Tax Day is just around the corner, and now is a good time to review your financial habits and goals, particularly as they relate to retirement planning. This reflection is also timely because retirement preparation can have significant tax implications—ranging from whether you can deduct your account contributions to which tax rates apply when you start making withdrawals.
As long as you feel you are prepared to meet your retirement needs, there’s no right or wrong option, but depending on your scenario, certain retirement accounts may be more ideal than others. To help you think through what’s potentially best for you, we’ve provided two questions you should ask yourself before picking any retirement plan, based on the way it could impact your annual tax filing.
Question 1: How will my retirement account be taxed before I stop working?
When picking your ideal retirement planning option, one important aspect to consider is whether your account can grow tax-deferred. This means you will not pay taxes on the accrued interest until you begin withdrawing funds (ideally after you reach retirement).
Consider fixed indexed annuities as an example. Unlike a traditional savings account, for which interest is taxed each year, you do not have to pay taxes on the interest accrued from an annuity until you begin making withdrawals. This tax-deferral period can have a dramatic effect on the growth of your account. For instance, if you were to purchase an annuity with an initial payment of $25,000 and add just $5,000 each year, over the course of 20 years, the annuity would amount to $209,624 versus just $186,464 in the savings account, according to the FIA Insights calculator. This striking difference represents the power of tax-deferred growth.
Question 2: How will my retirement income be taxed once I begin making withdrawals?
Another key question is how your retirement account will be taxed—if at all—when you begin to make withdrawals. In most cases, you will pay taxes on your retirement income. However, the way you are taxed will look different based on the income source. Common examples include:
- Social Security: Depending on the proportion of your retirement income accounted for by Social Security payments, you could be taxed on up to 85 percent of Social Security income. The rate can also vary between 15 and 45 percent.
- Pensions, IRAs, 401(k)s and other types of retirement accounts: Except for Roth IRAs, which are funded with after-tax dollars, most retirement and pension accounts are taxed as normal income, meaning your rate will be determined by the income bracket in which you fall for the year.
- Annuities: Other retirement tools, such as fixed index annuities, are also taxed as ordinary income.
Recognizing the impact of taxes in retirement can help you build a solid foundation in your working years, allowing you to construct the optimal lifestyle for you after you leave the workforce. Additionally, as preparation is key to success, you may find tools like retirement calculators can help you craft the right path.