Plan For Tomorrow | How different types of retirement accounts are taxed
A ret0rement-aged couple walk hand-in-hand in the park.

How different types of retirement accounts are taxed

Monday 4 December 2023 | Reading Time: 5 minutes

As people in their working years plan for the future, many retirement savings options can help create income to provide financial security during their next chapter. Part of the retirement planning process includes reviewing how contributions and income payments are taxed. Understanding the tax rules that can impact each type of retirement account can help you choose which options work for you and possible strategies for minimizing taxes in retirement.

How different types of retirement accounts are taxed

What is the difference between pre-tax and post-tax retirement accounts?

There are critical differences between pre-tax and post-tax retirement accounts. Pre-tax retirement accounts, like 401(k)s and IRAs, mean that the money contributed to these accounts and potential earnings are not taxed at the time of contribution. “When retirement arrives, and withdrawals begin, taxes will then need to be paid since the money withdrawn is now taxable income,” shared Tyler De Haan, Certified Financial Professional and Director of Advanced Sales at Sammons Institutional Group, a member of Sammons Financial Group. “Post-tax retirement accounts, like a Roth IRA, require the contributions made to the account to be taxed. Then in retirement, assuming the five-year rule is met, those qualified distributions will be tax-free since taxes have been paid." 

When choosing a pre-tax retirement savings account, contributions can be made without losing additional income today. However, this means an individual must cover taxes on retirement withdrawals when income can be less predictable. On the other hand, post-tax retirement options may save a person less in the present, but retirement funds will not be subject to taxation upon withdrawal.

Pre-tax retirement accounts

“Since money is taxed once withdrawals are made down the road, choosing a pre-tax retirement account can provide an opportunity to grow savings for the future, explore investing, and find ways to create a steady income for retirement,” shared De Haan. If you believe you will be in a lower tax bracket in retirement, which may offer more favorable tax rates. In building a long-term financial plan, there are many retirement accounts and income sources that offer pre-tax options:

How pensions are taxed

Most pensions are funded with pre-tax dollars, so typically, retirees are not taxed until they begin receiving payments. The amount owed can depend on several factors, including if that income is subject to tax. If pension payments are received periodically, the retiree may be taxed at their regular income tax rate, whereas cashing in on a lump-sum payment from the pension often requires paying the total tax due when filing the tax return for that year. Sometimes, a pension can be converted to a lump sum and rolled into an IRA.

How Social Security benefits are taxed

If there is no other substantial income besides Social Security there may not be any federal taxation. However, a retiree will be required to pay 85% of their Social Security benefits if they file:

  •  File a federal tax return as an "individual" and your combined income is more than $34,000
  •  File a joint return, and you and your spouse have a combined income that is more than $44,000

Additionally, if a retiree is married and files separately from their spouse, they will likely only be required to pay tax on 85% of their Social Security benefits.

How annuities are taxed

If an annuity is purchased with pre-tax funds, it can offer tax-deferred growth and a way to supplement retirement income in the future. Not paying taxes while an annuity is in its accumulation phase can allow the money to compound over the years instead of going toward taxes. Once an annuitant enters retirement and begins receiving distributions, all or a portion of the payments can be taxable.

How an IRA is taxed

Similar to a 401(k), contributions to a traditional IRA are not taxed, and earnings can grow tax-free, but when withdrawals begin, those funds will be subject to income taxes. Early withdrawals before age 59 ½ are generally subject to a 10% penalty, but there are exceptions to this rule.

How a 401(k) is taxed

Contributions to a 401(k) often come out of a paycheck and reduce taxable income while a person still earns, typically resulting in fewer taxes being paid throughout the working years. Just remember that once retirement arrives and money is withdrawn, income taxes will need to be paid at that time.

Post-tax retirement accounts

Some individuals may choose a post-tax retirement account because they prefer to pay taxes upfront and avoid paying them later in retirement. This strategy can help make retirement income more predictable since taxes on contributions are already paid. This may be desirable if the person feels financially secure in their day-to-day earnings to cover taxes but is worried it may be more challenging when they’re on a tighter budget after leaving the workforce.

How a Roth IRA is taxed

Different from a traditional IRA, Roth IRAs are funded with after-tax dollars, so contributions are taxed immediately and are not typically reported on a tax return. Another critical difference is retirees generally have to take required minimum distributions (RMDs) from traditional IRAs at age 72. Roth IRAs do not require withdrawals until after the owner passes away, so money can be left to continue to grow without penalty.

Helping to minimize taxes in retirement

“An important part of retirement planning includes exploring ways to minimize taxes and understanding the limits and requirements mandated for each retirement option,” adds De Haan. “Working with a tax advisor can help you navigate general tax rules, early withdrawal tax penalties, and RMDs more easily, and they can explain ways to reduce a tax bill before and after retirement.”

To explore the various retirement savings accounts available, it can be helpful to connect with a financial professional to discuss which options would make the most sense for your financial situation. Often, including pre-tax and post-tax options in a retirement plan can create a more diversified financial portfolio and ensure all income gaps are filled for the future.

Neither North American Company for Life and Health, nor any financial professionals acting on its behalf, should be viewed as providing legal, tax or investment advice. Please rely on your own qualified tax professional.

The term financial professional is not intended to imply engagement in an advisory business in which compensation is not related to sales. Financial professionals that are insurance licensed will be paid a commission on the sale of an insurance product.

The views and opinions expressed by Tyler De Haan are his views and opinions as an individual and do not reflect the views and opinions of North American Company for Life and Health®.