You probably already know that there are several common ways to save for retirement. These include 401(k) and IRA accounts. What you might not be as familiar with, is how these various retirement vehicles are taxed. There are four concepts in the taxation of retirement accounts. First, some accounts allow you to invest money without paying any taxes on the invested principal (at least up front). Second, some accounts allow the investment to grow without paying taxes on the growth (at least prior to withdrawals). Third, some accounts offer tax-free distributions. And finally, some investments offer none of these tax advantages – all funds are taxed. Stock market investments are an example of this. Let’s take a brief look at the first three situations.
Tax-Deductible Contributions. Traditional retirement accounts such as 401(k) and traditional IRA accounts are good examples of this. You lower your gross income by the amount invested. The investment grows on a tax-deferred basis. You pay ordinary income taxes when you withdraw. There are rules that limit the size of your annual investments, penalties if you withdraw funds before age 65 and distribution requirements (RMDs) starting at age 72 (that’s a new age beginning in 2020).
Tax-Deferred Growth. Tax-preferred retirement accounts offer tax-deferred growth. This includes 401(k)s, traditional IRAs, Roth IRAs and non-qualified annuities. In these accounts, your investments grow without having to pay any taxes (for most traditional investments). For traditional IRAs, 401(k)s and non-qualified annuities, taxes are paid at ordinary income rates upon withdrawal. For a Roth IRA, withdrawals are tax exempt and penalty exempt if you’re at least 59½ years old and you’ve had a Roth IRA for at least 5 years.
Tax-Free Distributions. As noted in the previous section, retirement-account taxes are paid upon withdrawal with the single exception of Roth IRAs. This can provide a very attractive source of tax-free retirement income.
How your retirement investments are taxed can guide where you invest your retirement dollars. However, there are other important considerations too. For example, many companies match your 401(k) contributions up to some limit. Often, the match is 100%. No tax break can match an immediate doubling of your investment. Also, there are limits as to how much you can invest in most of these vehicles which cause people to use multiple approaches. Additionally, some tax benefits are not available to taxpayers who have a significant income. Traditional IRAs are an example of this.
In addition to the above considerations, there are other investments such as Health Savings Accounts (HSAs) and 529 college savings plans which offer tax advantages. (Indeed, HSAs are the only plans that offer all three of the tax advantages described above: tax-deductible contributions, tax-deferred growth and tax-free distributions.) If you’d like some help mapping out the right retirement-account strategy for your situation or if you want to review any other financial questions that you may have, please visit our website or give us a call at 970.419.8212 so that we can discuss your situation in a no-charge, no-obligation initial meeting.
This article is for informational purposes only. This website does not provide tax or investment advice, nor is it an offer or solicitation of any kind to buy or sell any investment products. Please consult your tax or investment advisor for specific advice.