Whatever your age, it pays to think about how taxes fit into retirement planning

Planning for your retirement means making a series of financial decisions that will impact you both today and tomorrow: What type of plan should you invest in? How much should you save? What should you do with your plan when you change jobs? When should you start taking withdrawals? In what amounts? Whether you're just starting to think about retirement planning, are retired already, or are somewhere in between, addressing the relevant questions will help ensure your golden years are truly golden.

401(k)s and other employer plans

Contributing to an employer-sponsored defined contribution plan, such as a 401(k), 403(b), 457, SARSEP or SIMPLE, is usually the first step in retirement planning:

  • Contributions are typically pretax, reducing your modified adjusted gross income (MAGI), which also can help you reduce or avoid exposure to the 3.8% NIIT,
  • Plan assets can grow tax-deferred — meaning you pay no income tax until you take distributions.
  • Your employer may match some or all of your contribution.

Employee contributions are subject to annual limits. Because of tax-deferred compounding, increasing your contributions sooner rather than later can have a significant impact on the size of your nest egg at retirement.

If your employer offers a match, at minimum contribute the amount necessary to get the maximum match so you don’t miss out on that “free” money.

If your employer provides a SIMPLE, it’s required to make contributions (though not necessarily annually). But the employee contribution limits are lower than for other employer-sponsored plans.

Traditional IRA

If your employer doesn’t offer a retirement plan, consider a traditional IRA. You can likely deduct your contributions, though your deduction may be limited based on your adjusted gross income (AGI) if your spouse participates in an employer-sponsored plan. The annual contributions limits for IRAs are lower than for employer-sponsored plans, but you can make contributions for the tax year until the income-tax-return-filing deadline for individuals, not including extensions.

Catch-up contributions

Under current law, eligible taxpayers age 50 or older can make additional “catch-up” contributions to employer-sponsored 401(k), 403(b), or 457 plans, SIMPLES and to IRAs.

If you didn't contribute much when you were younger, this may allow you to partially make up for lost time. But even if you've saved a lot for retirement already, you can use catch-up contributions to grow your tax-advantaged nest egg even more.

However, the SECURE 2.0 Act, signed into law Dec. 29, 2022, makes some changes to the taxation of catch-up contributions that could reduce the upfront tax savings for some taxpayers. Generally beginning in 2024, it requires catch-up contributions to be treated as post-tax Roth contributions if you earned more than $145,000 during the prior year. (This amount will be annually indexed for inflation.) A traditional pre-tax or deductible catch-up contribution option will no longer be available to affected taxpayers. But, the IRS is providing an “administrative transition period” that gives employers and plan providers more time to make the changes needed to comply. Essentially, for 2024 and 2025, the Roth requirement won’t apply.

A SECURE 2.0 catch-up contribution enhancement is that, beginning in 2025, taxpayers ages 60 to 63 will be able to make catch-up contributions to most employer-sponsored plans up to the greater of $10,000 ($5,000 for SIMPLEs) or 150% of the amount allowed for those age 50 and over.

Roth alternatives

A potential downside of tax-deferred saving is that you’ll have to pay taxes when you make withdrawals at retirement. Roth plans, however, allow tax-free distributions; the tradeoff is that contributions to these plans don’t reduce your current-year taxable income:

1. Roth IRAs. In addition to tax-free distributions, an important benefit is that Roth IRAs can provide estate planning advantages: Unlike other retirement plans, Roth IRAs don’t require you to take distributions during your lifetime.

But Roth IRAs are subject to the same low annual contribution limit as traditional IRAs, and your Roth IRA limit is reduced by any traditional IRA contributions you make for the year. It may be further limited based on your AGI.

2. Roth conversions. If you have a traditional IRA, consider whether you might benefit from converting all or a portion of it to a Roth IRA. A conversion can allow you to turn tax-deferred future growth into tax-free growth and take advantage of a Roth IRA’s estate planning benefits.

There’s no income-based limit on who can convert. But the converted amount is taxable in the year of the conversion.

Whether a conversion makes sense for you depends on a variety of factors, such as:

  • Your age,
  • Whether the conversion would push you into a higher income tax bracket or trigger the NIIT,
  • Whether you can afford to pay the tax on the conversion,
  • Your tax bracket now and expected tax bracket in retirement, and
  • Whether you’ll need the IRA funds in retirement.

Warning: Unlike before the TCJA went into effect, you can’t change your mind during the year and recharacterize a Roth conversion back to a traditional IRA.

3. “Back door” Roth IRA contributions. If the income-based phaseout prevents you from making Roth IRA contributions and you don’t have a traditional IRA, consider setting up a traditional account and making a nondeductible contribution to it. You can then wait until the transaction clears and convert the traditional account to a Roth account. The only tax due will be on any growth in the account between the time you made the contribution and the date of conversion.

4. Roth 401(k), Roth 403(b) and Roth 457 plans. Employers may offer one of these in addition to the traditional, tax-deferred version. You may make some or all of your contributions to the Roth plan. No income-based phaseout applies, so even high-income taxpayers can contribute.

Plans for business owners and the self-employed

If most of your money is tied up in your business, retirement can be a challenge. So if you haven’t already set up a tax-advantaged retirement plan, consider setting one up this year. If you might be subject to the NIIT, this may be particularly beneficial because retirement plan contributions can reduce your MAGI and thus help you reduce or avoid this 3.8% tax. You generally can set up a plan and make deductible contributions for the tax year as late as the due date of your income tax return for the year, including extensions. Keep in mind that, if you have employees, they generally must be allowed to participate in the plan, provided they work enough hours and meet other qualification requirements. Here are a few options that may allow you to make large contributions:

Profit-sharing plan. This is a defined contribution plan that allows discretionary employer contributions and flexibility in plan design. If you’re age 50 or older, you may be able to contribute more than you could to a SEP.

SEP. A Simplified Employee Pension is a defined contribution plan that provides benefits similar to those of a profit-sharing plan. But depending on your situation, your contribution limit may be lower. A benefit is that a SEP is easier to administer than a profit-sharing plan.

Defined benefit plan. This plan sets a future pension benefit and then actuarially calculates the contributions needed to attain that benefit. The maximum compensation for benefit purposes is the statutory limit for the plan year — or 100% of average earned income for the highest three consecutive years, if less. Because it’s actuarially driven, the contribution needed to attain the projected future annual benefit may exceed the maximum contributions allowed by other plans, depending on your age and the desired benefit.

Warning: Employer contributions generally are required.

Early withdrawals

Generally, making early withdrawals from a retirement plan should be a last resort. With a few exceptions, retirement plan distributions made before age 59½ are subject to a 10% penalty, in addition to any income tax that ordinarily would be due on a withdrawal.

This means that, if you’re in the top federal tax bracket, you can lose nearly half of your withdrawal to federal taxes and penalties. If you’re also subject to state income taxes and/or penalties, the total of your taxes and penalties almost certainly will exceed 50%. Even if you’re in a lower bracket, you can lose a substantial amount to taxes and penalties. Additionally, you’ll lose the potential tax-deferred future growth on the amount you’ve withdrawn.

If you have a Roth account, you can withdraw up to your contribution amount without incurring taxes or penalties. But you’ll still be losing the potential tax-free future growth on the withdrawn amount.

So if you’re in need of cash, you’re likely better off looking elsewhere. For instance, consider tapping your taxable investment accounts rather than dipping into your retirement plan. Long-term gains from sales of investments in taxable accounts will be taxed at the lower long-term capital gains rate, and losses on such sales can be used to offset other gains or carried forward to offset gains in future years.

Another option to consider, if your employer-sponsored plan allows it, is to take a loan from the plan. You’ll have to pay it back with interest and make regular principal payments, but you won’t be subject to current taxes or penalties.

Leaving a job

When you change jobs or retire, avoid taking a lump-sum distribution from your employer’s retirement plan because it generally will be taxable, plus potentially subject to the 10% early-withdrawal penalty. Here are options that will help you avoid current income tax and penalties:

Staying put. You may be able to leave your money in your old plan. But if you’ll be participating in a new employer’s plan or you already have an IRA, this may not be the best option. Why? Because keeping track of multiple plans can make managing your retirement assets more difficult. Also consider how well the old plan’s investment options meet your needs.

A rollover to your new employer’s plan. This may be a good solution if you’re changing jobs, because it may leave you with only one retirement plan to keep track of. But also evaluate the new plan’s investment options.

A rollover to an IRA. If you participate in a new employer’s plan, this will require keeping track of two plans. But it may be the best alternative because IRAs offer nearly unlimited investment choices.

If you choose a rollover, request a direct rollover from your old plan to your new plan or IRA. Otherwise, you’ll need to make an indirect rollover within 60 days to avoid tax and potential penalties. Warning: If you don't do a direct rollover, the check you receive from your old plan may be net of 20% federal income tax withholding. If you don’t roll over the gross amount (making up for the withheld amount with other funds), you’ll be subject to income tax — and potentially the 10% penalty — on the difference.

Required minimum distributions (RMDs)

Generally, you must begin taking RMDs annually from your IRAs (except Roth IRAs) and defined contribution plans once you reach a certain age. If you don’t comply with RMD rules, you can owe a penalty on the amount you should have withdrawn but didn’t. Fortunately, SECURE 2.0 has increased the age at which RMDs must begin and decreased the penalty.

Historically, after reaching age 70½, taxpayers had to begin taking annual RMDs from their IRAs (except Roth IRAs) and, generally, from any defined contribution plans. However, the SECURE Act raised the age to 72 for taxpayers who didn’t turn age 70½ before Jan. 1, 2020.

SECURE 2.0 raises the age again, to 73, for taxpayers who didn’t turn age 72 before Jan. 1, 2023 (that is, were born after Dec. 31, 1950). It then will boost the age to 75 on Jan. 1, 2033.

SECURE 2.0 also relaxes the penalty for failing to take full RMDs, from 50% to 25% beginning in 2023. If the failure is corrected in a “timely” manner, the penalty drops to 10%.

Remember that qualified charitable distributions from your traditional IRA can satisfy your RMDs. You can avoid the RMD rule for a Roth 401(k), Roth 403(b) or Roth 457 by rolling the funds into a Roth IRA.

Waiting as long as possible to take distributions generally is advantageous because of tax-deferred compounding. But a distribution (or larger-than-required distribution) in a year your tax rate is lower than usual may save tax in the long run. Before making such a distribution, consider the lost tax-deferred growth and, if applicable, whether the distribution could: 1) cause your Social Security payments to become taxable, 2) increase income-based Medicare premiums and prescription drug charges, or 3) affect other deductions or credits with income-based limits.

Warning: While retirement plan distributions aren’t subject to the additional 0.9% Medicare tax or 3.8% NIIT, they are included in your MAGI and thus could trigger or increase NIIT, because the thresholds for that tax are based on MAGI.

If you’ve inherited a retirement plan, consult your tax advisor regarding the distribution rules that apply to you.

Warning: The time period for distributions has been reduced to 10 years for beneficiaries — other than surviving spouses and certain others — inheriting plans after Dec. 31, 2019. (The IRS is providing relief for certain taxpayers subject to the 10-year rule who didn’t take RMDs in 2021, 2022 or 2023.)