What to know about how your retirement savings is taxed

How traditional and Roth retirement accounts are taxed

One of the first choices that you make when saving for retirement will affect your future tax liabilities. Retirement accounts can have specific tax benefits that other investment accounts do not. You can decide between different retirement accounts that will allow you to pay taxes on the investment either now or later.

With a traditional individual retirement account (IRA) or 401(k) plan, you don’t pay ordinary income taxes on the money you’re contributing. Instead, you’ll be taxed when you withdraw your savings at then-current income tax rate. This can reduce your tax expense in the year you contribute. You could further benefit later because your tax bracket in retirement might be lower than it is today.

With a Roth IRA or 401(k) plan, you pay taxes on what you save now. Because you’ve already met your tax obligations for that income, anything you set aside in the account will grow tax-free and won’t be taxed again when you withdraw it. A Roth account might make more sense if you’re further from retirement and in a low tax bracket today.

Your eligibility to contribute to a Roth account is based on your income level. For example, if you file taxes as a single individual, your Modified Adjusted Gross Income (MAGI) must be less than $153,000 for the 2023 tax year. That ceiling rises to $161,000 in 2024.

You can split your savings between these two accounts if you want. There’s also the option to change your mind and switch which type of account you use. Doing so could require you to pay income taxes on the balance at that time though.

Addressing some top retirement tax concerns

• If you’re concerned about the withdrawals from your traditional 401(k) and IRA being taxed as ordinary income and pushing you into a higher tax bracket, you may be able to convert these retirement accounts into plans like Roth IRAs that offer tax-free withdrawals.
• Be familiar with your state income tax exemptions. Some states require little or no state income tax, while others exempt Social Security benefits and pension payouts.
• Research whether you live in a state where pension or annuity benefits are taxed. In some states, you might be exempt from those taxes.
• If you file a joint tax return with your spouse and your income exceeds certain amounts, you could owe federal income tax on up to 85% of your Social Security benefits.
• Dividends or proceeds from the sale of an investment (capital gains) typically are subject to federal tax and potentially state tax, depending on your state of residence.