Questions you’re asking: How can I plan for taxes in retirement?

A well-rounded retirement plan includes not only strategies for setting aside money before you retire but also how you will receive or create income once you’re retired. One of the key considerations for both aspects of retirement planning is taxes.

As you consider the best ways to save and withdraw money for retirement, make sure you factor in how you will pay your taxes. Christina Williams, senior wealth strategist at Wells Fargo Wealth & Investment Management, Wells Fargo Bank, N.A. shares these steps to consider before and during retirement.

Before retirement: Consider both tax-deferred and taxable investment options

Common retirement accounts such as IRAs and company-sponsored 401(k) plans allow you to save for the future on a tax advantaged basis. Depending on the type of IRA account or provisions of the 401(k) plan, your contributions may be made on a pre-tax, or after-tax basis. While the assets remain within these accounts, any appreciation is generally tax-deferred. This means you may not be paying taxes now, however, it could create a tax burden in retirement depending on how your contributions were made.

• Traditional 401(k) plan contributions are pre-tax, which means they reduce your income for the year you make them. Traditional IRA contributions may also reduce your income, depending on your situation. Traditional 401(k) and traditional IRA distributions are generally subject to ordinary income taxes, with some exceptions.
• Contributions to Roth IRAs or Roth 401(k) are made with after tax amounts. At retirement distributions could be tax free as long as you are 59½ or older and have had the account for five years or more or meet other requirements.
• Withdrawals may be subject to an IRS 10% additional tax for early or pre-59½ distributions.

For added flexibility, you may also want to consider saving in a taxable account. Depending on the type of investments, any income earned or appreciation realized may be subject to income taxes. Some items occurring within taxable accounts, such as qualified dividends and long-term capital gains are currently taxed at lower long-term capital gain rates than ordinary income.

Age 50 or older: Proceed smartly with catch-up contributions

If you’re 50 or older, you can make additional catch-up contributions to 401(k) plans and IRAs. Many companies now have the option for employees to make contributions to a Roth 401(k) plan. You could consider using a portion of your annual maximum retirement contribution amount to allocate contributions to both a Roth 401(k) plan and a traditional 401(k) plan (this strategy can be employed even before you attain age 50).

Once you’re in retirement

Evaluate liquidating your taxable assets first to fund your lifestyle needs before making distributions from your IRAs and employer-sponsored plans. When you reach your required beginning date you may be required to start taking distributions (known as required minimum distributions, or RMDs) from your Traditional IRAs and traditional 401(k). Once you attain your RMD age¹, first take your RMDs and then consider funding your remaining cash flow needs with taxable investment assets.

What you can do today

Tax laws change over time. For example, just because long-term capital gains are currently taxed at lower rates than ordinary income, there’s no guarantee that will still be the case in the future when you retire.

Everyone’s tax situation is unique. The impact of taxes is dependent on many things specific to your income and the structure of your investments. It may not be accurate to assume that your tax rate or the amount of tax you will pay in retirement will be lower than during your working years.

For these reasons, it is important to work with your financial and tax advisors on a regular basis to understand the tax implications of your investments and to plan accordingly to help structure your retirement income plan.

¹What to know about Required Minimum Distributions (RMDs)