sum of money each year when they reach a certain age.

Per IRS.gov: “You generally must start taking withdrawals from your traditional IRA, SEP IRA, SIMPLE IRA, and retirement plan accounts when you reach age 72 (73 if you reach age 72 after Dec. 31, 2022).” This may factor into your decision about whether to do a rollover to an IRA.

Get a 1% IRA match on rollovers and contributions.

Double down on your retirement goals with a 1% match on every dollar you roll over and contribute to a SoFi IRA.1

1Terms and conditions apply. Roll over a minimum of $20K to receive the 1% match offer. Matches on contributions are made up to the annual limits.

What Is an IRA?

An individual retirement account, also referred to as an IRA, is a tax-advantaged savings account that you can open independently of your employer.

You can open an IRA online through a brokerage and make contributions up to the annual limit. Whether you pay tax on distributions from your IRA depends on which type of account you open.

Types of IRAs

It’s important to know how an IRA works, since the options are quite different, especially when it comes to making a 403(b) rollover:

•   Traditional IRAs. Traditional IRAs allow for tax-deductible contributions, and qualified distributions are subject to ordinary income tax. Whether you’re eligible to claim IRA tax deductions, and how much, is determined by your income, filing status, and whether you’re covered by an employer’s retirement plan at work.

A rollover from a 403(b) account to a traditional IRA is an apples-to-apples transfer in terms of tax treatment, as both are tax-deferred accounts. Traditional IRAs also fall under RMD rules.

•   Roth IRA. It’s important to understand the distinctions between a Roth IRA vs a 403(b). Roth IRAs do not offer tax-deductible contributions, but they do allow you to take qualified distributions tax-free in retirement. Also, you’re not required to take RMDs from a Roth IRA, unless it’s inherited.

A rollover to a Roth IRA from a 403(b) is essentially a Roth conversion (see below), and would require you to pay income tax on the rollover amount. That said, you might be able to avoid the income limits for traditional Roth accounts. As this option is more complicated, you may want to consult a tax professional.

Note: while IRA contributions for traditional and Roth accounts are capped at $7,000 for 2024, with an additional catch-up contribution limit of $1,000 for those 50 and up, those limits don’t apply to rollovers of higher balances from other retirement accounts.

•   SIMPLE IRA. SIMPLE IRAs are designed for small business owners and their employees. These plans allow employees to defer part of their salary while requiring employers to make a contribution each year.

SIMPLE IRAs generally follow traditional IRA tax rules, and a rollover from a 403(b) would not trigger a tax event in most cases, when using a direct rollover method (see below for details).

•   SEP IRA. A SEP IRA is another retirement savings option for business owners and individuals who are self-employed. SEP IRAs offer higher annual contribution limits than SIMPLE IRAs, though they also follow traditional IRA tax rules, and the same rollover terms generally apply.

Unlike many employer-sponsored plans, ordinary traditional and Roth IRAs don’t offer employer matching contributions. Withdrawing money early from an IRA could trigger a 10% early withdrawal penalty, with some exceptions. Traditional IRAs are subject to required minimum distributions (RMDs) beginning at age 72, or 73 if you turn 72 after Dec. 31, 2022.

Recommended: How to Open an IRA in 5 Steps

Can You Roll Over a 403(b) Into an IRA?

Yes, the IRS allows you to roll a 403(b) over to an IRA. That includes rollovers to a traditional IRA, SIMPLE IRA, or a SEP IRA. You may be able to do a rollover to a Roth IRA, with possible tax implications.

You can also roll over a 403(b) into another 403(b), a 457(b) account — which is for state and local government employees, and some non-profits. If you have a 403(b) with a designated Roth feature, you can do a rollover to a Roth IRA without tax implications.

There are, however, a few things to consider before rolling over a 403(b).

Investment Options

Some people may choose to roll a 403(b) to an IRA if the IRA custodian (i.e., the brokerage holding the account) has better investment options. In many cases an IRA can offer a wider range of investment options.

If you’re feeling limited by what your 403(b) offers, then it may be to your advantage to move your savings elsewhere. However, it’s important to look at not only the range of investments an IRA offers but the types of investment fees you’ll pay for them. Ideally, you’re able to find a rollover IRA that features a variety of low-cost investments.

Rollover Methods

There are different ways to rollover a 403(b) to an IRA, including:

•   Direct rollovers

•   Indirect rollovers

With a direct rollover, your plan administrator moves the money from your 403(b) to a tax-deferred IRA for you. All you may need to do is fill out some paperwork to tell the plan administrator where to transfer the money. No taxes are withheld for this type of transfer, as long as the account designations match, i.e. a tax-deferred 403(b) to a tax-deferred or traditional type of IRA; a Roth-designated 403(b) to a Roth IRA.

Indirect rollovers may allow you to receive a paper check, then deposit the money to an IRA yourself. The problem with that, however, is that if you fail to deposit the funds within 60 days of receiving them, the entire amount becomes a taxable distribution (meaning: you will owe income tax on that money, as if it were a straight withdrawal).

You may want to ask your plan administrator what options you have for rolling over a 403(b), and choose the method that’s easiest for you.

Withholding

If you decide to request an indirect rollover with a check made payable to you, your distribution is subject to a 20% mandatory withholding. The withholding is required even if you plan to deposit the money into an IRA within the 60-day window.

Should you choose the indirect rollover option, you’d need to keep in mind that you wouldn’t be receiving the full balance, unless you have the rollover check made out to the institution holding the receiving IRA.

Other Retirement Plans

Certain employees may be eligible to contribute to both a 403(b) and a 457(b). For example, public school teachers who are also classified as state employees may have access to both plans.

If you have a 403(b) and a 457(b) you’d need to decide if you want to rollover funds from both plans, or just one, when you leave work or retire. That might require you to take a closer look at how much money you have in each plan, how it’s invested, and the fees you’re paying before you make a decision.

Do You Pay Taxes When Rolling a Pension Into an IRA?

Whether you pay taxes when rolling a pension into an IRA depends on which type of IRA you’re moving the money into, and whether you’re completing a direct or indirect rollover. If you’re rolling over your 403(b) to a traditional IRA, then you’d pay no tax if you’re doing a direct rollover.

If you choose an indirect rollover, the 20% withholding applies.

Roth Rollovers

Rolling over a 403(b) to a Roth IRA would, however, trigger tax consequences if your plan was funded with pre-tax dollars. In that case, you’d have to pay income tax on those assets when you roll over the money to a Roth IRA, similar to doing a Roth conversion. When you make qualified distributions from the Roth IRA later, those would be tax-free.

If you’re rolling funds from a Roth-designated account to a Roth IRA that would be a tax-free rollover. Qualified withdrawals would also be tax-free, though taking money out prior to age 59 ½ could result in a 10% early withdrawal penalty.

Pros and Cons of Rolling a 403(b) Into an IRA

A 403(b) rollover to an IRA can offer some advantages but there are some potential drawbacks to consider, too.

Pros of a 403(b) Rollover

Rolling over a 403(b) to an IRA could benefit you if you’re looking for different investment options or you want to convert traditional retirement savings to a Roth account.

Roth IRAs can be attractive thanks to the ability to take qualified tax-free distributions. If your income is too high to make direct contributions to a Roth account, then rolling over 403(b) funds could offer a backdoor point of entry (sometimes called a backdoor Roth).

A 403(b) to IRA rollover may also be attractive if your current retirement plan charges high fees or you’re finding it difficult to diversify based on the current range of investments offered. You may also prefer rolling over a 403(b) to your IRA so that all of your retirement savings are held in one centralized account.

Cons of a 403(b) Rollover

One of the biggest cons of rolling over 403(b) funds has to do with taxes. If you choose an indirect rollover, 20% of your savings is automatically withheld. You also run the risk of having the rollover treated as a taxable distribution if you’re not able to deposit the money to your IRA within the 60-day window.

Aside from that, there are also the tax implications from rolling a traditional 403(b) into a Roth IRA. If you’re rolling over a large amount of money, that could lead to a much higher than usual tax bill.

Deciding Which Retirement Account Is Right for You

Choosing the right retirement account starts with understanding your needs and goals. One of the best features of 403(b) plans and other workplace plans is that you may be able to get additional savings in the form of employer-matching contributions. Those contributions could help you to build a larger nest egg.

The annual contribution limits for 403(b)s and similar plans are also much higher than what you’re allowed with an IRA.

On the other hand, IRAs can offer more investing options and some tax savings in retirement, if you rollover funds to a Roth account.

•   When deciding which retirement account to use, it can help to ask the following questions:

•   How much money do I need to save for retirement?

•   Do I expect to be in the same tax bracket at retirement, a higher one, or a lower one?

•   When do I think I’ll need to start taking distributions?

•   Am I comfortable taking required minimum distributions?

•   How much can I contribute to the plan each year?

Asking those kinds of questions can help you figure out which type of retirement plan may be best suited to your needs. And of course, you’ll also want to take a look at the investment options and fees for any retirement plan you might be considering.

The Takeaway

Whether you should roll over money from your existing 403(b) retirement account can depend on whether you’re still working, what kind of investment options you’re looking for, and how much you’re paying in fees.

Ready to invest for your retirement? It’s easy to get started when you open a traditional or Roth IRA with SoFi. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

Easily manage your retirement savings with a SoFi IRA.

FAQ

Can a 403(b) plan be rolled over into an IRA?

Yes. It’s possible to roll a 403(b) plan into a traditional IRA, SIMPLE IRA, or SEP IRA. You can also rollover a 403(b) to a Roth IRA, but there may be tax implications. Before rolling over a 403(b), it’s important to consider the reasons for doing so, and how you’ll be able to invest your retirement funds should you decide to move them elsewhere.

Is a rollover from a 403(b) to an IRA taxable?

A rollover from a 403(b) to an IRA may incur a 20% tax withholding if you’re requesting an indirect rollover instead of a direct rollover. A rollover can be taxable if you’re rolling over funds from a traditional 403(b) to a Roth IRA. This would not apply if your 403(b) is a Roth-designated account and the rollover is to a Roth IRA.

Is it better to leave money in my 403(b) or roll it over to an IRA?

Whether it makes sense to leave money in your 403(b) or roll it over to an IRA can depend on how happy you are with the investments offered by your plan, what you’re paying in fees, and if you need access to any of the money right away. An IRA rollover could offer more investment options with fewer fees. You could also withdraw funds, though tax penalties may apply.

Photo credit: iStock/FreshSplash

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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Oct
10
2024

Recharacterizing IRAs: A Complete Guide

By | invest, Investing, Preparing for Retirement | Comments Off on Recharacterizing IRAs: A Complete Guide

An IRA recharacterization allows you to make changes to the type of contribution you made to one IRA by transferring it to a second IRA within the same tax year. For example, you might recharacterize traditional IRA contributions as Roth contributions, or vice versa.

This process is different from an IRA conversion, which is not limited to the tax year in which you made a contribution. A conversion typically involves moving funds from a traditional IRA into a Roth IRA, not the reverse. In most cases, you would owe income tax on the amount converted to a Roth.

There are different reasons for the recharacterization of an IRA, and some important IRS rules to know for completing one.

Key Points

•   An IRA recharacterization allows you to change the type of IRA contribution made within the same tax year, such as from traditional to Roth IRA or vice versa.

•   Executing a recharacterization typically involves notifying the IRA custodian, opening a second IRA, if needed, and meeting the tax-filing deadline or extension.

•   Reasons for recharacterization may include avoiding tax penalties for excess contributions, or taking advantage of certain tax benefits.

•   A recharacterization differs from a conversion, which can be done anytime with contributions from multiple years, and typically involves moving funds from a traditional IRA to a Roth IRA.

•   Following the Tax Cuts and Jobs Act passed in 2017, a conversion from a traditional IRA to a Roth IRA cannot be reversed using a recharacterization.

What Is an IRA Recharacterization?

An IRA recharacterization allows you to treat contributions made to one type of IRA as contributions made to a second, different type of IRA. The IRS allows taxpayers to recharacterize contributions to traditional or Roth IRAs only up until the tax-filing deadline each year, assuming you meet relevant income limits and other restrictions for the second IRA account.

For instance, say you deposit money in a Roth IRA, but when it’s time to file taxes you realize that you’ve made contributions in excess of what’s allowed for your tax filing status and income (see details below).

You could execute a recharacterization to have some of that contribution amount treated as traditional IRA contributions for the tax year, and transfer the assets (and any earnings or net losses) to the second IRA.

In that scenario, a recharacterization of Roth IRA contributions could allow you to avoid the 6% excise tax penalty the IRS imposes on excess contributions.

How Do IRA Recharacterizations Work?

IRA recharacterizations work by allowing you to change your IRA contributions for the year from one type of IRA to another. The process is fairly simple; you’ll just need to notify the company, a.k.a. the custodian that holds your IRA, that you’d like to recharacterize your contributions, and open a second IRA for that purpose (unless you have an existing IRA).

You can also transfer the amount you want recharacterized to an IRA at a different institution. This is known as a trustee-to-trustee transfer. In most cases, either one of these methods is preferable to withdrawing the money and redepositing it yourself, which can be tricky and could lead to taxes and/or a penalty if you fail to transfer the money within a 60-day window.

Again, you have until the annual tax-filing deadline to complete an IRA recharacterization. If you filed an extension, then you’ll have until the October extension-filing cutoff. You should receive a Form 1099-R documenting the recharacterization that you’ll need to file with your tax return.

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1Terms and conditions apply. Roll over a minimum of $20K to receive the 1% match offer. Matches on contributions are made up to the annual limits.

Reasons for a Recharacterization

Why would you need to recharacterize IRA contributions? There are reasons for doing a recharacterization in either direction (Roth to traditional IRA, or traditional IRA to a Roth). You might consider recharacterization if you:

•   Contributed too much to a Roth IRA for the year and need to shift some of that money to a traditional IRA in order to avoid a tax penalty.

•   Made traditional IRA contributions, but later learned that you can’t deduct them because you’re covered by a retirement plan at work and your income puts you over the threshold to claim a deduction.

•   Contributed to a Roth IRA, but believe you’d benefit more from getting a deduction for traditional IRA contributions.

•   Initially contributed to a traditional IRA, but later decided that you’d prefer to contribute to a Roth IRA to enjoy its tax benefits later in life.

Sample Calculation of IRA Recharacterization

How you calculate an IRA recharacterization can depend on whether you’re recharacterizing some or all of your contributions for the year. To keep things simple, let’s assume that you contributed $5,000 to a Roth IRA at the beginning of the year. The IRA earned $1,000 in investment gains.

You’d now like to recharacterize the entire amount to a traditional IRA. You’d tell your IRA custodian that you’d like to do a full recharacterization. This strategy does not require a separate calculation of investment earnings, because the entire balance of the IRA is being recharacterized.

However, if you only wanted to convert $3,000 of your contributions you’d have to do a separate calculation to figure the amount of earnings that need to be recharacterized.

The IRS offers a formula for doing so, which looks like this:

Net Income = Contributions x (Adjusted closing balance – Adjusted opening balance) / Adjusted opening balance

If you don’t want to do the math by hand, it might be easier to plug the numbers into an IRA recharacterization calculator, or consult with a tax professional.

Pros and Cons of Recharacterizing an IRA

There are pros and cons to using a recharacterization strategy.

Pros

IRA recharacterization offers some flexibility with regard to how your IRA contributions are treated, if your financial circumstances or tax considerations change.

If you start off the year making one type of IRA contribution, you can decide to switch things up at any time before the tax filing deadline. There’s no penalty for changing your mind about what type of IRA contributions you’d like to make, as long as you’re doing so before the filing or extension deadlines.

Recharacterizing an IRA is a simpler process than converting IRA assets, which we’ll discuss shortly. There’s less paperwork involved, and since the transaction can be completed by the custodian without any money being withdrawn from your IRA, a recharacterization can be a more tax-efficient way to adjust your contribution choices.

Cons

That said, there are downsides to a recharacterization. For one thing, you’ll need to be mindful of the tax filing deadlines if you want to recharacterize IRA contributions. If you miss the tax or extension deadline, you won’t be able to recharacterize your contribution amount.

If you recharacterize traditional IRA contributions as Roth IRA contributions, you will owe taxes.

If you recharacterize Roth IRA contributions as traditional IRA contributions, you can only claim the tax deduction a) if you qualify and b) you cannot deduct any earnings on the original contribution, if there were any.

Recharacterization vs. Conversion of an IRA

Recharacterization of an IRA and an IRA conversion are not the same thing. When you recharacterize IRA contributions, you’re changing the type of contributions you made for that specific tax year.

When you convert an IRA, you’re moving money from one type of IRA to another that may include contributions from multiple years. Generally, an IRA conversion refers to moving money from a traditional IRA to a Roth IRA.

If you have a Roth IRA, there would be little benefit to doing a conversion to a traditional IRA since you couldn’t then take the tax deduction. Also, if you first converted a traditional IRA to a Roth, it’s no longer possible to convert it back to a traditional IRA, thanks to changes implemented by the 2017 Tax Cuts and Jobs Act.

Amounts rolled over to a Roth IRA from qualified retirement plans cannot be reversed either.

For example, you might have chosen a traditional option when opening your first IRA but later decided that you’d like to have the tax benefits of a Roth IRA. Converting an IRA to a Roth would allow you to make contributions to a Roth IRA if you’d otherwise be prevented from doing so because your income is too high.

As noted, you’d have to pay taxes on the money you’re converting to a Roth IRA, because the money you deposited in your traditional IRA originally was tax deductible. Roth IRAs are funded with after-tax contributions.

IRA Recharacterization

 IRA Conversion
How It Works Recharacterization allows you to change the type of IRA contributions you make for the current tax year. Conversion allows you to move amounts in one type of IRA to another, typically a traditional IRA to a Roth IRA.
Rules Recharacterizations must be completed before the annual tax filing deadline. Conversions can be done at any time and may include contributions made over multiple years.
Advantages IRA recharacterization allows some flexibility in deciding what type of IRA contributions you want to make. Converting a traditional IRA to a Roth IRA can allow you to take advantage of tax-free withdrawals in retirement.
Disadvantages You must complete a recharacterization by the tax filing deadline or extension deadline; you cannot recharacterize IRA contributions pertaining to one year in a subsequent year. You will likely owe taxes on converted amounts, which can increase your tax bill.

The Takeaway

Recharacterization of an IRA could make sense if it allows you to gain a tax advantage, or avoid a tax penalty for excess contributions. If you’re unsure whether a recharacterization makes sense, it might be a good idea to talk to a tax professional first.

Ready to invest for your retirement? It’s easy to get started when you open a traditional or Roth IRA with SoFi. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

Easily manage your retirement savings with a SoFi IRA.

FAQ

Are IRA recharacterizations still allowed?

Yes, the IRS still allows IRA recharacterizations. There are some limitations, however, as converted IRAs cannot be recharacterized back, after the fact. You also can’t recharacterize rollovers from a 401(k) or 403(b) to a Roth IRA either.

What is the reason for recharacterizing an IRA?

One of the most common reasons to recharacterize Roth IRA contributions is to avoid a tax penalty for having made excess contributions. It may also be necessary to recharacterize Roth contributions in order to be able to claim a tax deduction for traditional IRA contributions.

Meanwhile, one reason to recharacterize traditional IRA contributions might be that you don’t qualify for the full (or any) tax deduction, and therefore a Roth might look appealing from a tax standpoint.

What is the difference between an IRA conversion and recharacterization?

Converting an IRA means moving assets from one type of IRA to another, typically involving amounts you’ve contributed over several years. Recharacterization of IRA contributions is more limited, and it means you’ve changed your mind about the type of contributions you want to make for the current tax year. A recharacterization of IRA contributions can only be done only for the tax year the contributions were made; an IRA conversion can be done at any time.

Photo credit: iStock/nortonrsx

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.

SOIN0423008

Read more
Oct
10
2024

What to Do About Excess Contributions to a Roth IRA

By | Financial Topics, Preparing for Retirement | Comments Off on What to Do About Excess Contributions to a Roth IRA

If you contribute more than the annual allowable limit to a Roth IRA given your income and tax filing status, you need to withdraw the excess amount or face a 6% penalty.

The good news is that it’s possible to withdraw or transfer excess IRA contributions. Knowing how to fix this mistake — and how to best plan yearly contributions — can help you to avoid an excess IRA contribution penalty going forward. 

Note that the rules are generally the same for excess contributions to a traditional IRA or to a Roth IRA.

Key Points

•   Excess contributions to a Roth IRA incur a 6% penalty each year they remain in your account.

•   You can withdraw excess contributions before the tax filing deadline (or extension deadline) to avoid penalties.

•   Report excess IRA contributions on IRS Form 5329, which you include with your Form 1040 when you file your return or an extension.

•   If you don’t wish to withdraw excess contributions, you may be able to recharacterize — or shift them — to another type of IRA before the deadline.

•   You may also be able to apply excess contributions to future years within the allowed limits to avoid penalties.

Maximum Annual Roth IRA Contributions

If you don’t know what a Roth IRA is, it’s a tax-advantaged individual retirement account. Contributions to a Roth are made with after-tax dollars, and qualified withdrawals from a Roth IRA are tax-free, which can make them attractive for people who expect to be in a higher tax bracket when they retire — or who want a tax-free income source later in life. 

You can contribute to both a Roth IRA and a workplace retirement plan like a 401(k), at the same time, as long as you observe the contribution limits for each type of account, and as long as you qualify for a Roth IRA.

Whether you’re eligible to contribute to a Roth IRA depends on your tax filing status and income (see chart below). Roth IRA contribution limits are set by the IRS and adjusted periodically for inflation. 

For 2024, the maximum Roth IRA contribution is $7,000. The limit increases to $8,000 for individuals aged 50 and older. These annual limits are the same, whether you’re saving in a traditional IRA vs. Roth IRA, and these are total amounts across all IRA accounts.

Here’s how Roth IRA income limits and contribution rules work for 2024. 

Filing Status

If your Modified Adjusted Gross Income (MAGI) is …

You can contribute…

Married filing jointly or qualifying widow(er)

< $228,000

Up to a maximum of $7,000 per year ($8,000 for those 50 and older)

Married filing jointly or qualifying widow(er)

≥ $228,000 and < $240,000

a reduced amount

Married filing jointly or qualifying widow(er)

≥  $240,000

Not eligible to contribute to a Roth

Married filing separately and you lived with your spouse at any time during the year

< $10,000

a reduced amount

Married filing separately and you lived with your spouse at any time during the year

≥ $10,000

Not eligible

Single, head of household, or married filing separately and you did not live with your spouse at any time during the year

< $146,000

up to the limit

Single, head of household, or married filing separately and you did not live with your spouse at any time during the year

≥ $146,000 and < $161,000

a reduced amount

Single, head of household, or married filing separately and you did not live with your spouse at any time during the year

≥ $161,000

Not eligible

Get a 1% IRA match on rollovers and contributions.

Double down on your retirement goals with a 1% match on every dollar you roll over and contribute to a SoFi IRA.1

1Terms and conditions apply. Roll over a minimum of $20K to receive the 1% match offer. Matches on contributions are made up to the annual limits.

What Happens If You Contribute Too Much to a Roth IRA?

Opening an IRA can get help you save for retirement. The downside is that contributing too much money to a Roth IRA (or traditional IRA) can result in a tax penalty. An excess contribution to an IRA can happen when:

•   You contribute more than the annual contribution limit because you have multiple IRAs.

•   You make an improper rollover contribution. 

•   You inadvertently contribute more than the amount allowed for your income and filing status.

•   You made a contribution early in the year, but you ended up earning more than anticipated, which changed the amount you would be allowed to contribute.

Excess IRA contributions are subject to a 6% penalty each year that they remain in your account. Per the IRS: “The tax can’t be more than 6% of the combined value of all your IRAs as of the end of the tax year.” 

If you’ve contributed too much to your Roth IRA, there are some steps you can take to rectify this mistake. 

How Do You Report Excess Roth IRA Contributions?

Excess IRA contributions are reported on IRS Form 5329. You’ll include this form with your Form 1040 when you file your return or an extension. 

This form allows the IRS to calculate how much of a tax penalty you’ll owe if you don’t take steps to correct an excess Roth IRA contribution. 

Can You Withdraw Excess Roth IRA Contributions?

If you realize that you contributed too much before you file your tax return, you can avoid the tax penalty by withdrawing the excess Roth IRA contribution by the tax filing deadline, or by the extension deadline. Any excess amounts withdrawn before the tax filing or extension deadline, would not be subject to the 6% penalty. 

That said: If those excess contributions generated investment gains while in your IRA account, you’d have to withdraw the gains as well. And you would have to report them as income. 

However, as of Dec. 29, 2022, a “corrective distribution” — meaning, a withdrawal of the gains on an excess contribution — is no longer subject to a 10% early withdrawal penalty.

You can contact your IRA custodian (the bank that holds your IRA account) if you’re not sure how to withdraw excess amounts. Keep in mind that you’ll need to withdraw the excess contribution amount as well as any earnings those contributions generated. 

You may owe tax on the earnings from the excess contribution amount (see below for possible ways to avoid this). There are no guarantees that a Roth contribution would see a gain, however; if there is a net loss, you could still withdraw the remainder of your contribution, minus the loss.

If you’ve already filed your taxes, you have up to six months — usually until October 15 of the same year — to amend your return and make the necessary withdrawals. 

Recharacterizing Excess Roth IRA Contributions

Recharacterizing IRA contributions allows you to move assets deposited in one IRA to a second IRA, and treat that money as if it had originally been contributed to the second IRA. 

If you have excess contributions because you contributed more than was allowed based on your income and filing status, recharacterization could allow you to avoid a tax penalty. You would transfer the excess contribution from one IRA to the second IRA by the tax-filing or extension deadline, doing a direct transfer within the same institution, or a trustee-to-trustee transfer to an IRA at another bank (not a withdrawal, which could be subject to additional taxes and/or a penalty).

For example: If you made excess contributions to an IRA for tax year 2024, you have until April 15, 2025 to recharacterize the excess contribution and earnings (or net loss); or until the extension deadline in October. 

If you made excess contributions in prior years (e.g. tax year 2023), you couldn’t recharacterize these, as the window for recharacterization would have passed, and you’d likely owe a penalty. 

In order to complete a recharacterization of the excess funds, you must take the following steps: 

•   Include any earnings specific to the excess amount. If there was a loss attributable to that contribution, you would note a negative amount. 

•   Be sure to report the recharacterization on your tax return for the year in which you made the original excess contribution. 

•   Use the date of the excess contribution to the first IRA as the date the contribution is made to the second IRA.

Applying Excess Contributions to the Following Year

The IRS also allows you to carry excess Roth IRA contributions forward. You can apply excess contributions to your annual contribution limit for future years. 

Again, the contributions you carry forward must be within your allowed limit for that following year. Be sure to check, so as not to create excess contributions in a subsequent year. 

Penalties for Excess Roth IRA Contributions

As mentioned, the IRS imposes a penalty on excess Roth IRA contributions in the form of a 6% tax, as of 2024. It applies each year that excess Roth IRA contributions remain in your account. 

Keep in mind that you might also owe ordinary income tax on any earnings on that contribution amount as well. 

When Are Excess Contributions Penalized?

Excess Roth IRA contributions are penalized when they’re not corrected. The IRS will continue to penalize you for each year that you allow the excess contributions to remain in your IRA. That rule goes for both Roth and traditional IRA contributions. 

Again, if you haven’t filed your tax return yet, the simplest way to correct them and avoid the penalty is to withdraw the excess amounts, plus any gains. As long as you do that by the tax-filing deadline or extension deadline, then the IRS doesn’t consider those amounts to be excess contributions. 

How to Avoid Excess IRA Contributions

Avoiding excess IRA contributions is possible if you understand how much you’re able to contribute each year, then planning your contributions accordingly. With Roth IRA contributions, your contribution amount will depend on your tax filing status and modified AGI for the tax year. 

You can use a tax calculator to estimate your modified AGI and use that to plan your contributions. Remember that you have until the April tax-filing deadline to make IRA contributions for the current tax year. Example: All IRA contributions for tax year 2024 must be made by April 15, 2025. 

The extra few months allow you time to prepare your return and make your contributions — or withdraw them if necessary — to stay within your annual contribution limit. 

Calculating Excess Contributions

While you have until tax day in April of the following year to contribute to a Roth IRA for the current tax year, the income you use to determine the amount of your allowable Roth contribution is based only on the current tax year, which ends on December 31. 

Example: To determine whether your modified AGI is within allowable Roth IRA limits for 2024, you would calculate your compensation from Jan. 1 to Dec. 31, 2024.

If you’re married, filing jointly for tax year 2024, your modified AGI must be less than $230,000 in order to make a full contribution of $7,000 ($8,000 if you’re 50 and up). From $230,000 to $239,999 you can only make a partial contribution. If you earn $240,000 or more, you are not eligible to contribute to a Roth IRA.

If you need help to determine your allowable contribution, you can use an Roth IRA contribution calculator to estimate what you can save. You may want to consult with a tax professional if you have any questions.

The Takeaway

A Roth IRA can be a useful tool for retirement planning, but it’s important to keep track of how much you’re saving. All IRAs, including Roth IRAs, have strict annual contribution limits. Making excess Roth IRA contributions could result in an unexpected — and costly — tax penalty. 

Ready to invest for your retirement? It’s easy to get started when you open a traditional or Roth IRA with SoFi. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

Easily manage your retirement savings with a SoFi IRA. 

FAQ

What happens if you accidentally contribute too much to a Roth IRA?

If you make excess Roth IRA contributions the IRS can assess a tax penalty of 6% each year that they remain in your account. You can avoid the tax penalty by withdrawing excess amounts, recharacterizing them, or carrying them ahead for future tax years. 

How do you correct excess Roth IRA contributions?

The easiest way to correct an excess Roth IRA contribution is to withdraw the excess amount, along with any interest earned. You can do that before the tax filing deadline, including extension deadlines, to avoid the IRS tax penalty. You cannot correct or recharacterize excess contributions once the tax-filing and extension deadlines have passed for the relevant tax year.

What is the penalty for excess IRA contributions?

A 6% tax applies to excess IRA contributions. The penalty applies each year that the excess contributions remain in your retirement account.

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Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.

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2024

States With No Income Tax

By | Financial Topics | Comments Off on States With No Income Tax

In 2024, there are nine states with no income tax, meaning residents may enjoy a major tax break when they go to file. (One of these states, though, does tax interest and dividend income.) It’s worth noting, however, these nine states earn revenue in other ways, including higher sales and property taxes.

Read on for details on this important financial issue that can impact one’s quality of life significantly.

Which States Don’t Have Income Tax?

Across the U.S., only nine states don’t charge income tax:

•   Alaska

•   Florida

•   Nevada

•   New Hampshire

•   South Dakota

•   Tennessee

•   Texas

•   Washington

•   Wyoming

It’s worth noting that while New Hampshire doesn’t charge taxes on earned wages, it does tax interest and dividend income.

Recommended: How to File Your Taxes for the First Time

Alaska

Not only does Alaska have no state income taxes, but the Last Frontier is also devoid of state-level sales taxes. (Localities can leverage their own sales taxes, however.)

The state’s economy largely depends on oil and gas, as well as tourism and fishing. The median home price is approximately $354,333 (compared with the national figure of $362,870), but Alaska isn’t exactly a cheap place to live. The state has a cost of living that’s 25% higher than the national average.

Plus, Alaska’s remoteness and 60-plus days every year with almost no daylight make it a tough — though beautiful — place to live.

Florida

Florida is known for its beaches, theme parks, retirement communities, and gators. With three national parks (and even more national seashores, preserves, etc.), Walt Disney World and Universal Studios, and beach paradises like Miami and Destin, Florida brings in a lot of tourism money.

While Florida has no state income tax, its sales taxes and property taxes are considered average. If you can withstand hurricane season, you might appreciate Florida’s cost of living. With a cost of living index of 103.1, it’s just above the national average of 100. 

For many people, the state’s wallet-friendly profile can allow them to make ends meet and maybe stash some cash in an online savings account.

Nevada

Nevada may be most famous for the Las Vegas Strip, which is probably why the state does so well with its sin taxes on gambling and alcohol. While those excise taxes may be high, the state income taxes sure aren’t. 

Like Florida, Nevada is just above the national average cost of living, with a score of 102.7 versus the U.S. average of 100. It seems that many people have felt the pull of living here: It’s one of our country’s fastest-growing states.

New Hampshire

If you’re thinking about moving to New Hampshire because it doesn’t have income tax, consider this: Overall, New Hampshire doesn’t fare that well in terms of cost of living, with a current figure of 113.6 vs. the national average of 100. But this desirable state offers stunning foliage in the fall, great skiing in the winter, and a beautiful landscape to explore in warmer weather.

Note: New Hampshire does charge state income tax on interest and dividends. The state will phase this out in 2025.

South Dakota

Those who live in South Dakota primarily work in agriculture, though the state’s economy also depends heavily on a mix of forestry, mining, and tourism. (The state is home to Badlands National Park and Mount Rushmore.)

Not only does South Dakota have no state income tax, but the state’s overall cost of living is below the national average at 93.4.

Tennessee

From the honky tonks of Nashville to the stunning mountain vistas of the Smokies, Tennessee has a lot of appeal. Plus, it doesn’t hurt that the state has no income tax.

Tennessee’s sales tax is among America’s most expensive, but as for overall cost of living? Tennessee ranks 10th most affordable in the country at 90.3.

Texas

Everything’s bigger in Texas, except your state income tax bill. That’s because Texas doesn’t have state income tax. Overall, cost of living in Texas is promising — it comes in at 92.4 vs. the national average of 100 in terms of affordability. And property taxes recently clocked in at 46th out of the states, meaning you may be able to enjoy relatively low housing costs compared with elsewhere.

Texas is a huge state with a lot to offer. Cities like Houston, Dallas, and Austin have plenty of restaurants, sports teams, and music festivals; the Gulf Coast region is great for fishing and relaxing on the beach; and the state’s natural landscape is vast and varied.

Washington

Not to be confused with our nation’s capital of Washington, D.C., this state has no state income tax. While property taxes are average (ranking 23rd in America), sales tax rates range from average to on the high side.

With three national parks, a famous city packed with coffee and nightlife, and plenty of whale watching, Washington makes a great state to visit and live in. Just be aware of its cost of living: Washington’s is high at 115.1 compared with the average of 100 for the country.

Note: High earners may pay taxes on capital gains in Washington.

Wyoming

Wyoming has some of the most beautiful landscapes in the country, including the Grand Tetons and part of Yellowstone. Perhaps that’s why its tourism industry is on the rise. The state also depends heavily on agriculture (cows and sheep) and mining.

In addition to not having state income taxes, Wyoming also has some of the lowest property tax rates in the country. Even better, the cost of living in Wyoming is under the national average (95.1 vs. the average of 100).

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Advantages of Living in a State Without Income Tax

Before packing up the boxes and budgeting for moving expenses, it’s important to weigh the pros and cons of states with no income tax. Here are some of the advantages:

Money-Saving Benefits for Families and Retirees

Living in a state with no income taxes can inject extra money into a family’s budget. However, it’s important to remember that states may make up that lost revenue through other types of taxes, like higher sales and property taxes.

Retirees may especially appreciate living in one of the nine states without income taxes, as they also don’t tax retirement distributions. (Illinois, Mississippi, and Pennsylvania also give this tax break to retirees; Alabama doesn’t tax pensions.)

Recommended: Financial Tips for People in Their 40s

Economic Benefits

Businesses are often attracted to tax-friendly states. While they’ll be paying more attention to states with corporate tax breaks, there’s a lot of overlap between the two. (Six of the 10 most tax-friendly states for businesses don’t have state income taxes.)

States that attract businesses will theoretically have more job opportunities, making them a smart place to move if you’re looking for higher pay and more options.

Easier Tax Filing

Living in a state without income taxes makes tax season a little easier. After all, it’s one less place to file.

It also means you may save money on tax filing. Tax software and accountants may charge more if you want to include state filing each year.

Considerations Before Moving to a State With No Income Tax

Clearly, living in a state without income tax has some benefits. But it’s important to consider the potential downsides to living in a no-income-tax state.

Higher Property and Sale Taxes

While it varies by state, some of the states without income tax make up that revenue through higher sales and/or property taxes.

Researching sales and property tax rates, as well as a state’s cost of living, can give you a fuller picture beyond the income tax rate.

Funding for Government Projects

If states are earning less revenue from income taxes, that can sometimes mean there’s not as much budget to tackle government projects. Proponents of state tax argue that they help fund important priorities, like education and infrastructure.

How Does No Income Tax Impact Cost of Living?

Income taxes are just one of many factors used to calculate a state’s cost of living. Without having to budget for state income tax — which goes as high as 13.30% in California — residents in these states already have an advantage.

But cost of living depends on more than just state income taxes. Economists also consider factors like housing, food, transportation, gas, and healthcare when calculating a state’s cost of living.

For example, Washington may not have income tax, but it has some of the highest home prices in the United States. Currently, the average home value is $600,477 versus the national average of $362,870.

And remember: Though some states may not have income tax, they may charge higher sales and property taxes.

How Does No Income Tax Impact Your Tax Return?

If you live in a state that doesn’t require you to file a tax return, you’ll still have to file a federal return. However, you can omit the state-level step in your process. 

It also means your paycheck will have fewer taxes withheld throughout the year — leading to a higher take-home paycheck.

The Takeaway

Is living in a state without income tax all it’s cracked up to be? For some, it can mean serious savings. But it’s important to consider other taxes, like sales and property taxes, as well as a state’s cost of living, when making any big decisions about where to live.

Expecting a big tax refund this year, whether from federal or state returns? Consider putting it in a high-yield bank account.

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Better banking is here with SoFi, NerdWallet’s 2024 winner for Best Checking Account Overall.* Enjoy up to 4.30% APY on SoFi Checking and Savings.

FAQ

Is it better to live in a state with no income tax?

People may find more flexibility in their budget when they don’t have to worry about paying state tax. They’ll also have an easier (and potentially more affordable) experience when it’s time to file their taxes.

That said, residents may find they’re paying more in other taxes — sales and property taxes, primarily — and may encounter higher costs outside of taxes, like housing and food.

Ultimately, people should consider cost of living and tax rates alongside other important factors when choosing a place to live, such as climate, access to healthcare, proximity to friends and family, the job market, and more.

What is the most tax-friendly state?

Determining the most tax-friendly state for your situation depends on a few factors, like your main source of income (paycheck, capital gains, etc.), your propensity for spending (how often you’ll encounter sales tax), and property ownership (do you own or rent your home?).

That said, Alaska is objectively the most tax-friendly state, as it places the lowest tax burden on its citizens overall. However, that may be balanced by a higher cost of living.

What is the best state to live in to avoid taxes?

Alaska is currently the state with the lowest tax burden when you factor in income tax, sales taxes, and property taxes. The Last Frontier has no state income tax or state-level sales taxes (though individual localities can impose their own taxes), though it ranks somewhere in the middle for property taxes.

What are the three least taxed states in the US?

The three least taxed states in the U.S. are Alaska, New Hampshire, and Wyoming. These states are considered to be highly tax-friendly not only because of their lack of state income tax but also because of their sales and/or property tax rates.

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As an alternative to direct deposit, SoFi members with Qualifying Deposits can earn 4.30% APY on savings balances (including Vaults) and 0.50% APY on checking balances. Qualifying Deposits means one or more deposits that, in the aggregate, are equal to or greater than $5,000 to an account holder’s SoFi Checking and Savings account (“Qualifying Deposits”) during a 30-day Evaluation Period (as defined below). Qualifying Deposits only include those deposits from the following eligible sources: (i) ACH transfers, (ii) inbound wire transfers, (iii) peer-to-peer transfers (i.e., external transfers from PayPal, Venmo, etc. and internal peer-to-peer transfers from a SoFi account belonging to another account holder), (iv) check deposits, (v) instant funding to your SoFi Bank Debit Card, (vi) push payments to your SoFi Bank Debit Card, and (vii) cash deposits. Qualifying Deposits do not include: (i) transfers between an account holder’s Checking account, Savings account, and/or Vaults; (ii) interest payments; (iii) bonuses issued by SoFi Bank or its affiliates; or (iv) credits, reversals, and refunds from SoFi Bank, N.A. (“SoFi Bank”) or from a merchant. SoFi members with Qualifying Deposits are not eligible for other SoFi Plus benefits.

SoFi Bank shall, in its sole discretion, assess each account holder’s Direct Deposit activity and Qualifying Deposits throughout each 30-Day Evaluation Period to determine the applicability of rates and may request additional documentation for verification of eligibility. The 30-Day Evaluation Period refers to the “Start Date” and “End Date” set forth on the APY Details page of your account, which comprises a period of 30 calendar days (the “30-Day Evaluation Period”). You can access the APY Details page at any time by logging into your SoFi account on the SoFi mobile app or SoFi website and selecting either (i) Banking > Savings > Current APY or (ii) Banking > Checking > Current APY. Upon receiving a Direct Deposit or $5,000 in Qualifying Deposits to your account, you will begin earning 4.30% APY on savings balances (including Vaults) and 0.50% on checking balances on or before the following calendar day. You will continue to earn these APYs for (i) the remainder of the current 30-Day Evaluation Period and through the end of the subsequent 30-Day Evaluation Period and (ii) any following 30-day Evaluation Periods during which SoFi Bank determines you to have Direct Deposit activity or $5,000 in Qualifying Deposits without interruption.

SoFi Bank reserves the right to grant a grace period to account holders following a change in Direct Deposit activity or Qualifying Deposits activity before adjusting rates. If SoFi Bank grants you a grace period, the dates for such grace period will be reflected on the APY Details page of your account. If SoFi Bank determines that you did not have Direct Deposit activity or $5,000 in Qualifying Deposits during the current 30-day Evaluation Period and, if applicable, the grace period, then you will begin earning the rates earned by account holders without either Direct Deposit or Qualifying Deposits until you have Direct Deposit activity or $5,000 in Qualifying Deposits in a subsequent 30-Day Evaluation Period. For the avoidance of doubt, an account holder with both Direct Deposit activity and Qualifying Deposits will earn the rates earned by account holders with Direct Deposit.

Members without either Direct Deposit activity or Qualifying Deposits, as determined by SoFi Bank, during a 30-Day Evaluation Period and, if applicable, the grace period, will earn 1.20% APY on savings balances (including Vaults) and 0.50% APY on checking balances.

Interest rates are variable and subject to change at any time. These rates are current as of 10/8/2024. There is no minimum balance requirement. Additional information can be found at https://www.sofi.com/legal/banking-rate-sheet.

*Awards or rankings from NerdWallet are not indicative of future success or results. This award and its ratings are independently determined and awarded by their respective publications.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
 
Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

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How Are Savings Accounts Taxed?

By | Financial Topics | Comments Off on How Are Savings Accounts Taxed?

A savings account is a secure place to keep your cash while earning interest, but any amount of interest you earn from a savings account will usually be taxable. 

You are required to report any interest earnings from most savings accounts to the IRS. If the yearly earned interest is $10 or more, your bank or financial institution will send a Form 1099-INT to the IRS and a copy to you to include when completing your tax return. 

Here’s a closer look at how taxes affect different types of savings accounts.

Key Points

•   Interest earned on money in a typical savings account is taxable and must be reported to the IRS.

•   The promotional bonuses from savings accounts are also considered taxable income.

•   You will receive a 1099-INT form from your financial institution when the interest earned on your savings account is $10 or more — however, you should report any amount you earn to the IRS.

•   Some types of savings accounts, including IRAs, 529 plans, and HSAs, offer various tax benefits, such as tax-deferred growth or tax-free withdrawals. 

•   While both 529 plans and Coverdell Education Savings Accounts both offer tax advantages when saving for college and education expenses, they differ in their requirements, contribution limits, fees, and flexibility. 

A Quick Refresher on Savings Accounts

A typical savings account is a place where you can deposit money not meant for everyday expenses — rather, the funds might be set aside for emergencies or a dream vacation. Savings accounts differ from checking accounts in that they tend to offer a higher APY (annual percentage yield), so you can earn a modest interest while saving for the future.

Many savings accounts can be independent or attached to a checking account. Other types, like CDs (certificates of deposit) operate as a financial product where you may earn a higher interest rate over a fixed amount of time. Almost all savings accounts are insured by the Federal Deposit Insurance Corporation (FDIC). 

Most savings accounts can be opened online, over the phone, or in person at a bank or credit union. Steps to opening a savings account can include:

•   Providing proof of identification. You’ll need your Social Security number and a valid government-issued ID, such as a passport or driver’s license.

•   Offering personal details such as your legal name, address, phone number, email address, and date of birth. 

•   Selecting the type of account. You can usually choose between a single or joint savings account. Some banks may offer a selection of savings accounts with varying rates and terms. 

•   Making your initial deposit. Once your application is completed and approved, financial institutions will generally require an initial deposit — between $25 and $100 for banks and $1 and $10 for credit unions. Sometimes you may open an account without any opening deposit at all.

There are other types of savings accounts and vehicles, such as IRA plans for retirement and 529 plans for college, that may require additional steps and information.

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What’s Taxable in Savings Accounts?

Earned interest on your savings account is almost always taxed. It will be reported on a 1099-INT form if it equals $10 or more per year, but you should report it even if it’s under $10. Here’s a closer look at what can be taxed.

Earned Interest Taxes

Any amount of earned interest you make on a savings account is taxable, be it $600 dollars a year or a mere $.50. The interest will be taxed according to your income tax bracket for the year. 

Promotional Bonuses

Some savings accounts may offer a promotional bonus for opening the account. Unfortunately, that “free money” counts as taxable income. You must report it to the IRS, and your bank will report it on your 1099-INT form.

If the notion of paying taxes on your savings has you clutching to your piggy bank, know this: A savings account is still a good idea, in most cases, since it provides a secure place to save money for your goals and earn interest while having easy access to your funds. 

Which Savings Accounts Are Tax-Advantaged?

Knowing how different types of savings accounts are taxed may help you reach your financial goals. As mentioned above, the interest in a typical savings account is taxable.

For example, if you have $10,000 in a high-yield savings account with a $4.00% APY, you will be paying taxes on $400 (or more, depending on compounding interest) of earned interest for the year.

Some types of savings accounts or plans, however, are tax-advantaged in certain ways. If a savings plan is tax-exempt, for example, you may contribute after-tax money, but then later have the benefit of making tax-free withdrawals, when you may be in a lower income bracket. Conversely, some accounts are tax-deferred, which means taxes aren’t paid until withdrawals are made down the road.

There are different ways a savings account may be tax-advantaged. Here are common types of savings accounts that offer tax benefits.

Types of Savings Accounts That Are Tax-Advantaged

You might think of a few savings accounts as “special cases” in terms of taxes. These may include certain accounts that can be used to save for retirement, a child’s college costs, and healthcare costs. Some of these plans may offer a higher rate of return but also higher risks, and may have rules about when and how you can access your funds in order to avoid paying a penalty.

IRA Accounts

An IRA is an individual retirement account that comes with tax advantages. Contributions to your IRA may be invested in stocks, bonds, CDs, and other investments. 

An IRA is different from a savings account in that it’s meant to serve as a long-term investment. The funds you contribute to your plan may be subject to the highs and lows of the stock market over time, but historically, the average rate of return is 7% to 10% — which can be significantly higher than a savings account. Barring certain exceptions, penalties will be applied if you withdraw funds before the age of 59 ½. 

There are two types of IRAs:

•   Traditional IRA. Contributions to a traditional IRA are typically made with pre-tax dollars up to an annual limit. This money will then grow tax-deferred within the account. These contributions can typically lower your taxable income in the year you make them.  You will need to pay taxes on both the principal and earnings later, however, when you withdraw the money in retirement.  

•   Roth IRA. Contributions to a Roth IRA are taxed up front, but you won’t owe taxes on the earnings or the principal when you later make qualified withdrawals for retirement, after the age of 59 ½. As with a traditional IRA, you can only contribute up to the limits determined by the IRS each year..

529 Plans

529 plans are savings accounts meant specifically for educational expenses, such as college for your children or for yourself. Like an IRA, they are meant for long-term investments and are subject to the ebbs and flows of the market. 

529 plan contributions are typically made post-tax and are not tax-deductible at the federal level when you put the money in the account, though some states do offer tax deductions. That said, 529 plans provide tax-free withdrawals for qualifying educational expenditures. There are no annual contribution limits and no age restrictions for beneficiaries. 

However, you may be subject to a 10% penalty and pay federal and state taxes on any funds used for non-educational expenses.

Coverdell Education Savings Accounts

A Coverdell Education Savings Account (ESA) serves the same purpose as a 529 Plan: to save for qualifying educational purposes. But a Coverdell ESA has contribution limits and can only be opened for a child under the age of 18 years old, excepting those with special needs, as per the IRS. Also, it must be used before the beneficiary reaches age 30, though this also excludes those with special needs. 

Coverdell ESA contributions are not tax-deductible, but qualifying withdrawals can be made tax-free. 

Health Savings Accounts (HSAs)

A health savings account, or HSA, is a tax-advantaged plan for people who have high-deductible health plans (HDHPs). Since individuals with these plans may have higher out-of-pocket costs, an HSA can help make healthcare more affordable. Contributions are made with pre-tax dollars and can then be applied tax-free to qualified medical expenses, meaning you are basically getting those goods or services at a discount. 

HSAs are not “use it or lose it” accounts; the funds can roll over year after year, and you may keep the money if you change jobs. 

Points worth noting: If you use money from your HSA for non-qualifying expenses (say, you need cash for an urgent home repair), the withdrawal will be taxed, and you will be assessed a 20% penalty charge. That said, once you turn 65, funds in your HSA may be used for non-qualifying expenses without penalty. You will, however, incur taxes on funds withdrawn.

Filing Taxes on Savings Accounts

You must report any amount of earned interest from your savings accounts on your tax return. If you earn $10 or more a year in interest, your banking institution will generate an IRS Form 1099-INT form and send it to the IRS and a copy to you for your taxes.

The Takeaway

Most traditional savings accounts are taxed, meaning that the interest earned is taxable. If an account earns more than $10 in interest per year, you and the IRS will each receive a form 1099-INT reporting that money. In addition, certain tax-advantaged accounts, such as IRAs and ESAs, may or may not be taxable. Check the fine print on your account to know how to handle earned interest come tax season. 

While interest you earn may be taxed, don’t let that stop you from saving. It can still be an important way to help your money grow.

Interested in opening an online bank account? When you sign up for a SoFi Checking and Savings account with direct deposit, you’ll get a competitive annual percentage yield (APY), pay zero account fees, and enjoy an array of rewards, such as access to the Allpoint Network of 55,000+ fee-free ATMs globally. Qualifying accounts can even access their paycheck up to two days early.


Better banking is here with SoFi, NerdWallet’s 2024 winner for Best Checking Account Overall.* Enjoy up to 4.30% APY on SoFi Checking and Savings.

FAQ

How much money can you have in your savings account without being taxed?

Any amount of money in a savings account will be taxed on the interest it earns. The financial institution where the funds are held will send a Form 1099-INT to the account holder and the IRS annually to reflect earned interest of $10 or more.

How can I avoid paying taxes on my savings account?

You cannot avoid paying taxes on any earned interest for a standard savings account. All interest earnings must be accounted for. Earned interest of $10 or more per account is reported on a 1099-INT and sent to the IRS.

How much tax do I pay on a savings account?

It depends on your tax bracket. Your earned interest will be taxed at your earned income rate for the year.

Photo credit: Rockaa/iStock

SoFi® Checking and Savings is offered through SoFi Bank, N.A. ©2024 SoFi Bank, N.A. All rights reserved. Member FDIC. Equal Housing Lender.
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SoFi members with direct deposit activity can earn 4.30% annual percentage yield (APY) on savings balances (including Vaults) and 0.50% APY on checking balances. Direct Deposit means a recurring deposit of regular income to an account holder’s SoFi Checking or Savings account, including payroll, pension, or government benefit payments (e.g., Social Security), made by the account holder’s employer, payroll or benefits provider or government agency (“Direct Deposit”) via the Automated Clearing House (“ACH”) Network during a 30-day Evaluation Period (as defined below). Deposits that are not from an employer or government agency, including but not limited to check deposits, peer-to-peer transfers (e.g., transfers from PayPal, Venmo, etc.), merchant transactions (e.g., transactions from PayPal, Stripe, Square, etc.), and bank ACH funds transfers and wire transfers from external accounts, or are non-recurring in nature (e.g., IRS tax refunds), do not constitute Direct Deposit activity. There is no minimum Direct Deposit amount required to qualify for the stated interest rate. SoFi members with direct deposit are eligible for other SoFi Plus benefits.

As an alternative to direct deposit, SoFi members with Qualifying Deposits can earn 4.30% APY on savings balances (including Vaults) and 0.50% APY on checking balances. Qualifying Deposits means one or more deposits that, in the aggregate, are equal to or greater than $5,000 to an account holder’s SoFi Checking and Savings account (“Qualifying Deposits”) during a 30-day Evaluation Period (as defined below). Qualifying Deposits only include those deposits from the following eligible sources: (i) ACH transfers, (ii) inbound wire transfers, (iii) peer-to-peer transfers (i.e., external transfers from PayPal, Venmo, etc. and internal peer-to-peer transfers from a SoFi account belonging to another account holder), (iv) check deposits, (v) instant funding to your SoFi Bank Debit Card, (vi) push payments to your SoFi Bank Debit Card, and (vii) cash deposits. Qualifying Deposits do not include: (i) transfers between an account holder’s Checking account, Savings account, and/or Vaults; (ii) interest payments; (iii) bonuses issued by SoFi Bank or its affiliates; or (iv) credits, reversals, and refunds from SoFi Bank, N.A. (“SoFi Bank”) or from a merchant. SoFi members with Qualifying Deposits are not eligible for other SoFi Plus benefits.

SoFi Bank shall, in its sole discretion, assess each account holder’s Direct Deposit activity and Qualifying Deposits throughout each 30-Day Evaluation Period to determine the applicability of rates and may request additional documentation for verification of eligibility. The 30-Day Evaluation Period refers to the “Start Date” and “End Date” set forth on the APY Details page of your account, which comprises a period of 30 calendar days (the “30-Day Evaluation Period”). You can access the APY Details page at any time by logging into your SoFi account on the SoFi mobile app or SoFi website and selecting either (i) Banking > Savings > Current APY or (ii) Banking > Checking > Current APY. Upon receiving a Direct Deposit or $5,000 in Qualifying Deposits to your account, you will begin earning 4.30% APY on savings balances (including Vaults) and 0.50% on checking balances on or before the following calendar day. You will continue to earn these APYs for (i) the remainder of the current 30-Day Evaluation Period and through the end of the subsequent 30-Day Evaluation Period and (ii) any following 30-day Evaluation Periods during which SoFi Bank determines you to have Direct Deposit activity or $5,000 in Qualifying Deposits without interruption.

SoFi Bank reserves the right to grant a grace period to account holders following a change in Direct Deposit activity or Qualifying Deposits activity before adjusting rates. If SoFi Bank grants you a grace period, the dates for such grace period will be reflected on the APY Details page of your account. If SoFi Bank determines that you did not have Direct Deposit activity or $5,000 in Qualifying Deposits during the current 30-day Evaluation Period and, if applicable, the grace period, then you will begin earning the rates earned by account holders without either Direct Deposit or Qualifying Deposits until you have Direct Deposit activity or $5,000 in Qualifying Deposits in a subsequent 30-Day Evaluation Period. For the avoidance of doubt, an account holder with both Direct Deposit activity and Qualifying Deposits will earn the rates earned by account holders with Direct Deposit.

Members without either Direct Deposit activity or Qualifying Deposits, as determined by SoFi Bank, during a 30-Day Evaluation Period and, if applicable, the grace period, will earn 1.20% APY on savings balances (including Vaults) and 0.50% APY on checking balances.

Interest rates are variable and subject to change at any time. These rates are current as of 10/8/2024. There is no minimum balance requirement. Additional information can be found at https://www.sofi.com/legal/banking-rate-sheet.

*Awards or rankings from NerdWallet are not indicative of future success or results. This award and its ratings are independently determined and awarded by their respective publications.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

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