What Are the Tax Implications of Retirement Plan Distributions?

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What Are the Tax Implications of Retirement Plan Distributions?

Maybe you have dutifully scrimped for a number of years, putting aside savings into one or more retirement plans. Maybe you’ve even saved a little to meet your long-term financial goals. While saving money is undoubtedly the most important step in retirement planning, it surely is not the only one. Tax planning also ranks as an important consideration.

Tax deferral

For instance, you often can defer taxes on the money you contribute to your retirement plans. You can make a pre-tax contribution to your plan and deduct the contribution from your taxable income on your tax return. Then, when you are older and working less or not at all, you can withdraw regular amounts from your plan and pay tax on the income at a lower rate.

The advantage of after-tax contributions

On the other hand, if you contribute after-tax money to your retirement plan, you develop a basis in the account. This basis cannot be taxed again as you withdraw it from your plan. To take best advantage of the tax rules, you usually should make as many tax-deductible contributions as possible, before making any nondeductible contributions of after-tax income.

Timing

Clearly, timing is a crucial tax issue. The same retirement plans that can help you accrue your nest egg during your primary working years are also designed to encourage you to use that nest egg during your retirement years. The tax code aims both to hinder you from taking out your money before retirement and also from saving your money to pass it to your heirs. If you take money out of your plan before retirement, or if you fail to take money out of your plan after you have reached your required retirement age, you will face certain tax penalties.