Taxes for different retirement savings options
Apr 1, 2024, 3:41:55 PM | Reading Time: 5 minutes
There are a variety of retirement options to help individuals prepare for the future. Depending on specific needs and future expectations, it’s important to consider how taxes on contributions and distributions may impact retirement income.
Pre-tax retirement accounts, like 401(k)s and IRAs, mean that the money contributed to these accounts and potential earnings are not taxed at the time of contribution. “When retirement arrives, and withdrawals begin, taxes will then need to be paid since the money withdrawn is now taxable income,” shared Tyler De Haan, Certified Financial Professional and Director of Advanced Sales at Sammons Institutional Group, a member of Sammons Financial Group. "Post-tax retirement accounts, like a Roth IRA, require the contributions made to the account to be taxed. Then, in retirement and assuming the five-year rule is met, those qualified distributions will be tax-free since taxes have been paid."
When choosing a pre-tax retirement savings account, contributions can be made without losing additional income today. However, this means an individual will have to cover taxes on retirement withdrawals when income can be less predictable.
“Since money is taxed once withdrawals are made down the road, choosing a pre-tax retirement account can provide an opportunity to grow savings for the future, explore investing, and find ways to create a steady income for retirement,” shared De Haan. Many people are in a lower income tax bracket in retirement, which can offer more favorable tax rates. There are many retirement accounts and income sources that offer pre-tax options for a long-term financial plan:
If there is no other substantial income besides
Social Security there may not be any federal taxation. However, a retiree will be required to pay tax on up to 85% of their Social Security benefits if they file:
- File a federal tax return as an "individual" and your combined income is more than $34,000
- File a joint return, and you and your spouse have a combined income that is more than $44,000
Additionally, if a retiree is married and files separately from their spouse, they will likely only be required to pay tax on 85% of their Social Security benefits.
Contributions to a 401(k) often come from a paycheck and reduce taxable income while a person still earns, typically resulting in less taxes being paid throughout the working years. Just remember that once retirement arrives and money is withdrawn, income taxes will need to be paid at that time.
Similar to a 401(k), contributions to a traditional IRA are not taxed, and earnings can grow tax-free, but when withdrawals begin, those funds will be subject to income taxes.
Early withdrawals before age 59 ½ are generally subject to a 10% penalty, but there are exceptions to this rule.
If an
annuity is purchased with pre-tax funds, it can offer tax-deferred growth and a way to supplement retirement income in the future. Not paying taxes while an annuity is in its accumulation phase can allow the money to compound over the years instead of going toward taxes. Once an annuitant enters retirement and begins receiving distributions, then all or a portion of the
payments can be taxable.
Most
pensions are funded with pre-tax dollars, so typically, retirees are only taxed once they begin receiving payments. The amount owed can depend on several factors if that income is subject to tax. If pension payments are received periodically, the retiree may be taxed at their regular income tax rate, whereas cashing in on a lump-sum payment from the pension often requires paying the total tax due when filing the tax return for that year. Sometimes, an annuity can be converted to a lump sum and rolled into an IRA.
When an individual prefers to pay taxes upfront and avoid paying them later in retirement, choosing a post-tax retirement account may make more sense. This strategy can help create retirement income more predictable since taxes on contributions are already paid. This may be desirable if the person feels financially secure in their day-to-day earnings to cover taxes but is worried it may be more challenging when they’re on a tighter budget after leaving the workforce.
Unlike a traditional IRA,
Roth IRAs are funded with after-tax dollars, so contributions are taxed immediately and are not typically reported on a tax return. Another critical difference is retirees generally have to take required minimum distributions (RMDs) from traditional IRAs at age 73 or 75, depending on the year you were born. Roth IRAs do not require withdrawals until after the owner passes away, so money can be left to continue to grow without penalty.
“An important part of retirement planning includes exploring ways to minimize taxes and understanding the limits and requirements mandated for each retirement option,” adds De Haan. “Working with a tax advisor can help you navigate general tax rules, early withdrawal tax penalties, and RMDs more easily, and they can explain ways to reduce a tax bill before and after retirement."
Partnering with a financial professional can also be helpful when exploring the types of retirement savings accounts available and what would make the most sense for your situation. Often, creating a retirement portfolio with both pre-tax and post-tax options can help diversify savings and investment opportunities and ensure there is enough income for the future.
Neither Midland National Life Insurance Company, nor any financial professionals acting on its behalf, should be viewed as providing legal, tax or investment advice. Please rely on your own qualified tax professional.
The term financial professional is not intended to imply engagement in an advisory business in which compensation is not related to sales. Financial professionals that are insurance licensed will be paid a commission on the sale of an insurance product.
The views and opinions expressed by Tyler De Haan are his views and opinions as an individual and do not reflect the views and opinions of Midland National® Life Insurance Company.
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