With so many retirement plans on the market, it can be challenging to understand the potential tax benefits of each plan. While most plans have some potential tax benefits, what plan might suitable depends on current age, desired retirement age, tax bracket, income, and more.
First of all, you will always pay taxes on your retirement plan at some point.The question is, when? Some plans offer tax savings when money is contributed and other types of plans offer tax savings when money is withdrawn.
A tax-deferred plan is when contributions are income tax-free, but when withdrawals are made they may be taxed as income. The funds can still be subject to payroll, medicare, and other taxes at the time of contribution.
Tax exempt is the opposite, when contributions are subject to income tax at the time of contribution, but when funds are withdrawn in retirement, they won’t be taxed as income, as long as certain requirements are met.
While a tax professional is the best person to help you evaluate your situation, there are some basic things to consider when looking at retirement plans and the potential tax benefits.
- Current income and projected retirement income
- Current and future tax bracket
- Current age and planned age of retirement
What are the Tax Benefits?
In each type of retirement plan, there are potential tax benefits depending on the factors listed above. Also remember, each person has their own unique situation, and sometimes it is possible to use a mixture of different types of plans.
With tax-deferred retirement plans there is sometimes an incentive to contribute to the account now. Because it is not taxed when a contribution is made, some people might be able to contribute more than if it was considered taxable income at the time.
Sometimes people with a high current income will choose to use a tax-deferred plan because of the assumption that they will be in a lower tax bracket in retirement, meaning there is the potential to pay less taxes overall.
Tax-exempt retirement plans are sometimes preferred by low-income contributors or young investors just starting their careers. Because they are in a lower tax bracket now, and expecting they will be in a higher tax bracket in retirement, it might make sense to pay the income tax now, when contributing, and realize more potential tax benefit in retirement.
A tax-exempt policy might also be beneficial for investments, because there are no capital gains taxes when a withdrawal is made, as long as certain requirements are met.
So, an individual with a tax-deferred plan will owe taxes in the future, they are just delayed, and with tax-exempt plans the tax savings are after retirement.
Retirement Plans and Tax Benefits
We know that some people might benefit from tax-deferred contributions now and paying income tax on the retirement funds when they are withdrawn, while others might benefit from paying taxes now, and withdrawing money tax free in retirement.
Some of the most popular tax-deferred plans are 401(k) plans and Traditional Independent Retirement Account (IRA). Well-known tax-exempt plans include Roth IRAs and Roth 401(k)s.
It is helpful to understand the basics of tax benefits and retirement plans, but to develop a strategy most beneficial to you, it is essential to meet with a tax professional or financial advisor.
