Many retirement plans don’t require taxes during the accumulation phase. However, at some point, you always pay taxes on income. There is no skirting it. Because you withdraw from those tax-deferred retirement plans during retirement, you also pay taxes on the money you withdraw. That’s why tax preparation for retirement is so important.
The benefit of many retirement plans is that you don’t pay taxes on income when you earn it. Because you’re actively working, this often when you achieve your highest tax rate. The theory is that when you retire, you’re at a lower tax rate and can pay taxes on your deferred income at a lower rate. As long as the federal, or your state government, doesn’t raise tax rates, that theory should hold.
There is also the deferral of the tax obligation on the earnings within many retirement plans, such as 401k plans. Also, many employers make plan contributions that remain tax deferred until withdrawn. These employer funds often come with a vesting schedule, so the employee does not walk away with that portion until they have worked for that employer for a certain number of years.
This all works out well in theory, and absent of some new taxes that would throw a fly in the ointment, it does currently benefit retirement savers. Under the current marginal tax rates, a worker may squirrel away a dollar into a retirement plan that they might have paid thirty cents in taxes on. Upon withdrawing that dollar, they might only pay fifteen cents in taxes on it; which sounds like a good deal. The money management issue then becomes how to best deal with that fifteen cents. In retirement, it isn’t easy to compensate for something that depletes income.
Retirement Plans and Taxes
Just as with IRA’s, many 401k plans offer the choice between a traditional and a Roth. However, the tax treatment of the two is very different. Contributions to a traditional 401k are pre-tax. Contributions to a Roth 401k are post-tax. With the traditional 401k, you pay taxes on income you receive, which has been reduced by the contributions into your retirement plan.
At withdrawal, the tax implications are reversed. On those contributions and earnings in your traditional plan, you would pay income taxes as you withdraw them as ordinary income. On withdrawals from a Roth 401k, there are no taxes. The money must have remained in the account for at least five years though.
There may be some penalties when you make withdrawals from your traditional 401k also. There is a 10 percent penalty on withdrawn amounts prior to age 59 1/2. There’s also a penalty for not taking enough money out of your traditional retirement plans. When you reach age 70 1/2, you are required to take required minimum distributions from your traditional accounts. Depending on the size of these funds, you might want to begin earlier than this age to avoid paying too much tax on a large amount of accumulated funds.
While you might be paying ordinary income on those traditional retirement funds, based on the existing marginal tax rates, you would be paying capital gains rates on the sale of investments. The tax rate depends on the length of time you have held that investment. Again, as with marginal tax rates, the rates on capital gains could change in the future as well.
You also have to consider how social security funds, annuities and pensions impact your taxes in retirement. Getting the advice and direction of a professional can help navigate this complex subject.