Whatever your age, it pays to think about how taxes fit into retirement planning
What type of plan should you invest in? When should you start taking distributions? What are the tax consequences? 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. Employees age 50 or older can also make “catch-up” contributions, however, so if you didn't contribute much when you were younger, this may allow you to partially make up for lost time.
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 catch-up contributions are also allowed.
Roth options
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 IRAs. 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, but any employer match will be made to the traditional 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. 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. You generally can make deductible 2022 contributions as late as the due date of your 2022 income tax return, including extensions.
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 for 2023 is generally $265,000 (up from $245,000 for 2022) — 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.
You can make deductible 2022 contributions until the due date of your 2022 income tax return, including extensions. 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.
If you took an eligible 2020 distribution, consider these tax-deferral options:
Recontribute the distributions. Normally once you’ve taken a distribution, you have only 60 days to return it to the plan. But the CARES Act created an exception for eligible COVID-19 distributions: They may be recontributed to the retirement plan over the three-year period starting the day after the withdrawal.
If you can afford to do so, this is likely the best option. You can avoid current tax liability, and the funds can return to growing tax deferred, building up your retirement nest egg. Depending on when you recontribute, you may have to initially pay some tax and then file an amended return after the recontribution to get that tax back.
Spread out the income tax payments. Generally, tax on retirement plan distributions is due by the filing deadline for the year the distribution was taken. But under the CARES Act, you can spread out the reporting of eligible COVID-19 distributions evenly over 2020, 2021 and 2022.
If you can’t afford to recontribute the distribution, this option might be beneficial — though if your 2020 tax bracket was lower than usual, you may be better off reporting the entire distribution on your 2020 return (filing an amended return if necessary). Also, you still have the option to return some or all of the distribution up until the end of the three-year period; you’ll just need to file one or more amended returns to get the tax refunded.
The rules are complex, so be sure to consult your tax advisor
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
Previously, in the year in which a taxpayer reached age 70½, he or she has had to begin to take annual required minimum distributions from his or her IRAs (except Roth IRAs) and, generally, from any defined contribution plans. The age has now increased to 73 for taxpayers who reached age 72 after Dec. 31, 2022. A direct contribution from your IRA to charity can also satisfy your RMD. An RMD deferral is allowed for the initial year, but you’ll have to take two RMDs the next year. 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.
If you don’t comply with RMD rules, you can owe a penalty equal to 50% of the amount you should have withdrawn but didn’t.
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. 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 taxpayers who didn’t take certain RMDs from inherited plans. The relief under Notice 2022-53 is for taxpayers subject to the “10-year rule” who didn’t take RMDs in 2021 or 2022 but were required to do so.)
