No one can fully escape taxes, but you do have some say in when you pay them. Different types of retirement income are taxed at different times. Orchestrating these sources in retirement can take some work, as the rules for each differ. Under the umbrella of tax-advantaged income sources, there are those that require taxes to be paid now, and others that require taxes to be paid later. While this may seem unimportant, it can make a difference when you consider your tax burden now versus in the future. So, should you pay taxes now or later?
Tax Later
If you’ve saved in a 401(k), IRA, or similar retirement account, you’ve probably appreciated its tax-advantaged nature. Contributions can be deducted from your income, and unlike other investment accounts, you don’t pay tax on the interest every year. But eventually, you will pay tax on the funds when you withdraw them.
Consider that starting at age 72, you will have to take Required Minimum Distributions (RMDs) from these accounts. RMDs can cause you to withdraw more than you would otherwise, potentially increasing your income and tax burden. When you take into account other income sources you might have in retirement, such as Social Security benefits, pensions, annuities, or investment income, you might consider working to minimize your tax burden in retirement. Income from a traditional retirement plan is just one piece of the retirement income puzzle. A financial advisor can integrate income planning with tax minimization strategies to create a comprehensive retirement plan.
Tax Now
Many Americans know the advantages of contributing to a traditional IRA or 401(k), but not everyone may know about the advantages of Roth retirement accounts. A Roth IRA, for example, can also be used to save for retirement. The main difference is in a Roth IRA, after-tax dollars are contributed, and then withdrawals are tax-free. Required Minimum Distributions aren’t due from Roth IRAs unless they are inherited.
If you haven’t saved in a Roth, it’s not too late: You can convert funds from a traditional IRA, 401(k), or similar qualified retirement account, into a Roth IRA. In this case, you would pay tax on the funds converted, and then be able to withdraw them tax-free later on. Ultimately, a Roth conversion is just one tax minimization strategy a financial advisor can suggest when creating a plan to help minimize your taxes in retirement.
There’s no simple answer to the question, ‘should you pay taxes now to later?’ Everyone’s income and tax burdens are different. Ultimately, having a mix of these income sources can help when creating a tax minimization plan in retirement. If you’re looking to do a Roth conversion or explore other tax minimization strategies, a financial advisor can help. There are many ways to help minimize taxes and the right approach depends on the individual, which is why it helps to have an advisor who knows your specific situation.