Investing in retirement savings accounts during our working years is important to any retirement plan. Just as important, is to plan on how to handle income during retirement years as well.
The timing of different retirement distributions could drastically affect the amount of taxes paid throughout retirement. To start, the various retirement accounts available have different tax treatments and consequences.
For example, withdrawals from traditional IRA accounts are taxed as ordinary income. If any amounts were contributed on an after-tax basis, then those amounts are not subject to tax. Likewise, Traditional 401(k) accounts are also taxed as ordinary income when funds are withdrawn. In contrast, both Roth IRA and Roth 401(k) account withdrawals are tax free, although the account holder must be older than 59½ and the first contribution must have been made at least five years prior to the withdrawal.
In order to time withdrawals to minimize tax liabilities, taxpayers must evaluate whether and when they will stop working and when they plan on applying for Social Security. Social Security benefits are available at age 62 however if a taxpayer continues working, receiving Social Security may push the taxpayer into a higher tax bracket. The taxpayer could end up paying taxes on their wage or business income, Social Security income, and any additional withdrawals from any retirement plans.
Many advisors recommend taxpayers make withdrawals first from taxable accounts, then from tax deferred accounts and lastly, Roth accounts withdrawals from which are tax free. This way, the taxable accounts are paid first, and the tax-deferred accounts have longer to grow and increase in value. While this method does allow for less paid in taxes later on in a taxpayer’s life, it may mean the taxpayer is paying an increased amount of taxes for a few years upfront with little to no taxes in later years. By taking stock of where retirement income is coming from and creating a proportional withdrawal strategy, however, a taxpayer can spread out their taxable income evenly over retirement and potentially reduce taxes paid on Social Security benefits.
Each individual’s situation and hopes for retirement will be different, so it is essential to take a thorough look at your projected income for retirement and plan ahead. Additionally, periodic adjustments during retirement years are also important as tax laws, tax rates, and needs change.