You’ve been making deposits in these retirement accounts for years, if not decades. But do you really understand how they save you money in taxes?
Most of us are very responsible about making our regular contributions to 401(k), 403(b) or IRAs, but when it comes to really knowing why this is a good move for your retirement, most people can’t articulate it. A recent article from Forbes, “Want To Cut The Taxes In Your Retirement Money?” explains how this works.
We should begin by looking at how your money gets taxed if it’s not in a tax-deferred account. Investments like CDs that are held at a bank or brokerage firm are considered short-term investments. These investments are taxed as a short-term gain at your marginal tax rate, which could be as high as 39.6%. If your gain is considered a long-term gain, then it is taxed at long-term capital gains rates, which could be as high as 20%.
For your retirement savings, you can use tax-deferred investments such as a 401(k) or an IRA. For these investments, the government doesn’t tax your savings when you deposit it, and you’re not immediately taxed on any gains you make. Instead, the money can accumulate much more quickly and grow to much larger account balances, since you’re not paying taxes on your investment (at least until you withdraw it). If you participate in a company-sponsored retirement plan, such as a 401(k) or 403(b), you may save up to $18,500 annually. If you’re over 50, you can put away an additional $6,000 annually as a “catch up” contribution. A traditional IRA only lets you contribute $5,500, with an additional $1,000 for the over 50 “catch-up” contribution.
Unlike a taxable account (such as a CD), where you have the possibility of short or long-term gains, all future earnings, (including the savings in a 401K or IRA that never got taxed) will be taxed at your future income tax rate, when the money is withdrawn. You must be mindful of the withdrawal rules or face some significant financial penalties. For 401(k) or IRA accounts, with limited exceptions, you cannot withdraw funds before age 59½, without triggering a 10% penalty. Later, at age 70½ you must begin withdrawing Required Minimum Distributions (RMDs), or pay a 50% penalty on the amount you should have taken. Note: you must pay income taxes on any amount you withdraw from these retirement accounts.
A Roth IRA or Roth 401(k) are different from their traditional cousins, because your contribution is taxed today. In other words, your contribution dollars are post-tax as opposed to pre-tax like 401(k) or IRA contributions. However, similar to a 401(k) and IRA, your investments earnings are not taxed, and neither are your withdrawals.
Roth IRAs and Roth 401(k)s allow you to withdraw your money without tax or penalty starting at 59½. However, unlike the 401(k) and traditional IRA, you don’t pay taxes on the gains (you paid taxes on your original savings when it was deposited into the Roth). There are penalties for withdrawals before age 59 ½, but if you don’t pull more out than you contributed, they don’t apply.
There are as many investing strategies for taxable or tax-deferred accounts, as there are mutual funds—countless numbers. Some investments are likely to lead to greater gains than other investments. However, whatever your investment earnings are, you will be paying taxes on them, at some point.
Be cautious and don’t act without good advice. Taking money out of tax-deferred accounts before age 59 ½ can become very expensive, very quickly, because of taxes and early withdrawal penalties. If your retirement plan includes retiring before 59 ½, good for you—but be careful. You could find yourself back at work, just to pay off your taxes!
Reference: Forbes (August 10, 2018) “Want To Cut The Taxes In Your Retirement Money?”