Tax Implications of Different Types of Retirement Accounts

Peacock & French CPAs
Aug 01, 2021

There are several types of retirement accounts out there, and each of them has their own tax implications and benefits. Proper tax planning is key to getting the most out of your retirement accounts. Learn more about the tax implications of the three main types of retirement accounts in this article.

Contributing to retirement accounts is an important part of investing in and planning for your financial future. However, it’s important that you do more than simply put money away into any account at any time; and, more importantly, you shouldn’t simply pull money out of any account at any time after you retire either. There are several types of retirement accounts out there, and each of them has their own tax implications and benefits. Proper tax planning is key to getting the most out of your retirement accounts. Keep reading to learn more about the tax implications of each of the main types of retirement accounts.

401(k) Plans

Most people establish their 401(k) plans through their employers, and contributions are often taken directly out of the worker’s paycheck before taxes are applied to the income. If this is the case for your 401(k) account, then your contributions are known as “pre-tax” contributions, and they can’t be written off on your taxes, as those funds were never taxed.

401(k)s have very high contribution limits. For 2021, the limit is $19,500 annual contributions for anyone under the age of 50. For those over this age, you can contribute an additional $6,500 this year, for a total maximum contribution of $26,000. Because of these high contribution limits—and the prevalence of employer matching—401(k)s are often the primary retirement accounts for most W2 employees.

Because your contributions to this type of account are made prior to income tax being applied, this means that distributions from your 401(k) will be considered taxable income. However, because taxes are not automatically applied when you take your distributions, you will need to plan for these taxes and pay any amount due in a lump sum when you file your tax return. This can often be a big shock to recent retirees, so it’s important to plan for these taxes ahead of time; you may even want to consider making quarterly estimated payments to the IRS to avoid any late payment fees.

Traditional IRAs

Unlike 401(k)s, traditional IRAs are typically set up through your bank; in some cases, you can also establish a traditional IRA through your stockbroker, life insurance company, or mutual fund. This type of account is fast and easy to set up, and if you haven’t established one already, it’s a good idea to contact your bank and open one for yourself.

Like a 401(k), contributions to a traditional IRA are considered pre-tax contributions. However, most people contribute to these accounts out of their personal funds, which have already had taxes applied. This means that you can write off any contributions you make to your traditional IRA when you file your tax return. Obviously, this is an excellent, immediate tax benefit, and can reduce your overall tax liability so that you owe less or receive a larger refund. However, once again, you need to plan to pay taxes on any distributions you receive from your traditional IRA after you retire.

Contributions limits on IRAs are much lower than on 401(k)s. For 2021, anyone under 50 can contribute up to $6,000 throughout the year; those over 50 can contribute up to $7,000.

Roth IRA

As you could probably guess from their names, Roth and traditional IRAs are similar in their structure. They’re both set up through your financial institution, and they share the same contribution limits. It’s very important to note that the contribution limits for IRAs are cumulative across all of your IRA accounts. So, if you have both a traditional and a Roth IRA, you can only contribute a total of $6,000 between both accounts (or a total of $7,000 if you’re over 50).

There is also one big difference between Roth and traditional IRAs—how they’re taxed. Roth IRAs are considered post-tax contributions, so you can’t write off these contributions on your tax return. However, the benefit here is that distributions from a Roth IRA are not considered taxable income after your retirement. This can be a very helpful source of income to have, not only because it does leave you with a tax bill, but because it won’t drive up your total taxable income, which can impact how much of your Social Security income is taxed during your retirement.

Properly Managing Your Retirement Account Taxes

While contributing to any retirement account is better than contributing to none, good retirement planning includes good tax planning. With the various tax implications of different retirement accounts, knowing where to contribute first, where to withdraw from first, and the right timing of those withdrawals in conjunction with your Social Security benefits, could potentially save you thousands in taxes. Give us a call to get help with properly managing your retirement account taxes.