How Taxes Impact Retirement Planning, No Matter Your Age
Planning for retirement involves making financial decisions that affect both your present and future: What type of plan should you choose? How much should you save? What happens to your plan when you change jobs? When and how much should you withdraw? Whether you’re just starting to plan, are already retired, or fall somewhere in between, addressing these questions will ensure your retirement years are truly golden.
401(k) and Other Employer-Sponsored Plans
The first step in retirement planning is often contributing to an employer-sponsored defined contribution plan, such as a 401(k), 403(b), 457, SARSEP, or SIMPLE plan. Here’s why it’s crucial:
Contributions are typically made on a pretax basis, lowering your modified adjusted gross income (MAGI) and potentially reducing your exposure to the 3.8% NIIT.
Plan assets grow tax-deferred, meaning you only pay taxes when you withdraw funds.
Employers may match your contributions, helping you save more for retirement.
Employee contributions are subject to annual limits. Because of tax-deferred compounding, increasing your contributions early can significantly grow your retirement savings. If your employer offers a match, aim to contribute enough to receive the full match—it’s essentially free money.
If your employer provides a SIMPLE plan, they are required to contribute (though not annually). However, the contribution limits are lower than those for other employer-sponsored plans.
Traditional IRA
If your employer doesn’t offer a retirement plan, consider opening a traditional IRA. You may be able to deduct your contributions, although the deduction could be limited if your spouse participates in an employer-sponsored plan. IRA contribution limits are lower than those for employer-sponsored plans, but you can contribute until the tax return filing deadline, excluding extensions.
Catch-Up Contributions
If you’re 50 or older, you can make additional “catch-up” contributions to your employer-sponsored plan or IRA. Even if you’ve saved a lot already, catch-up contributions allow you to boost your retirement savings further.
There are two notable changes for higher-income taxpayers:
The SECURE 2.0 Act will treat catch-up contributions as Roth (post-tax) for individuals earning over $145,000 (adjusted for inflation). This rule takes effect in 2024, but the IRS is allowing a transition period, so the Roth requirement won’t apply for 2024 and 2025. If you’re affected, consider maximizing catch-up contributions in these two years.
Starting in 2025, taxpayers aged 60 to 63 can contribute up to the greater of $10,000 ($5,000 for SIMPLE plans) or 150% of the limit for those aged 50+.
Roth Alternatives
A potential downside of tax-deferred saving is paying taxes upon withdrawal in retirement. Roth plans, however, offer tax-free distributions. The trade-off is that Roth contributions don’t reduce your taxable income in the current year.
Roth IRAs: Besides tax-free withdrawals, Roth IRAs have estate planning benefits since they don’t require you to take distributions during your lifetime. Roth IRAs have the same contribution limits as traditional IRAs, but these may be further reduced depending on your AGI.
Roth Conversions: You can convert some or all of a traditional IRA to a Roth IRA. This conversion allows you to turn tax-deferred growth into tax-free growth, with the added estate planning benefits of Roth IRAs. There are no income limits for conversions, but the converted amount is taxable in the year of conversion. Consider factors like your current and future tax brackets, whether the conversion triggers NIIT, and your ability to pay the tax.
Backdoor Roth IRA: If income limits prevent you from contributing to a Roth IRA, consider making a nondeductible contribution to a traditional IRA, then converting it to a Roth IRA. You’ll only owe tax on any growth in the account before the conversion.
Roth 401(k), Roth 403(b), and Roth 457 Plans: Some employers offer these options alongside traditional plans. You can contribute to the Roth version regardless of your income level, with no income-based phaseout.
Retirement Plans for Business Owners and the Self-Employed
If most of your wealth is tied up in your business, retirement planning can be challenging. If you haven’t set up a tax-advantaged retirement plan yet, consider doing so this year. This is especially beneficial if you may be subject to the 3.8% NIIT, as retirement plan contributions can reduce your modified adjusted gross income (MAGI) and help you avoid this tax. You can typically set up a plan and make deductible contributions up until the due date of your income tax return, including extensions. Note that if you have employees, they generally must be allowed to participate if they meet eligibility requirements. Here are a few retirement plan options:
Profit-Sharing Plan: This defined contribution plan offers discretionary employer contributions and flexibility in design. If you’re 50 or older, you may be able to contribute more than to a SEP.
SEP (Simplified Employee Pension): A defined contribution plan similar to a profit-sharing plan, but the contribution limit might be lower. It’s easier to administer than a profit-sharing plan.
Defined Benefit Plan: This plan sets a future pension benefit and calculates the contributions needed to achieve that benefit. Contributions may exceed the limits of other plans, depending on your age and desired benefit. Employer contributions are generally required.
Early Withdrawals from Retirement Plans
Early withdrawals from retirement plans should generally be avoided. If you take a distribution before age 59½, it’s usually subject to a 10% penalty, in addition to any income tax. If you’re in the highest tax bracket, you could lose nearly half of the withdrawal to taxes and penalties, and additional state taxes could push this higher. Furthermore, you’ll lose the potential tax-deferred growth on the withdrawn amount.
If you have a Roth account, you can withdraw your contributions without taxes or penalties, but you’ll forgo any potential tax-free growth. If you need cash, it’s usually better to tap taxable investment accounts, where long-term capital gains are taxed at a lower rate. Losses from these sales can offset other gains or carry forward to future years.
Another option, if available in your employer-sponsored plan, is to take a loan. This allows you to avoid taxes and penalties, but you’ll need to pay it back with interest.
Leaving a Job or Retiring
When changing jobs or retiring, avoid taking a lump-sum distribution from your employer’s retirement plan, as it’s typically taxable and may incur a 10% early withdrawal penalty. Here are alternatives to avoid current taxes and penalties:
Stay in your old plan: You may be able to leave your funds in the old plan, but managing multiple plans can be cumbersome. Consider how well the old plan’s investment options fit your needs.
Roll over to your new employer’s plan: This simplifies your retirement tracking, but assess the new plan’s investment options first.
Roll over to an IRA: This may be the best choice if you want more investment options. However, managing multiple plans can be more complex.
When rolling over, request a direct rollover to avoid withholding tax and penalties. An indirect rollover requires you to complete the transfer within 60 days; otherwise, you’ll be taxed and possibly penalized.
Required Minimum Distributions (RMDs)
RMDs must generally begin once you reach a certain age. Failing to take RMDs can lead to penalties. Fortunately, SECURE 2.0 has introduced several changes:
Roth 401(k), 403(b), and 457 Plans: Starting in 2024, RMDs will not apply to these plans during the owner’s lifetime.
Increased RMD age: The age at which RMDs must begin has increased to 73 for those born after Dec. 31, 1950, and will increase to 75 in 2033.
Reduced penalty for missed RMDs: SECURE 2.0 lowers the penalty from 50% to 25%, and if corrected in a timely manner, it drops to 10%.
To avoid triggering taxes or penalties, consider whether delaying distributions is advantageous. Waiting until a year with a lower tax rate could save you money in the long run, but be mindful of how it might affect Social Security taxes, Medicare premiums, and other income-based limits.
Note: While retirement plan distributions aren’t subject to the 0.9% Medicare tax or 3.8% NIIT, they are included in your MAGI, which could increase your NIIT liability.
If you inherit a retirement plan, consult a tax advisor about applicable distribution rules. The time period for inherited plans has been reduced to 10 years (for non-spouses and certain others) for plans inherited after Dec. 31, 2019.