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401(k) and IRA Taxes

 HOW THESE ACCOUNTS ARE AFFECTED

Taxes are, inevitably, a part of life. Even in retirement, we may have to pay income taxes on our retirement fund withdrawals and Social Security benefits which can definitely take a bite out of income.

Although taxes may be unavoidable, planning for them can make the process more bearable. In order to prepare, it is important to understand how taxes affect retirement income.

Traditional IRAs and 401(k)s

These are tax-deferred retirement accounts, meaning you receive a tax deduction when you make the initial contribution but will need to pay taxes when you withdraw your cash.

With Roth IRAs, on the other hand, you will pay taxes upfront but your withdrawals will be tax-free. If you are saving in a 401(k) or traditional IRA, you can expect to pay income taxes on your retirement withdrawals. But exactly how much you will pay depends on your tax bracket.

If your spending levels do not shift very much between now and retirement, you may find yourself in the same tax bracket once you retire. But if you expect to spend significantly more or less in retirement than you are earning now, you might end up in a higher or lower tax bracket.

Keep in mind that this is a progressive tax system, meaning that whatever tax bracket you fall under, you will not pay that rate for your entire income.

So if you withdraw $50,000 per year from your 401(k) or traditional IRA, for example, you will pay 10% on the first $9,875, then 12% on the amount from $9,875 to $40,125, then 22% on the amount from $40,125 to $50,000.

One other factor to consider with 401(k)s and traditional IRAs is your required minimum distributions (RMDs). Once you turn 72 years old (70 1/2 if you turned 70 1/2 before January 1, 2020), you will be required to start withdrawing a certain amount from your 401(k) or traditional IRA -- since those accounts are tax-deferred and Uncle Sam wants the money eventually. If you do not start taking RMDs on time, you will owe a hefty tax penalty -- 50% of the amount you were required to withdraw.

Taxes On Social Security Benefits

Depending on how much you are receiving from Social Security, you could also owe taxes on your benefits. The good news is that no matter how much you are earning, you will not pay taxes on your entire benefit amount. However, you could owe taxes on up to 85% of your benefits.

To determine how much you will owe in taxes, you will first need to know your "combined income," which is half of your annual Social Security benefit amount plus any other sources of income (Roth IRA withdrawals are excluded).

So, for example, if you are receiving $20,000 per year in Social Security benefits and are withdrawing $40,000 per year from your 401(k) or traditional IRA, your combined income is $10,000 plus $40,000, or $50,000.

If these income limits seem low, it is because they have not been adjusted since Social Security benefits first became taxable in 1984 -- despite the fact that benefits are increased slightly each year to account for inflation. That means more retirees will likely end up paying taxes on their benefits in the future if the income limits stay the same.

How To Minimize Taxes In Retirement

One of the best ways to prevent taxes from eating away at your retirement income is to invest in a Roth IRA. You will need to pay taxes upfront, but you will not pay any taxes on your withdrawals in retirement.

In addition, because Roth IRA withdrawals do not count toward Social Security's combined income, that could reduce your taxes on your benefits. You may not be able to wriggle out of paying taxes entirely in retirement, but taking steps now to determine what your tax situation will look like, and to reduce your future taxes as much as possible, will help you maximize your retirement income.