5 min read
Retirement savings accounts and taxes: How to plan ahead
You’ve probably heard that retirement savings accounts are “tax advantaged” – meaning you don’t pay taxes on money you put into those accounts until you withdraw it in retirement.
You’ve probably heard that retirement savings accounts are “tax advantaged” – meaning you don’t pay taxes on money you put into those accounts until you withdraw it in retirement. Traditional IRAs, 401(k)s, 403(b)s SEP IRAs and SIMPLE IRAs are all examples of pre-tax accounts.
In addition to pre-tax accounts, you have another savings option – after-tax retirement accounts. With these, you pay taxes on your contributions the same year you make them. Then, in retirement, you don’t pay taxes when you withdraw that money. Roth IRAs, Roth 401(k)s and Roth 403(b)s are examples of after-tax retirement accounts.
Depending on which accounts you have, you’ll end up paying taxes on your retirement savings either now, in retirement, or a combination of both. You’ll want to consider your current situation and your retirement needs when deciding where to save.
Tax considerations while you’re still contributing
Contributions to pre-tax accounts lower your taxable income for that year, which may mean a lower tax bill. You also won’t have to budget for that tax payment right away, which may be helpful, depending on your financial situation. And if you end up being in a lower tax bracket in retirement, you’ll pay less in taxes then vs. now.
An after-tax account can make sense if you’re in a lower tax bracket today than you think you will be in retirement. If you can afford to budget for those tax payments up front, you’ll likely pay less taxes in the long run. And your withdrawals in retirement (both your original contributions, and any investment growth) will be tax-free, as long as you meet certain criteria.
If you have both pre-tax and after-tax accounts, you have the flexibility to decide which account(s) to contribute to for a given year based on your tax bracket, your overall budget and other considerations. In some years, it may make more sense to save more in a pre-tax account and defer paying those taxes until retirement. In other years, it may be better to put more into an after-tax account and pay those taxes up front.
Tax considerations when you’re living in retirement
When you retire, you’ll pay taxes on any money you withdraw from a pre-tax account, but your after-tax accounts won’t be taxed (again, subject to certain requirements).
Maybe the biggest consideration is required minimum distributions, or RMDs. Like the name implies, RMDs are minimum withdrawals the IRS requires you take from your pre-tax accounts, usually starting after you turn age 72 (as discussed below, you may have the option to waive your 2020 RMD). The amount you’re required to withdraw is based on your account balance, age and other factors specific to your situation.
If all your savings are in pre-tax accounts, you might face a hefty tax bill. Maybe you’ve planned ahead for this scenario, and it’s not a problem. But it can come as an unpleasant surprise to some retirees.
Certain after-tax accounts (such as Roth IRAs) aren’t subject to RMDs during your lifetime. If all your money is in this type of after-tax account, you won’t be required to withdraw it at any given age, and you won’t be taxed when you do withdraw it. Accounts like these can also be a way to leave tax-free inheritance to your heirs.
However, not many people save for retirement only in after-tax accounts. Some (again, like a Roth IRA) have income limits that limit the ways higher earners can contribute . Also, many investors have at least one employer-sponsored retirement plan account that includes pre-tax money.
It’s not uncommon to retire with both pre-tax and after-tax retirement savings accounts – for example, a 401(k) plan account and a Roth IRA. In this scenario, you have the flexibility to choose which one (or ones) you want to pull money from for a given year. In general, you may not have to withdraw as much for RMDs as you would if all your savings were in pre-tax accounts. An after-tax account can also be another source of additional tax-free income if you’ve already taken your RMD from a pre-tax account, but it isn’t enough to cover your expenses for the year.
For the year 2020, taxpayers may have the option to not take an RMD from certain eligible retirement plans and IRAs. You can read more about this and other recent provisions under the CARES Act.
It’s best to get help from a professional
Figuring out where to save – and the corresponding tax impact – is complex. What’s best for you depends on your unique circumstances, both today and in retirement. And of course, no one really knows what tax rates are going to look like in the future.
If you’re not sure what’s best for you, talk to your financial professional or tax advisor. He or she can help you look at your overall financial picture today and consider what may happen down the road.
- Talk to your financial professional or tax advisor about how you can use retirement savings accounts to manage your taxes. Don’t have a financial professional? We’ll help you find one.
- Are you in, or nearing, retirement? Check out principal.com/retire for more information on RMDs and tax planning during those years.
- Learn more about one after-tax account option— a Roth IRA.
The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, investment advice or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.
Insurance products and plan administrative services provided through Principal Life Insurance Co., a member of the Principal Financial Group®, Des Moines, IA 50392.