Saving for retirement is one of the most important factors behind ensuring a comfortable lifestyle in old age. Simply setting aside money, though, is not always enough to guarantee a financially secure retirement because there are several planning issues many people too often overlook. For example, one in three retirees in a new Nationwide poll said that they wish they had better prepared for paying taxes in retirement. Such regrets are not too surprising since 35 percent of surveyed retirees said that they never considered how taxes could affect their old-age finances.
Encouragingly many younger survey respondents still in the workforce appear aware of the potential impact taxes could have on their retirement income. Thirty-eight percent of surveyed workers even said that they are now more “terrified of what taxes will do to their retirement income” than prior to the recent economic disruptions caused by the coronavirus. Thirty-five percent of future retirees, though, admitted that they “rarely consider the taxes they are paying or will pay in retirement,” and not even half (43 percent) felt knowledgeable enough to properly “leverage the taxable, tax-deferred, and tax-free accounts” available to them. Such respondents would likely benefit from an overview of the various tax advantages provided by popular savings vehicles.
Participants in a traditional 401(k), for instance, may contribute pre-tax earnings to a retirement plan where the funds grow on a tax deferred basis. The account owner can start to receive “qualified distributions” after reaching the age of 59½ when these withdrawals will be taxed as ordinary income. Since workers participating in a traditional 401(k) set aside a portion of their wages before any federal and state income taxes are withheld, the money pulled from their take-home pay and put into the plan basically provides them with more control over their periodic tax withholdings and end-of-year tax liability. That additional flexibility in how and when taxes are paid is one of the key factors behind the popularity of a traditional 401(k) arrangement.
Further, many Americans will likely have a reduced income once they retire. Since this would put them into a lower tax bracket than when they were fully-employed, the earnings from their tax-deferred 401(k) plan during retirement could wind up being taxed at a much more favorable rate. However, for savers who anticipate being in a higher tax bracket later in life, a Roth 401(k) is often considered a better option because these plans allow participants to potentially reduce their post-retirement tax liability through paying taxes as they contribute rather than when they start to make withdrawals. Moreover, Roth-style accounts provide a way to lock in current tax rates and hedge against an unexpected tax rate spike, a growing risk as the fiscal strain from Social Security and Medicare increases.
It is also worth remembering that when you withdraw money from a traditional 401(k) plan you are subject to both federal and state income taxes. This means that individuals who spend their working careers in high-income-tax states but then retire in a low- or no-income-tax state may have the ability to reduce or outright avoid any state income tax liabilities. On the other hand, a Roth 401(k) subjects your retirement dollars to both federal and state income taxes today in return for “tax-free” income during retirement. Since state-level income tax rates can vary significantly, the effect on a person's retirement can be huge. Additional clarity on these and other retirement issues will as usual be available by consulting with a professional financial advisor.
Sources: Nationwide Retirement Institute, U.S. IRS, Fidelity, CNBC