Taxes are a critical factor when saving — and spending — in retirement. Taking a little extra time to think about what your tax situation in retirement might look like can save thousands of dollars.
Retirement Tip of the Week: While saving for retirement, weigh the pros and cons of using different types of accounts for investing, and what the tax implications of those accounts may be. This way, when it comes time to spend your hard-earned savings, you’re doing it in the most tax-efficient way possible.
Individual retirement accounts, and even some 401(k) plans, are divided into two types: traditional accounts, which use pre-tax dollars, and Roth accounts, where contributions are made with after-tax dollars. At distribution, withdrawals from traditional accounts are taxed, whereas with Roths, they are not.
There’s no one right answer when deciding to go with a traditional or Roth account, and not all experts agree on which to use. Personal finance guru Suze Orman has suggested Americans steer clear of traditional accounts, but financial planners say they serve a purpose.
Traditional accounts are a good choice for people who are in a high tax bracket today and expect to be in a low tax bracket in retirement, because those contributions aren’t being taxed at the higher rate now. Taxpayers are eligible for deductions based on their income, and Roth accounts do not allow for any deductions. Traditional accounts also allow for more of a contribution to grow with compound interest, unlike the Roth account, where there’s less money from the contribution going into the account because it’s already been taxed.
On the flip side, Roth accounts are a solid choice for people who are in a lower tax bracket now and expect to be in a higher tax bracket in retirement. Regardless how high their bracket is when they’ve retired, they won’t have to pay taxes on the distributions (assuming they adhere to the rules of Roth distributions — here’s more on that from the IRS). Investors might have an easier time withdrawing funds before retirement age from a Roth, unlike traditional accounts, depending on how long the account has been open, how much of the withdrawal is contributions versus earnings and what expenses the distributions are going toward. Taxpayers are subject to income limits to contribute to a Roth IRA.
Individuals have required minimum distributions beginning at age 72 for traditional individual retirement accounts and 401(k) plans, but Roth IRAs do not. The rule does apply to Roth 401(k) plans however.
Want to take advantage of your current tax situation? Americans have until the tax filing deadline to fund an IRA for the previous year. For example, those who want to fund an IRA for 2020 would have until May 17, 2021 to contribute to their 2020 IRA. The IRA announced the tax filing deadline had been pushed forward a month, from April to May.
To contribute to an IRA, individuals must have earned income. For 2020 and 2021, workers can contribute a maximum of $6,000 to a traditional or Roth account, and an additional $1,000 if they are 50 or older. Traditional accounts are subject to income limits for deductions — which means they can still contribute above those thresholds but won’t be eligible for any deductions come tax time. To contribute to a Roth IRA, workers must earn no more than $140,000 if filing single and $208,000 if married filing joint.