What’s your retirement plan? Do you have a pension? A 401(k)? Do you think this will be enough for you to live comfortably on?
While millions of Americans have a retirement account in place, the scary truth is, they have not considered the impact of taxes in retirement. And taxes are vital – they determine how much of your money you will actually keep.
Your retirement tax planning must go beyond maximizing your 401(k) or IRA contributions. You need to learn about the different types of retirement savings accounts and the pros and cons of each.
Don’t get to retirement only to find out that a huge chunk of your life savings will go to taxes. Check out our tax and retirement planning guide to see which type of plan is right for you – and eliminate surprise taxes in retirement.
Retirement tax planning: Traditional plans
With traditional plans, you don’t pay taxes on your contributions at the time they are made. Taxes are deferred until you begin withdrawing from your plan – and then you are taxed at the current tax rate for your income bracket. However, your contributions are tax deductible in the year they are made. This means you can deduct them from your adjusted gross income – and therefore pay fewer taxes on your annual income right now.
Traditional 401(k)
This option is one of the most popular for retirement tax planning, but be smart about it. The 401(k) can be a great piece of tax code that, if structured right, can fuel your retirement for years. But, many of today’s 401(k) plans are chock full of fees and unseen costs. In 2012, service providers became required by law to disclose these fees, but despite this change, the majority of employees still aren’t aware of how much they’re paying – and really, how much they’re losing.
With that said, if your employer matches your contributions, then it is worth getting in the game with a 401(k), since they are basically covering your future tax costs. Just be sure to know how your company’s plan stacks up. 401(k)s also allow higher annual contributions: up to $19,500 per year, compared to just $6,000 for IRAs.
Traditional IRA
If you are self-employed, you’ll need to look into IRAs for retirement tax planning – 401(k)s are only offered by employers. But you can have both a 401(k) through your employer and an IRA. Opening both account types is a smart move for those who are eligible.
IRAs offer you access to many more types of investments and more control over those investments, as you’re not limited by a company plan. But contribution limits are lower: $6,000 per year, or $7,000 per year for those age 50 and over.
The main benefit of traditional IRAs is that they do not have income limits. For individuals who earn more than $124,000 or married couples earning more than $196,000, traditional IRAs are the way to go – you won’t be able to make full contributions to a Roth IRA.
Retirement tax planning: Roth plans
If you think that taxes will go up in the future, then you may want to consider a Roth retirement plan. A Roth IRA, and more recently the addition of the Roth 401(k), is often overlooked, but is actually one of the most tax efficient solutions to retirement out there.
Roth plans can ease your worries about taxes in retirement. With a Roth account, you pay taxes today, then deposit the after-tax amount and never have to worry about taxes again. Your money grows tax-free and you don’t have to worry about taxes when you take your money out. You cannot deduct Roth contributions from your annual income. However, you are completely protected if the government decides to raise taxes in the future. And most importantly, you will know with absolute certainty how much money you will actually have when you decide to start making withdrawals.
Roth 401(k)
Introduced in 2006, the Roth 401(k) option is considered relatively new. Most of today’s 401(k) plans allow you “check a box,” and your contributions will receive the Roth tax treatment. This means you can pay tax today and let your growth and withdrawals steer clear of the tax man. And while a Roth IRA is limited to a $6,000 annual contribution (or $7,000 if you’re over age 50), the Roth 401(k) allows you to deposit $19,500 every year.
Another difference between Roth IRA and Roth 401(k) is that no matter how much you make, you can always participate in a Roth 401(k). This is a relatively new change in the tax system, which can provide a big benefit for higher income earners.
Because Roth 401(k)s were just introduced in 2006, those closer to retirement – who may have been saving for years or even decades already – may not think they’re useful. However, if your employer offers a Roth option, you may be able to convert your existing 401(k). You’ll pay taxes on the full amount now, but won’t have to worry about taxes in retirement. With a Roth 401(k), however, you must have held the account for five or more years before you can withdraw money. So if you are very close to retirement age, this may not work for you.
You’re also allowed to have both a traditional 401(k) and a Roth 401(k). You can always start contributing to a Roth account now, and save on at least some taxes in retirement.
Roth IRA
Roth IRAs are one of the most beneficial types of retirement tax planning. With a Roth IRA, the government will allow you to pay the tax on your IRA today (because they could use the money now), and you will never have to pay tax again.
Some people are automatically turned off from the idea of paying tax today. But remember, you will have to pay taxes eventually. And by doing it now, you are protecting yourself and your nest egg from future taxes in retirement. One of the only downsides is that you cannot make a full contribution to a Roth IRA if your annual income exceeds $124,000 as an individual or $196,000 for a married couple.
However, Roth IRAs do have many benefits over traditional IRAs. They have more flexible early withdrawal rules, so – while we don’t recommend dipping into your savings early – if you do have an emergency, you can take out contributions without taxes or penalties. There is also no mandatory distribution date – that is, you can keep your savings in the account as long as you like and continue accruing tax-free dollars well into retirement. With traditional IRAs, you must start taking distributions at age 72.
Retirement tax planning: Additional options
Small business owners or high income earners that have a steady income and want to reduce their taxes today can find big benefits by coupling a cash-balance plan with their 401(k) plan.
A cash-balance, or CB plan, is basically a pension plan that happens to have elements of a 401(k). Like a pension, you won’t be investing any of your own money into the plan. You also don’t have control over the investment choices. But, rather than your overall benefits being based on a specific formula that considers how long you’ve worked at the company or what your average salary has been, the CB plan simply takes a set percentage of your salary each year, plus a set interest rate and adds it into your account. The best part is that you can max out your 401(k) plan and a profit-sharing plan, then still add a CB plan to create some substantial – and fully deductible – contributions.
According to the owner of America’s Best 401k, Tom Zgainer, “A cash balance plan starts to get very exciting when you get older, as you can put a more substantial amount of money away while reducing your tax liability. A cash-balance plan essentially allows you to squeeze 20 years of savings into 10 years.”
This tax and retirement planning guide is just the start of all the ways you can maximize your savings. Remember, it’s not enough to just protect your nest egg from the unscrupulous fees and costs that some 401(k) plans impose. You must learn how to protect your money from unforeseen taxes in retirement.
Don’t be blindsided by the hit taxes can take against your nest egg. Protect your nest egg and protect your road to retirement. Ultimately, you’re protecting your financial future – and nothing is more important than that.