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Carla Fried: Yes, retirees pay taxes — here's how to avoid some

Carla Fried, Rate.com on

Published in Home and Consumer News

For decades, 401(k) plans came in one flavor: so-called traditional, where contributions are made with pre-tax dollars and eventual withdrawals are taxed as ordinary income. Now, most 401(k) plans offer employees the option of saving in a Roth 401(k) -- no upfront tax break, but withdrawals are 100% tax-free in retirement.

Most savers are sticking with tradition. Vanguard, a major administrator of retirement plans, says about nine out of 10 employees who could use a Roth instead are sticking with a traditional 401(k).

Many plans encourage traditional accounts over Roth by automatically enrolling new employees in the 401(k), and the default option is the traditional.

Saving for retirement is a win, whether it's in the traditional or Roth. But if your plan offers a Roth, it's worth considering whether you'd benefit from its delayed gratification payoff.

That's the challenge with a Roth. You don't get the upfront tax break, and it's sooooo hard to make a choice where the payoff -- tax-free withdrawals in retirement -- doesn't come for years, if not decades. But thinking about what might work best for our older selves is the secret to retirement planning. Consider these scenarios:

--Your federal tax bracket today is 10%, 12% or 22%. These are today's lowest tax rates. If you are single and have $75,000 in taxable income, you fall in the 22% federal bracket, for an annual tax bill of $16,500. If you contribute $7,500 to a traditional 401(k), your taxable income drops to $67,500, and your tax bill is $14,850. Saving $1,650 in taxes today is great.

 

But let's look ahead. Let's say that $7,500 grows to $35,000 over a few decades. If that money is in a traditional 401(k), you'll owe income tax on every dollar withdrawn. Even if your tax bracket is lower in retirement -- as explained below, that's an assumption that could be wrong -- your tax bill will still likely be more than the upfront tax break.

--Your tax rate doesn't go down in retirement. A selling point for traditional 401(k)s has been that your tax rate will be lower in retirement. In that scenario, it makes sense to avoid taxes while you're working and wait to pay tax on withdrawals when you are retired and in a lower tax bracket.

That isn't necessarily how it will work. In fact, the more you have saved in traditional accounts, the likelier your tax rate may not budge in retirement.

The federal government insists you take money out of traditional 401(k)s and traditional IRAs in retirement, so it can collect tax on the withdrawal. This so-called required minimum distribution (RMD) formerly started the year you turn 70.5. Beginning in 2020, RMDs must start no later than the year you turn 72.

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