Understanding Retirement Account Taxes: 401(k)s & IRAs

Avoiding income taxes during retirement requires knowledge of the various types of 401(k)s and IRAs. Money in tax-advantaged investment accounts, such as 401(k)s and IRAs, can only be taxed on one of two occasions: when the money goes into the account or when the money comes out.

401(k)s and IRAs come in two types: traditional and roth. If money is held in a Traditional 401(k) or IRA, the money is taxed as income when it is withdrawn from the account. In contrast, money in a Roth 401(k) or IRA is taxed as income when it is deposited into the account. As a result, the Roth 401(k)s and IRAs allow their owners to avoid paying income taxes unconditionally during retirement.

As a result, people seeking to avoid income taxes during retirement should make funding a Roth account a top priority. Traditional accounts can be converted to Roth accounts by filling out paperwork with a custodial brokerage and paying income tax on the assets already in the account.  Although doing so diminishes the present value of the account, converting to a Roth 401(k) or IRA can lead to a tax-free retirement.