Not if, but When, Will I Pay Taxes in Retirement?

Today’s question is: Not if, but when, am I going to pay taxes in retirement?

Benjamin Franklin is commonly attributed with the quote that says, “There’s nothing certain in life but death and taxes.” Isn’t that the truth? However, understanding when you’re going to pay taxes really comes down to the most pivotal thing: what did you add your money to before you retired? And even in the early years of retirement, when we look at investments, there are generally three types of accounts that exist and each of them has a unique tax treatment.

#1: Fully Taxable Accounts

Number one are accounts that are fully taxable. Think your bank account. In the past few years, we’ve actually started to see people getting tax forms from a bank account and being able to have taxable interest. That’s true in what’s called a brokerage account, or a non-qualified account. It’s an investment account, not a retirement account, that holds investments whether those be stocks, bonds, mutual funds, etc. As those investments grow and the gains from the growth (or losses) are exposed, that’s when we pay the taxes.

Now that happens in those accounts whether we withdraw the funds or not. Here is a quick example: I buy ABC Company stock for $10. It grows to $20. If I haven’t sold that stock, I haven’t paid taxes on it. The moment I sell it, I now realize the taxable gain. Therefore, I’m taxed on the $10 of growth. I’m not taxed on the principal again, but the growth.

#2: Pre-Tax or Traditional Accounts

Account number two is probably the most common type that we interact with, which is pre-tax or traditional accounts. Those typically come in traditional IRAs, a traditional pre-tax 401(k), or some other type of retirement account like a 403(b). When you contribute money into those accounts, you’re getting a tax deduction upfront for the amount you put in. But then, in the future, any growth that account has experienced (along with the contribution itself) will be taxed upon withdrawal.

The benefit is deferred taxes and years of compounding growth that would have been taxed otherwise.

#3: Roth

Account number three is something that has been introduced more recently, in the past 20 years or so. That is a Roth.

Roth can, again, be a 401(k) or most commonly, an IRA. In that count, it’s inverse to a traditional IRA. You pay the taxes upfront, but as long as you follow a couple different rules that are established, you continue to get tax-free growth for the rest of your life. So, the principal would never be taxed again nor would the gains.

Long Story Short

So, the short answer to “when will I pay taxes?” is “when you withdraw.” While this holds truth, it’s not the whole story. Be sure when you’re building your retirement plan to know when it is you’re going to pay taxes. It’s not a matter of “if” but “when.” Ensure you plan accordingly to avoid giving Uncle Sam a tip.