How To Factor Taxes Into Your Retirement Planning

Retirement planning is not just about saving money—it’s about making the most of the money you saved and may receive in retirement, such as Social Security benefits. Tax considerations are easy to overlook when establishing a retirement plan, and different types of retirement income are taxed differently. Knowing these details might help you save more money now without being surprised by taxes later. Here are things to consider about taxes in retirement.

Why Taxes Matter in Retirement

You may expect to have lower tax rates when you retire, but that may not be the case. The tax bills you pay could be substantial, depending on your retirement income, where you live and your general financial situation. For example, with a Traditional IRA, you contribute pre-tax dollars and then pay taxes when you withdraw the money in retirement. But with a Roth IRA, your contributions are post-tax, meaning you don’t pay taxes on your withdrawals in retirement.

Don’t let surprise tax bills diminish your nest egg. Choose investments based on your risk tolerance and attractive after-tax returns.

Retirement Account Types and How They’re Taxed

Knowing the tax rates for each type of retirement account is essential to plan appropriately. Here are some details about popular account types:

Traditional 401(k) and Individual Retirement Account (IRA)

• Contributions are deductible before your current taxes, meaning they lower your taxes now before retirement.
• 401(k) and regular IRA distributions in retirement are taxed as ordinary income.
• Required minimum distributions (RMDs) start at age 73, and you must begin withdrawing money annually even if you don’t use it, potentially putting you in a higher tax bracket.
• Required minimum distributions for both 401(k) and IRA accounts start at age 73, and you must begin withdrawing money annually even if you don’t use it, potentially putting you in a higher tax bracket.
  

Tip: Consider how much you currently pay in taxes and how much you plan to earn when you retire. Contribute to a traditional IRA or 401(k) if you predict being in a lower tax bracket in the future.

Roth 401(k) and Roth IRA

• Contributions are made with money after you pay taxes, so these accounts don’t impact your regular taxable income before retirement.
• Withdrawals in retirement are not taxed, provided you have had the account for at least five years and are over 59 and a half.
• Roth IRAs don’t have required minimum distributions, so you have more flexibility taking withdrawals when it comes to retirement.

Tip: Roth accounts are helpful if you anticipate being at the higher end of the tax spectrum when you retire or if you worry about future tax hikes.

Taxable Investment Accounts

Investments in taxable accounts don’t receive tax-free advantages but are more versatile. Dividends and capital gains are taxed when received. Long-term capital gains on investments held for at least one year are subject to lower tax rates compared to short-term gains and ordinary income.

Tip: Open taxable accounts to get qualified dividends or long-term capital gains and take advantage of the tax advantages.

Ways To Pay Lower Taxes in Retirement

Here are some tips to make retirement taxes easier to manage.

Roth Conversions

It may be an appropriate strategy to convert some of your traditional IRA or 401(k) money into a Roth account if you expect to be in a higher tax bracket in the future. The conversion is taxable on its own, but after the money is in a Roth IRA, any gains are potentially tax-free, and you may also take withdrawals at any time.

Tip: To avoid a significant tax bill in one year, spread any Roth conversions over several years.

Take Advantage of Tax Brackets

Plan your withdrawals well to stay within a lower tax bracket. By taking calculated steps to withdraw from different accounts, you may cut down on your higher tax rate-exempt income.

Tip: Consider a mix of taxable, tax-sheltered and tax-free accounts for more options. Track income and taxes each year.

Delay Social Security Benefits

Taking Social Security after age 70 raises your monthly benefits payment and lowers your taxable income. You may choose to use the rest of your income first, so Social Security benefits may be used later to help manage your tax bill during retirement.

Tip: Consider your retirement cash flow needs and hold off on taking Social Security to increase benefits. Economists predict that the Social Security Trust Fund may have funding shortfalls in the future, a good reason to diversify your retirement savings if you can.

While you can’t control the future, you can include tax considerations in your retirement strategy today for more financial stability. Knowing how income from different sources is taxed may enable you to guard your retirement nest egg.

Lastly, consider working with a financial professional before retirement to create a strategy to keep as much of your hard-earned savings as you can in your golden years.

Important Disclosures:

This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking tax, legal or investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.

Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal.  Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.

Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.

This article was prepared by WriterAccess
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