Pay Now or Pay Later: Demystifying Income Taxes in Retirement

Retirement Income

Pay Now or Pay Later: Demystifying Income Taxes in Retirement

Posted by Asset Protection Group
2 weeks ago | February 15, 2021

Income taxes are an important part of your finances during your career, but they don’t exactly go away once you retire. One way or another, you will pay some income taxes on your retirement income, too. But because your tax liability will depend upon the choices you make now, it’s important to understand how to structure your retirement income for the future.

Pay now: Earning a tax-free income sounds like a dream come true, and something that many people would choose for their retirement years. One retirement saving option does allow you to enjoy tax-free withdrawals during retirement, but that’s because you’ve already paid income taxes on the money when you earned it.

A Roth account allows you to save money on an “after tax” basis. This means after you’ve paid regular income taxes on your earnings, you can make contributions to your Roth account from what is left over. You don’t earn a tax break for saving this way now, but you won’t owe income taxes on the withdrawals you take during your retirement years.

Pay later: If you save for retirement using a 401(k) account, your contributions to that account will be made on a “pre-tax” basis. That means if you stash $19,000 in your 401(k) this year, your taxable income will be reduced by the same amount. This can be a good choice for those who want to reduce their tax liability during their working years.

However, the trade-off is that you will pay income taxes on distributions from that account after you retire. So, anticipate your tax bracket in retirement, and plan to pay income taxes based on that annual income.

As you can see, income taxes are inevitable either way. But because you could potentially save a significant amount of money by choosing the retirement savings option that works best for your situation, this is a choice to make carefully. Let’s discuss this issue at your next appointment, so that we can help you decide what might work best for your current and future tax situations.

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