One guarantee about income made during your life? 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.
Why would I pay income tax on retirement savings later?
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, when you save, and deferring the tax liability until later. This is commonly referred to as a pre-tax or tax-advantaged retirement account.
But, you still are required to pay that income tax that 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 in tax.
Why would I pay income tax on retirement savings now?
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.
| 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 |
You may have both pre-tax accounts and after-tax accounts so you can be more flexible with how much and to what accounts you contribute from year to year. For example, your tax bracket and budget may change; some years you may want to save more in a pre-tax account and defer taxes until retirement. In other years, the reverse may be true.
The retirement tax effect of withdrawals
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.
However, RMDs are not required from certain after-tax accounts such as Roth IRAs. If some or 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.
What's next?
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). Ready to learn more ways you can build your financial foundation? Our learning library can help.