If you take the advice of financial experts and start planning for retirement in your 20s, you can enter your golden years expecting a comfortable income. You may be able to collect on a pension from your employer, or you may have investment returns piled up in various accounts, such as a 401(k), 403(b), profit-sharing plan or an Individual Retirement Account (IRA). Finally, there is Social Security, the mainstay for millions of Americans in their 60s and beyond.
No matter where your retirement money comes from, however, once you start to collect it or withdraw it from your accounts, it becomes income. This makes it essential to understand the tax implications of contributing to and cashing in your retirement funds.
What is taxable? The answer, perhaps not surprisingly, is that taxes must be paid on most types of retirement income.
Here are some examples:
- Unless they come from certain public pension funds, pension payments generally are taxable at the time that they’re issued.
- Money in 401(k)s and similar accounts that you funded with regular contributions from your paycheck becomes taxable when you withdraw it. Remember: You contribute to these accounts on a pre-tax basis, which means the money is deducted from your gross salary before taxes are calculated on your pay. Earnings on those contributions are allowed to pile up, also without being taxed. But once you retire and begin taking custody of the money, Uncle Sam finally wants his cut.
- Withdrawals from a Traditional IRA are similarly taxed, as the contributions used to fund them are generally tax-deductible.
- Social Security benefits received after retirement also may be taxable depending on your total income and marital status. Consult Internal Revenue Service Publication 915 for guidance.
Planning to Avoid Taxes
During your working life, it may be possible to make post-tax contributions to certain employer-sponsored retirement accounts, such as a 401(k), to avoid taxation later. But consider that your tax rate after age 59½ — the minimum age for withdrawing money without penalty — may be lower than in your younger years. Paying taxes as a retiree could be the better deal.
Another potential tax mistake is using discretionary income for retirement to make deposits to another type of savings account, such as a certificate of deposit or money-market savings account. After paying income tax through payroll you then must pay tax on any interest that you earn. That double taxation is why it is usually best to use a tax-deferred retirement fund.
The Tax Costs of Early Withdrawals
Although the purpose of a retirement fund is to keep money secure until the end of your working life, you can draw out money early if necessary. This should be avoided, however, because you must pay a tax penalty on each early withdrawal from a 401(k) or other qualified retirement fund to the tune of 10 percent. This is in addition to regular income tax on the amount you take out of the account.
There are exceptions to this early withdrawal rule. Consult IRS publication 590 for more information.
Tax Advantages of Roth IRAs
The Roth IRA is one of the most advantageous types of IRAs because of its tax benefits. If you meet a few minimum requirements, you do not have to pay taxes on withdrawals from the account once you reach the age of 59½. This is because you do not receive a tax break on your contributions to the account.
Also, if you decide to withdraw money early, you pay taxes and penalties only on the earnings you have accrued. This can be a deal if you expect your tax rate to be higher after you retire.
You can roll over money from a traditional IRA into a Roth IRA and never have to pay taxes on future withdrawals, but remember that you may have to pay what is called a “conversion tax” on the rollover amount.
Tax Deductions for Retirement Savings
The IRS also extends certain tax benefits to individuals who save for retirement, whether employed or self-employed. Depending on your financial situation, you may be able to deduct your yearly contributions from taxable income, which reduces the amount of tax you’re required to pay. The one main disadvantage of Roth IRAs is that you cannot take a deduction for contributions on your taxes.
If you are a low-income earner you may qualify for what is called the “saver’s credit,” which rewards those who contribute to retirement funds. To find out if you qualify, consult a tax professional.