When it comes to saving for retirement, you’ve got options. You can participate in a retirement plan at work, open an IRA or personal savings account, or use a mixture of all three. The options you choose will determine when you’ll pay taxes on your investments—now or later. Here’s an overview of how different retirement and investment accounts are generally taxed to help you create the most tax-efficient combination for your savings.¹
Contributing to your workplace retirement plan
A 401(k) plan is one of the most common workplace retirement plans, and it offers several tax-saving opportunities. Depending on your plan, you may be able to make one or more of the following contributions:
- Pretax contributions—As the name implies, pretax contributions are deducted from your pay before taxes, so every dollar you save helps reduce your current taxable income. For example, if you earn $3,000 per pay period and contribute 6% pretax to your 401(k) plan, you’ll be taxed on $2,820—not the full $3,000 ($3,000 x 0.06 = $180; $3,000–$180 = $2,820). Your contributions and any investment earnings grow tax deferred, which means you won’t pay any taxes until you take money out of the plan. At that time, you’ll owe income taxes on the amount withdrawn. If you’re under age 59½, you’ll also incur a 10% penalty (unless you qualify for an exception).
- Roth 401(k) contributions—These contributions are deducted from your paycheck after taxes, so they don’t reduce your current taxable income. Since you’ve already paid taxes on these payroll deductions, they’re tax free at distribution. Investment earnings on your Roth 401(k) contributions may also be tax free when you take a distribution.2 To qualify for this special tax treatment, you must be at least age 59½ and had your Roth account for five years at the time of the distribution or withdrawal.3 If you don’t meet this criteria, you’ll have to pay income taxes on the earnings and, potentially, a 10% penalty if you’re under age 59½ (unless you qualify for an exception).
- After-tax contributions—Many people think after-tax and Roth contributions are the same thing because they’re both deducted from pay after taxes, but they’re not. One of the primary differences is the way earnings are taxed. Unlike Roth accounts, investment earnings on after-tax contributions are always taxable when you take a distribution from the plan.
Not sure which type of contribution you’re making? You can usually find this information on your 401(k) statement or by logging in to your account.
You may also want to review your plan’s summary plan description to see which contributions are offered. If more than one type is available, you might consider splitting your savings among them, depending on your goals and financial circumstances. A financial professional can help you model different scenarios to maximize your savings and minimize your tax bills.
What about employer contributions? These contributions are treated the same as your pretax contributions. You’ll have to pay income taxes when you take the money out of the plan, plus a 10% penalty if you’re under age 59½ (unless you qualify for an exception).
Saving with traditional and Roth IRAs
Another popular way to save for retirement is with a traditional or Roth IRA (or a combination of both). A key difference between these IRAs is how contributions, earnings, and distributions are taxed.
Your contributions may be tax deductible, depending on your adjusted gross income, tax filing status, and whether you’re covered by a retirement plan at work.
Refer to IRS Publication 590 for details.
Contributions aren’t tax deductible.
Additionally, your ability to make Roth IRA contributions and the amount of these contributions are determined by your modified adjusted gross income and tax filing status.
Investment earnings grow tax deferred.
Investment earnings can be withdrawn tax free if certain requirements are met.⁴
You’ll pay income taxes on your tax-deductible contributions and any earnings when you take the money out of the account.
A 10% penalty may apply if you’re under age 59½, unless you qualify for an exception.
Nondeductible contributions are withdrawn tax free because you already paid taxes on this money.
If you’ve had your account for at least five years and are age 59½ or older, your entire distribution is tax free.³
If not, you’ll have to pay incomes taxes on your earnings and, possibly, a 10% penalty, unless you qualify for an exception.
Since both IRAs offer tax benefits, how do you know which one is right for you? It generally depends on whether you expect your tax bracket to go up or down in retirement.
- If you think your tax rate will increase, you may prefer a Roth IRA, so you can pay taxes now while you’re in a lower bracket.
- If you expect your tax rate to decrease, you might prefer a traditional IRA. You can take advantage of the potential tax deduction to reduce your current taxable income and delay paying taxes on your savings.
- Of course, no one knows for certain whether taxes will go up or down. For this reason, some people save in both traditional and Roth IRAs. Your decision should reflect your goals, financial circumstances, and personal preferences.
Supplementing your retirement savings with personal investments
In addition to your 401(k) or IRA, you may have personal savings that you’ve earmarked for retirement. You’ll generally pay taxes on these investments every year if your account earns interest or dividends. You may also have to pay capital gains tax when you sell the investments. Let’s take a look at the more common investments you may have.
Bank and money market accounts
The amount of interest you may earn varies by financial institution and the type of account. For example, money markets tend to have higher interest rates than checking accounts. Each year, your bank will send you a Form 1099-INT, which shows how much interest you earned and will need to report on your current tax return.
You’ll generally receive a 1099-DIV, which shows the dividends you earned for the year, plus any capital gains incurred by the fund. A mutual fund could experience a capital gain based on the investments the fund manager bought and sold during the year. Both amounts are usually taxable in the year you receive them, although special rules apply if you’re investing in municipal bond mutual funds. Your financial or tax professional can help you determine what you need to report.
If you sell your mutual fund for more than its purchase price, you’ll have to pay capital gains tax on the difference. For example, if you bought a mutual fund at $10 per share and it’s worth $20 per share when you sell it, you’ll have a gain of $10 per share. You’ll incur a capital loss if the mutual fund is worth less at the time of sale. The rules for capital gains and losses can be complex, so you may want to work with a financial or tax professional when this situation arises.
The taxation rules for mutual funds generally apply to individual stocks.
Although personal investments don’t offer the same tax benefits as 401(k)s and IRAs, they’re still an important part of your financial future. Because 401(k)s and IRAs have contribution limits and other requirements, you may not be able to save as much as you’d like. Investing your personal savings is a way to help fill the gap.
The right combination for you
401(k) plans, IRAs, and personal savings can all play a critical role in helping you attain and enjoy the future you want. Choosing the right mix of retirement and personal savings accounts depends on many factors, including when you want to pay taxes on your investments. Ultimately, you want the best combination of tax-deferred, tax-free, and taxable savings that will keep more of your money working for you to and through retirement.