Taxes and Retirement Planning
Individual Retirement Accounts (IRAs) and employer-sponsored retirement savings plans, such as 401(k) and 403(b) plans, offer excellent tax advantages. Earnings grow tax-deferred, contributions to retirement plans at work are generally made with pre-tax money, and you may get a tax deduction for investing in an IRA. Withdrawals are typically taxed, but they’re usually tax-free for Roth IRAs.
In different ways. Traditionally, the money you contribute to a 401(k) or 403(b) plan at work is taken out of your paycheck before federal and state taxes are withheld and earnings grow tax-deferred. Your plan may now also offer a Roth option; a Roth doesn’t reduce your income now but may be eligible for tax free distributions at retirement.
You may be able to get a tax deduction for traditional IRA contributions. There’s no deduction for a Roth IRA, however, because the growth is tax free.
Generally, no. You will pay taxes on your 401(k), 403(b), or traditional IRA when you withdraw money from them.
Roth IRAs and Roth 401(k)s are a different story. Contributions you make to a Roth IRA may be withdrawn at any time without a penalty. And you won’t owe taxes on withdrawals of Roth IRA or Roth 401(k) earnings if you have held the Roth account at least five years and are at least 59½.
- Compounding. As your money grows tax-deferred in a retirement plan or IRA, you don’t have to pay taxes on the earnings each year. This means your savings can grow faster and, because taxes aren’t taken out, they’ll compound at a higher rate than if you had put the money in a similar investment requiring you to pay taxes on the earnings each year.
- The way the federal tax system works. Our income is taxed by the IRS on a graduated, progressive basis. So the more money you make, the higher the percentage of your income that will be taxed.
If you earn less in retirement than while you’re working full time, which is a pretty safe assumption, your withdrawals will be taxed at a lower rate than if the money had been taxed during your peak earnings years.
Then you should consider a Roth,, since its withdrawals won’t be taxed when you take the money out in retirement. (Younger people should also consider Roths because they could benefit greatly from future market growth even if their tax rate in retirement is not higher than it is now.)
Yes. There’s no point in putting municipal bonds or municipal bond funds in these, because those investments are tax-sheltered to begin with. Municipal bond interest is free of federal (and sometimes state) taxes.
If you withdraw money from a traditional IRA before age 59½, you’ll generally owe a 10% federal tax penalty (in addition to ordinary income taxes). You might also owe that 10% penalty for a Roth IRA withdrawal of earnings before age 59½. The rules are fairly complicated, so be sure to talk with your tax advisor before making any withdrawal.
For 401(k) plans, withdrawals escape the tax penalty at age 55, provided you leave your job and take the distribution from that plan at that age or later.