The Importance of Tax Preparation For Retirement

The Importance of Tax Preparation For Retirement

While many retirement plans do not require taxes during the accumulation phase, as the old saying goes; "nothing can be certain except death and taxes." At some point, taxes are paid on income. There is no skirting it. The benefit of many retirement plans is that they are tax-deferred.

During retirement planning, many workers don't anticipate the effects of taxes during that phase of their lives. They forget that any consideration of living expenses must still be net of taxes.

The benefit of tax deferral on many retirement plans is that taxes don't have to be paid on the income at the time it is earned; often during the time, you are at your highest tax rate. The theory is that when you retire, you will be at a lower tax rate and you can pay taxes on your deferred income at that lower rate. As long as the federal, or your state government, does not raise tax rates, that theory should hold.

There is also the deferral of the tax obligation on the earnings within many retirement plans, such as 401k plans. Also, many employers will make a contribution into the plan, and that money usually remains tax-deferred also until it is actually withdrawn. These employer funds often come with a vesting schedule, so the employee does not walk away with that portion until they have worked for that employer for a certain number of years.

This all works out well in theory, and absent of some new taxes that would throw a fly in the ointment, it does currently benefit retirement savers. Under the current marginal tax rates, a worker may squirrel away a dollar into a retirement plan that they might have paid thirty cents in taxes on. Upon withdrawing that dollar, they might only pay fifteen cents in taxes on it; which sounds like a good deal. The money management issue then becomes how to best deal with that fifteen cents. In retirement, anything that depletes income cannot be easily compensated for.

Retirement Plans and Taxes

Just as with IRA's, many 401k plans offer the choice between a traditional and a Roth. The tax treatment of the two is very different. The contributions, that you make as an employee into a traditional 401k plan, are contributed pre-tax and those amounts are treated like a deferred salary. The contributions that are made into a Roth 401k plan are made with money that has already been taxed. With the traditional 401k, you are presently taxed on the income you receive, which has been reduced by the contributions into your retirement plan.

At withdrawal, the tax implications are reversed. On those contributions and earnings in your traditional plan, you would pay income taxes as you withdraw them as ordinary income. On withdrawals from a Roth 401k, there are no taxes. The money must have remained in the account for at least five years though.

There may be some penalties when you make withdrawals from your traditional 401k also. There is a 10 percent penalty on withdrawn amounts prior to age 59 1/2. On the other end of the retirement, age spectrum are the penalties associated with not taking enough money out of your traditional retirement plans. When you reach age 70 1/2, you are required to take required minimum distributions from your traditional accounts. Depending on the size of these funds, you might want to begin earlier than this age to avoid paying too much tax on a large amount of accumulated funds.

While you might be paying ordinary income on those traditional retirement funds, based on the existing marginal tax rates, you would be paying capital gains rates on the sale of investments. The tax rate depends on the length of time you have held that investment. Again, as with marginal tax rates, the rates on capital gains could change in the future as well.

There are considerations for social security funds, annuities, and pensions that all need to be considered as well. Getting the advice and direction of a professional can help navigate this complex subject.