There’s a financial crisis looming for the millions of Americans hoping to retire. With more than half of all workers saving for retirement having $25,000 or less squirreled away in their nest eggs, it’s clear that most people are woefully unprepared for the financial realities of living off Social Security, their life savings, and any supplemental income they may be fortunate enough to have.
Yet even if you’ve succeeded in building up a bigger nest egg, you can’t assume that you have it made. If you’re like most people, your retirement account balance dramatically exceeds the actual financial resources you have at your disposal, for one simple reason: The IRS is waiting in the wings to get its long-awaited pound of flesh.
Understanding retirement taxation
We’ve all heard about the benefits of saving for retirement using tax-favored accounts like IRAs and 401(k) plans. By setting aside pre-tax money in those accounts, you get an up-front tax deduction on your current-year return that reduces your tax bill or entitles you to a larger refund. With IRA contributions being one of the few ways you can decrease your tax liability after the tax year has already ended — you can make a 2012 contribution to an IRA up until April 15 — many taxpayers see the tax deduction as the primary reason for funding an IRA in the first place.
In addition to that up-front benefit, IRA and 401(k) account holders don’t have to pay taxes on the income from those accounts, either. Instead, as long as the money stays in the retirement account, Uncle Sam has to wait patiently, allowing assets to grow on a tax-deferred basis.
But eventually, you’ll need your retirement money, and that’s when you’ll feel the big tax hit. When you withdraw money from a traditional IRA or 401(k), the withdrawn amount gets added to your taxable income. Typically, it’s subject to tax both federally and at the state level.
Often, that ends up being a net win. Deductions you get during your career when your tax rates are high can be worth more than the taxes you have to pay at lower rates when your retirement income is low. But higher taxable income from IRA and 401(k) withdrawals can also have unintended secondary effects, such as lifting your income above the threshold at which a large chunk of your Social Security benefits become subject to tax as well. And regardless, having even 15% to 25% of your retirement-account balances go to pay income taxes is a major haircut for most savers’ modest nest eggs.
In order to fight this, the obvious first step is to take potential tax liability from your retirement assets into account when you’re planning how much you need in order to retire. That can prevent you from being overly optimistic and retiring sooner than you should.