Why Retirees Will Benefit from Tax Deferral

Most people will drop into a lower tax bracket in retirement.

By SHARE

There is no question that almost everyone should contribute enough to their 401(k) to get the employer match. But once you get the maximum possible match, where should you invest additional funds? You can continue to save in a 401(k) or allocate some money to a Roth IRA.

Traditional 401(k)s and IRAs allow you to defer paying taxes on your retirement savings until you withdraw the money, while Roth IRAs can be used to pay the income tax upfront, and distributions in retirement will be tax free. Individuals must decide whether it’s better in the long run to pay tax on the money now at current rates, or hope that they will be taxed at a lower rate in retirement. Here’s why many people will come out slightly ahead by deferring tax on their retirement savings.

You are likely to pay a variety of tax rates on traditional 401(k) and IRA withdrawals. Which type of retirement account will be better for you obviously depends on your unique situation as well as future tax laws. For people currently in a high tax bracket, it often makes sense to defer tax via traditional 401(k) contributions. You likely won't have a huge amount of income when you retire, which means a portion of your IRA withdrawals may be taxed at low rates, even if you consider income from Social Security. Part of your traditional IRA and 401(k) withdrawals may be taxed at 0 percent, some at the next tax bracket, and only some will be taxed at your marginal tax rate. If you instead choose a Roth account your entire contribution will be taxed now at your marginal rate.

It will require more income to be in a high tax bracket in retirement due to inflation. Many people estimate that they will have a retirement income similar to their current salary and decide they will probably pay just as much or more tax in retirement because they assume the government will raise taxes. Obviously, we don’t know what Congress will decide to do about tax rates. But we do know that inflation will push the limits of the income needed to be in a higher tax bracket up. Therefore, you may need much more retirement income to be in the same bracket as you are now, assuming a 3 percent inflation rate over 25 or more years.

You can reap huge tax savings by moving to a state with no income tax in retirement. Where you live plays a big role in how much income tax you pay. Those who live in a state with a high income tax can potentially save money if they defer income tax on their retirement savings and then move to a state with no income tax when they start withdrawing their retirement funds. Of course, there are many expenses involved with the move itself, so you would have to save a considerable amount of money on taxes to outweigh the costs of moving.

You can convert some money to a Roth IRA before taking Social Security. It’s most beneficial to save in or convert money to a Roth IRA in years when you have a low income, such as at the beginning of your career or when you don’t work for the entire year. Another good time to convert some of your pre-tax funds to a Roth IRA is between the time of retirement and taking Social Security. Let's say that you plan to retire at 65, but you want to delay claiming Social Security until age 70 in order to get higher payments. During the four years after you leave the workforce, your income will likely be much lower than usual, which means you can convert a portion of your pre-tax money into a Roth IRA while you are in a lower tax bracket than usual. You may be able to save quite a bit on taxes this way, making the prospect of delaying your Social Security checks even better. Of course, you can’t do this unless you have funds to live on while you delay claiming Social Security.

David Ning runs MoneyNing, a personal finance site that shares money moves you can make to significantly increase your chances of having a comfortable retirement. He likes to share simple changes that anyone can make, such as picking the best online savings account and figuring out whether a 0 percent balance transfer credit card makes sense.