Tax Planning Strategies for Maximizing Your Retirement Savings

James D. Klaffer is a senior director of High-Net-Worth Tax Planning at Northwestern Mutual.

If you diligently save into your 401(k) throughout your career and amass $2 million for retirement, you’ll have $2 million, right?

Not quite.

When you get to retirement, that money will be taxed as you withdraw it. Saving for retirement isn’t just about how much you save. It’s about how much you keep. That’s why it’s important to think about taxes at every step in your retirement journey—including when you’re saving.

The good news is that retirement account taxation doesn’t have to be complicated. It begins with understanding the various options you have for retirement and how they’re taxed. From there, you can come up with a plan to help minimize your tax burden in retirement. And you don’t have to do it alone. Your financial advisor can look at your whole financial picture and show you how the pieces all fit together—and help to make sure you’re using the various pieces in ways that help you be tax efficient.

Why taxes are an important part of retirement planning

Retirement planning isn’t just about saving. You’ll also want to enjoy a comfortable retirement without the fear of outliving your money. But without a plan, your tax liability could erode your savings more than you’d like. Retirement accounts come in several shapes and sizes, and each one has its own tax rules.

Some allow for tax-free withdrawals in retirement, while others treat distributions as taxable income. Some give you a tax break while you save; others require that you pay tax before using them. Being intentional about how you save and draw on these funds can help you stay in a lower tax bracket—and keep more money in your pocket as a retiree.

How is retirement income taxed?

Where you save your money during your working years will have a big impact on what you’ll pay in taxes during retirement. To get a better understanding, let’s fast-forward and look at potential sources of income in retirement and how they’re taxed. The million-dollar question is this: Do I have to pay taxes on retirement income? It depends on where that money is coming from.

Tax-deferred accounts

Tax-deferred retirement accounts are funded with pre-tax dollars. Contributions are generally tax-deductible, which can reduce your taxable income today, but you’ll be taxed on withdrawals you make in retirement. Tax-deferred accounts include the following:

• Traditional IRAs
• Traditional 401(k)s
• 403(b)s
• 457(b)s

These accounts are subject to required minimum distributions (RMDs) beginning at age 73. What’s more, tapping your funds before age 59½ typically triggers a 10 percent early withdrawal penalty.

Health savings accounts (HSAs) are also worth mentioning. These accounts, which allow for tax-deductible contributions and tax-free growth, let you set aside money for qualified medical expenses. You could save this money and use it to pay for health care in retirement. That means you will never owe tax on this money. You need to be enrolled in a high-deductible health plan to contribute to an HSA.

Tax-free retirement accounts

Roth accounts, including Roth IRAs and Roth 401(k)s, fall into this category. They’re actually not completely tax-free because these accounts are funded with money you’ve already paid taxes on. But that money will grow tax-free and generally won’t be taxed when you withdraw it in retirement. Also, there are ways to withdraw your contributions at any time, tax- and penalty-free. However, you could be taxed if you pull out investment earnings. To withdraw Roth IRA gains without paying taxes, you’ll need to own the account for at least five years and be 59½ or older. Another upside is that these accounts are not subject to RMDs. If you own municipal bonds, interest earned is generally exempt from federal income tax. You might also avoid state income tax if you live in the state that issued the bond.

Taxable accounts

These technically aren’t retirement accounts, but you can still use them to hold a portion of your nest egg. They might include one or more of these:

• Regular brokerage accounts
• Certificates of deposit (CDs)¹
• High-yield savings accounts
• Money market accounts

These accounts are funded with money that’s been taxed, and you may owe taxes on earnings by investments along the way. There are strategies you can use to minimize these taxes, such as tax-loss harvesting, which involves selling investments at a loss to offset capital gains.

While these accounts don’t have the tax benefits of retirement accounts, they do offer more flexibility. There are no RMDs or early withdrawal penalties.

Other sources of retirement income

In addition to the types of savings above, many retirees use additional financial options to help generate income in retirement. Here’s a look at three common income sources and how each is taxed:

• Social Security benefits: Your tax liability depends on your benefit amount and how much income you generate from other sources. If your combined income is above a certain amount, you could be taxed on up to 85 percent of your benefit.
• Annuities: You can purchase an income annuity with a lump-sum payment.² In exchange, you’ll receive guaranteed income payments in retirement that could last for life. Payouts are taxed differently depending on how you fund the annuity. If you fund the annuity with pre-tax money, perhaps from a 401(k), you’ll be taxed on your entire payment. If you purchase an annuity with money you already paid taxes on, you’ll be taxed only on the earnings.
• Cash that’s accumulated in a whole life insurance policy: While people get life insurance for the death benefit, the additional benefits offered by whole life insurance allow you to use it for multiple purposes throughout your life. In retirement, it can be a great option to help supplement your income. You’re allowed to withdraw the basis (total cost of premiums paid) that you paid into a policy tax-free (although withdrawing this cash value will reduce your death benefit). If you withdraw earnings, you will owe ordinary income tax on your withdrawals. However, if you borrow against your earnings, you won’t owe tax on this money as long as your policy remains in place (which typically means you’ll need to repay the amount you borrow).

How to be tax efficient in retirement

Being tax efficient while saving for retirement and while withdrawing your savings in retirement isn’t about using any single option above. It’s about using the right mix of multiple options.

Tax diversification is the name of the game. It can be helpful to visualize this as a tax triangle, with each corner representing a different type of account:

• Taxable accounts
• Tax-deferred accounts
• Tax-free retirement accounts

The goal is to create a diverse mix of retirement income, which can help minimize your total tax liability and be as flexible as you need. For example, instead of relying on a 401(k) for all your retirement income, which could result in a high tax bill, you might withdraw a percentage of your income from a tax-free Roth IRA. Adding in other sources of guaranteed income can help you stay even more diversified. That can include cash-value life insurance and income annuities.

Lower your taxable income now

Putting money into a 401(k) or traditional IRA during your working years has its tax benefits while you’re saving. Again, these contributions can be tax-deductible. That can bring down your taxable income—and possibly move you into a lower tax bracket. Here’s how much you can contribute in 2025:

• 401(k) contribution limits: Up to $23,500 (or $31,000 if you’re 50 or older)
• IRA contribution limits: Up to $7,000 across all IRAs (or $8,000 if you’re 50 or older)

Avoid early withdrawals and unnecessary taxes

One of the simplest retirement tax strategies is to avoid early withdrawals. If you have money in a 401(k) or traditional IRA, you’ll pay taxes and a 10 percent penalty if you withdraw funds before age 59½. That could take a big bite out of your savings. Even if there’s no penalty, which is the case for regular brokerage accounts, it can be wise to leave your money in the account as long as possible in order to take advantage of the opportunity for compound growth.. Selling assets for a profit means paying capital gains tax. Doing this often can take a bite out of any gains you make and means you could miss out on future returns.

How do I avoid a high tax bracket in retirement?

If you expect to be in a high tax bracket when you retire, consider maxing out your Roth accounts today. That can leave the door open for tax-free withdrawals later on. But if you think your tax bracket will be low in retirement, you might want to contribute more to tax-deferred accounts. That can help reduce your taxable income now. And when you do make withdrawals in retirement, you could be taxed at a lower rate than you would today.

Is there a better time of year to retire for tax purposes?

If you’re planning to retire soon, doing so midyear could have potential tax benefits. Calling it quits at this point of the year can help reduce your annual earnings. That could help you stay in a lower tax bracket.

Making sense of retirement account taxation can be tricky. The best tax strategy for you will depend on your unique financial situation and retirement goals. Your financial advisor will get to know you and ask the right questions to help you identify what’s most important to you. They can then build a plan to help you reach your goals while also helping to protect you from common risks like taxes.

All investments carry some level of risk, including loss of principal invested. No investment strategy can guarantee a profit or protect against loss. This is not intended as legal or tax advice. Financial Representatives do not render tax advice. Consult with a tax professional for tax advice that is specific to your situation.

¹ Certificates of Deposit (CDs) may be subject to an early withdrawal penalty.

² Income annuities have no cash value. Once issued, this annuity cannot be terminated (surrendered), and the premium paid for the annuity is not refundable and cannot be withdrawn.