The last thing you’d want to see—after working hard and saving diligently—is your money eaten up by taxes when you retire. By saving in an appropriate retirement account, whether you're years away from retiring or it's just around the corner, you may be able to reduce the potential tax impact.

There are two primary factors that you need to consider when deciding where to save: your expected future income tax bracket and tax rates. That said, you should also consider your current tax situation. For example, you may be making deductible traditional IRA and 401(k) contributions, which are reducing your current taxable income.

Here are some things to consider when trying to determine your expected future tax picture.

1. Don't assume your income will drop in retirement
Many believe that their taxable income will fall after retirement, and put them in a lower tax bracket. Sure, it often does if you no longer have a regular salary, which is usually the largest source of taxable income. But there are exceptions. For example, public employees like teachers and police officers typically have defined benefit pension plans that pay a fixed percentage of their salary. Combine this with income from other sources, and they could end up with taxable income as high, or even higher, during retirement.

Another reason for increased taxable income after retirement is the loss of certain deductions and exemptions. Many people find that their deductions and exemptions are much lower in retirement because, for example, they are less likely to have dependents, and they may have paid off their mortgages.

So while there may be a good chance that your taxable income will be lower, it’s important to consider your situation.

2. Future tax rates are hard to predict
Predicting future tax rates is impossible. No one knows what they will be in the future. Many observers think that federal income tax rates are likely to be higher in the future because of the federal deficit, which is currently very high. And, based on current trends, the deficit is expected to remain high. For instance, according to the Congressional Budget Office (CBO), a government agency that provides economic data to Congress, total federal spending is more than 25% of the gross domestic product (GDP), while federal revenues are 15%, clearly not enough to cover all expenditures. The CBO also projects that the gap between the two will widen.¹

The top federal income tax rate and, to a lesser extent, the bottom rate are at historical lows, and have been that way since 2002, according to the National Taxpayers Union.² While many economists have been concluding that federal income tax rates are likely to rise in the future, there’s no way to be certain of this. And even if they do rise, no one knows when that would happen, what the rates would be, or how long they would last.

Understanding your savings options
Once you give some thought to what you think your tax situation will be when you retire, consider aligning your retirement savings strategy with it. Here are some of the choices:

1. Delay paying taxes on savings until retirement with a tax-deferral strategy
If you’re primarily saving for retirement via a traditional IRA, 401(k), or other workplace savings plan, you’re putting off your tax liability until after you retire or begin taking withdrawals. You’re deferring taxation on your and your employer’s contributions (if any), and any growth on these contributions. This may make sense for those who expect their income and tax rates to be lower when they retire. This strategy also allows more of your money to stay in the tax-deferred account and the potential for it to grow over the years. Plus, lowering your current taxable income may make you eligible for other tax benefits, such as tax credits and deductions.

2. Pay taxes now with a tax-acceleration strategy
Contributions to a Roth IRA or Roth 401(k) are made with after-tax money—money that has already been included in your taxable income. So you’re paying taxes on your contributions when you make them—before you retire and begin taking withdrawals. In return for paying taxes up front, no federal income taxes are paid on earnings in a Roth account provided various requirements are met.³ This may make sense for those who expect their income and tax rate to be higher when they retire. 

3. Pay some taxes now and some later with a tax-diversification strategy
Saving in a combination of a traditional IRA and 401(k) and the Roth versions of each (if available and you're eligible) allows you to pay some taxes up front and some after you retire or begin taking distributions. This tax-diversification strategy also provides flexibility when you're retired. You may be able to choose which accounts to take distributions from to help reduce taxes. For example, if tax rates or your taxable income are high one year, you may choose to take a tax-free withdrawal from a Roth account. Conversely, if tax rates are low, you may opt to take a withdrawal from a traditional IRA or 401(k). Note that minimum required distributions (MRDs) are generally required to be taken each year from tax-advantaged retirement savings accounts, except Roth IRAs, beginning at age 70½. Roth 401(k) and 403(b) assets may rolled over to a Roth IRA to avoid MRDs from those accounts during your lifetime.

Making a decision
If you're closer to retirement, you may have a better sense of what your future taxable income is likely to be. Other factors, however, may make one option more appealing than the other. For example, some states have a much higher income tax rate than others. Seven states have no income tax at all, and several others exempt some or all of the income received from retirement accounts from income tax. For example, if you plan to relocate from a state with relatively high income taxes to one with no income tax (or one that doesn't tax retirement income) around the time you retire, this can sharply reduce the potential impact of taxes on your savings. In this case, waiting to pay your taxes (tax-deferral strategy) may be more appealing to you. On the other hand, if you plan to move from a state with little or no income tax to one with high rates, paying the taxes now (a tax-acceleration strategy) may make sense. 

If retirement is far down the road, it gets trickier to estimate your income and tax rates. That’s why for those who are uncertain of their future tax status, we suggest the tax-diversification strategy as a starting point because of its flexibility.

The chart shows which strategies you may want to consider based on your views.

If you want to change your mind
The good news is that you may have flexibility no matter which strategy you choose. A traditional IRA can be converted to a Roth IRA; a 401(k) from a former employer or at a job you retire from can be rolled over into a traditional IRA or converted to a Roth IRA. Some of these, however, are taxable events.

Information provided is not intended to be tax advice. Investors should consult their tax advisor regarding their personal situation.

1. Federal Revenues and Noninterest Spending, by Category, Under the Congressional Budget Office (CBO) Extended-Baseline Scenario, as a Percentage of GDP on November 2009

2. National Taxpayers Union; Eugene Steuerle, The Urban Institute; Joseph Pechman, Federal Tax Policy; Joint Committee on Taxation, Summary of Conference Agreement on the Jobs and Growth Tax Relief Reconciliation Act of 2003, JCX-54-03, May 22, 2003.

3. A distribution from a Roth IRA is tax-free and penalty-free provided that the five-year aging requirement has been satisfied and one of the following conditions is met: age 59½, death, disability, qualified first time home purchase.