All retirement savings accounts are taxed; the difference is when you pay it—either today or when you start withdrawing.
One guarantee about your income? It will be taxed.
The same is true of retirement accounts: You have to pay taxes on those savings at some point. The question is when: before you save it or after you withdraw it. Each has its pros and cons, and having both options may boost your flexibility with how much and to what accounts you contribute from year to year. Here’s how to plan.
Let’s say you participate in an employer-sponsored retirement account like a 401(k), and you contribute 10% of your income. Your employer withdraws that 10% from your paycheck before deducting any other federal or state taxes. What you’re really doing, then, is reducing the amount of income tax you may have to pay at this moment and on that 10%. You’re getting the tax benefit now. This is commonly referred to as a pre-tax or tax-advantaged retirement account.
But, you still are required to pay tax on what you’ve deferred. So, when you withdraw funds in retirement, you’ll be taxed. However, if your retirement tax bracket is lower than the one you’re in now, you may pay less.
On the flip side are post-tax retirement accounts such as a Roth IRA. To make a contribution to this account, you use income—i.e., your paycheck—that’s already been taxed. The benefit accrues to you in retirement: You are not taxed on withdrawals you make after you stop working, under certain conditions.
If you’re able to save in both types of retirement accounts, you’ll have flexibility. That’s because your tax bracket and budget may change over the years, and sometimes it may make more sense to save in one type of account versus the other. Your tax advisor can help you decide what works best for you.
| Type of retirement accounts | Pre tax or post tax | You pay taxes when … |
|---|---|---|
| Traditional IRAs, 401(k)s, 403(b)s SEP IRAs, and SIMPLE IRAs |
Pre tax | You make withdrawals in retirement |
| Roth IRAs, Roth 401(k)s, and Roth 403(b)s |
Post tax | You are paid, but before you contribute to your retirement account |
For retirees, required minimum distributions, or RMDs, remain a big consideration for tax planning. These minimum withdrawals from your pre-tax accounts must be made usually starting after you turn 73. The amount you’re required to withdraw is based on your account balance, age, and other factors specific to your situation. Because these are from pre-tax accounts, you’ll have to pay income tax on RMDs, based on the tax bracket you’re currently in in retirement (not the one you were in when you contributed the savings).
But here’s another wrinkle when it comes to retirement savings and tax planning: RMDs are not required from certain after-tax accounts such as Roth IRAs, as long as they have been open for five years. If some or all your money is in this type of after-tax account, you won’t be required to withdraw it, and you won’t be taxed when you do withdraw it, no matter what tax bracket you’re in at the time of retirement.
Do you have a tax-advantaged retirement account such as a 401(k)? When’s the last time you checked on your contributions? Log in to principal.com to see if you can boost your savings, even by a small amount. Don’t have an employer-sponsored retirement account or want to save even more? We can help you set up your retirement savings with an individual retirement account (IRA).
