Retirement savings accounts such as IRAs and 401(k)s offer certain tax advantages. The type of advantage depends on what kind of account you have, and revolves around when you choose to pay taxes. Uncle Sam will always collect his share at some point!
Here are three considerations about how and when taxes get paid on common retirement accounts — and some penalty pitfalls to avoid.
Tax-deferred savings accounts — pay taxes down the road.
Traditional IRAs and employer-sponsored plans (401(k), 403(b), 457 plans).
Tax-deferred accounts allow you to postpone paying taxes on the money you contribute and on any investment earnings. A big advantage of tax-deferred accounts is that you can deduct contributions from your taxable income. This can lower your current tax liability, and may even put you in a lower tax bracket to further reduce the amount of taxes you pay.
When you take withdrawals from tax-deferred accounts (usually in retirement), the money is considered regular income for that year. You’ll then owe income taxes based on your tax rate at that time. If you expect your tax rate to be lower in retirement than during your working years, this provides incentive to contribute to a tax-deferred account. But be forewarned. If you take money out before age 59½, you may be subject to a 10% federal income tax penalty unless you meet certain requirements.
One note about traditional IRAs, however: If you have access to an employer-sponsored retirement plan and your income exceeds a certain amount each year, some or all your contributions are no longer tax-deductible. Details about the rules are available on the IRS website.
After-tax retirement accounts — pay taxes up front.
Roth IRA, Roth 401(k), Roth 403(b), Roth 457(b).
With Roth accounts, your contributions are made with after-tax dollars, meaning you don’t get a current tax deduction. However, qualified withdrawals — including any investment earnings — are tax-free.
Be aware of the difference in how you’re taxed on contributions (the money you put in) and how you’re taxed on investment earnings (any interest, dividends, or other gains in your account). You’ve already paid taxes on your contributions so you won’t owe taxes when you take them out, and you can make a penalty-free withdrawal at any time. The earnings portion of your account won’t be taxed at all if you meet certain qualifications. To qualify for tax-free withdrawals of earnings, you must be age 59½ or older (or disabled) and your money must have been invested in the account for at least five years.
Keep in mind that there are limitations based on income when it comes to how much money you can invest in a Roth IRA or whether you can invest in one at all. If a Roth 401(k) option is available to you, you may be able to contribute much more to help maximize this benefit.
Required minimum distributions.
You can’t avoid taxes indefinitely, though. At some point, the government will require you to start withdrawing a certain amount from your retirement accounts each year. This is known as a required minimum distribution (RMD). Accounts that are subject to an RMD include:
- Traditional IRAs
- Most employer-sponsored retirement plans (such as a 401(k))
- Roth 403(b)
- Roth 457(b)
Note that Roth IRA owners are not required to take RMDs.
If you’re required to take an RMD, you’ll need to do so by April 1 of the year after you turn age 70½. You can, however, take your RMD by December 31 the year that you turn age 70½. This can help you avoid you taking two RMDs in one year (the first being by April 1 after you turn age 70½ and the second by December 31 that same year). For employer-sponsored retirement plan accounts (both traditional and Roth), you can delay this date for as long as you keep working. Beneficiaries must also take RMDs if the account owner was taking them at the time of death.
If you don’t take your RMD each year, you’ll have to pay a penalty tax of 50% of the amount you should have withdrawn, plus regular income taxes. So it’s very important to get your RMD right!
You should take taxes into consideration in all aspects of your personal finances, but especially when it comes to your retirement savings accounts. Making the most of available tax benefits can be a significant step toward meeting your retirement goals.