Retirement planning is one of the most important financial moves Americans can make as they get older. But many people who can put away money focus on the size of their contributions and total amount saved rather than the tax implications of what they set aside. However, how your retirement income is taxed has an impact on your money both now and in the future. Here's what you need to know about the three main tax options.
1. Tax-Deferred Savings
Tax deference is the putting off of taxation until a later date. The most common example is an employer-based 401(k) plan. Anything you contribute is not taxable income when you contribute it. However, it is taxed when you withdraw it. And savers must withdraw from tax-deferred plans like 401(k) plans at a set age whether or not they need the money.
Tax deferred plans can lead to unexpected tax bills on two counts. First, the required distributions are taxable and include penalties for not withdrawing the money. Second, the interest and dividends built up over the years are taxable income, along with the principal. The advantage to these, though, is less tax now — which can be beneficial if you expect to be subject to a lower tax rate at retirement.
2. Nontaxable Savings
The opposite of tax-deferred plans are those that don't offer tax benefits for contributing. Roth IRAs are the most common type of account. While you don't get to deduct your contributions, you can take all the money — both principal and growth — without paying tax on it in retirement. There is also no minimum required distribution.
Clearly, the benefit of this account is that there will be no tax surprises when you retire. You can use the full amount that's in your account. One common strategy is to use this money to delay the start of Social Security and keep taxable income lower over the years.
3. Taxable Savings
Finally, you don't have to use a retirement account to fund your retirement. You can instead use options like brokerage investment accounts and regular savings accounts. You pay taxes on what you earn but not what you have put in. If income from these is taxed regardless of whether you need it — or even whether or not you withdraw it — you should often use this money first during retirement.
Where to Learn More
Clearly, you have a lot of tax choices when saving for retirement. And the wrong tax strategy can result in paying too much in taxes both now and after retiring.
The best way to ensure this doesn't happen is to consult with an experienced tax professional long before you retire. Together, you can formulate a strategy to use taxable, nontaxable, and tax-deferred money to craft a happy and stable retirement. Contact a company that offers tax consulting services to learn more.