You have to pay the piper when the music stops
We've had a few questions about iDeCo and taxes, so here's a post summarising some of the main points.
For most people who pay income tax, using an iDeCo account to invest is an excellent idea. There are several advantages:
- You pay into the account with pre-tax income, which means you pay less income tax.
- You are not taxed on your investments while you have the account.
- You can rebalance your investments in the account without paying tax.
- You are taxed at a preferential rate when you cash out the account.
- You can't access the money until you are 60*
* some people might say that the fifth point is a disadvantage, but I think for something that is supposed to help you in your old age it's good that you can't blow it on sports cars when you hit your mid-life crisis ;)
Let's look at each of these in a bit more detail.
Invest with Pre-Tax Income
Your monthly payments into your iDeCo account come out of your pre-tax income. What this means is that the government reduces your taxable income by the amount you put away.
For example, my taxable income is 4,811,568 yen. This puts me in the 20% tax bracket.
I pay the maximum 144,000 yen a year into iDeCo (I'm a public servant, so can only pay in 12,000 yen a month), which reduces my income tax bill by 28,800 yen a year (20% of 144,000). You can play with the official iDeCo tax calculator here to see what your numbers might look like. Make sure you use your taxable income, which is calculated by subtracting any deductions you might have for dependents, mortgages, business expenses, etc.
Obviously the higher your taxable income, the better this is. If you were in the 45% income tax bracket you would be making an instant 45% 'profit' on your iDeCo contributions.
On the other hand, if you are a dependant spouse that doesn't pay income tax, iDeCo is much less attractive.
You won't pay any tax while you have the account. This is not as great as it sounds, because you wouldn't pay tax either if you bought investments in a taxable account and didn't sell them. You could get the same benefit, and receive dividends tax-free in a NISA account.
However, iDeCo is the only account I am aware of in Japan that lets you rebalance your investments within the account without being taxed or losing your annual allowance.
Rebalance without Paying Tax
If you rebalance within a taxable account, you will have to pay capital gains tax. If you rebalance in a NISA account, you will not be able to reuse your NISA allowance.
But in an iDeCo account you can rebalance without paying tax or losing your allowance. This is an amazing benefit that is only slightly diminished by the small contribution limits for most people.
Preferential Tax Rates when Cashing Out
Now this is slightly complicated, and I'm not completely sure I understand all of it perfectly. If you manage to accumulate a significant iDeCo balance, it might be worth consulting a tax specialist or financial planner to figure out the best way to minimize taxes due when you cash out.
You have two choices that will affect how much tax you will pay on your iDeCo: when you cash out and in what manner you cash out.
With iDeCo you cannot access your investments before you are 60, but you don't have to take your money then. You can actually choose to cash out any time between turning 60 and turning 70. This allows you to recover from market falls when you are 60, etc. but also to choose the timing of your payout.
You can also choose to receive your iDeCo funds as a lump-sum payment, as a 'pension' paid in instalments, or some combination of the two.
These are taxed differently, so it can matter which one you choose.
The lump sum is taxed like a retirement bonus. You have a tax-free allowance (400,000 per year for the first 20 years of contributions, then 700,000 a year for the next ten) up to a maximum of 15 million yen. Anything over this, half is taxed as ordinary income.
You can reduce your tax burden by paying in for as long as possible (this is why it is better to start paying into iDeCo even at the minimum rate as soon as possible) and by choosing to cash out in a year when you have little other income.
The complication is that if you use up your retirement bonus tax-free allowance on something else (like an actual retirement bonus) you may not be able to use it for iDeCo. If you will receive a retirement bonus and your iDeCo balance is large enough you may wish to consult a tax specialist to help you decide what to do.
If you choose to take your iDeCo as a pension it will be added to any other public pension you have (like kokumin or kosei nenkin) and taxed accordingly. Public pensions have a tax-free allowance as shown in the delightful table below:
There are different rates depending on whether you are under or over 65. If your annual pension amount is 700,000 or under (for under-65s) or under 1.2m (for over 65s) it will not be counted as income. For pension income worth more than that, some of it will be counted as income and will increase your health and long-term care insurance.
The standard advice seems to be if you have a decent pension otherwise, it might be better to take your iDeCo as a lump sum, even if that means you pay income tax on it (for one year only, as opposed for every year you have an increased pension).
Phew. A lot to digest there. If you are confused or unsure of how to proceed, I recommend you consult an independent financial planner or tax specialist to help you figure out the best solution for your situation.
What do you think? Did I get anything wrong? Had anyone been through this process already?