Taxes can have a significant impact on your finances in
retirement. But, if you are proactive and deliberately include taxes as a key
component of your retirement plan, then you may be able to reduce them quite a
bit.
The first step is to simply understand how taxes work in
retirement. Look, I understand what I just said — and I get it. I’ve taught
enough college students and worked with enough retirees to know that if we get
too into the weeds your eyes will gloss over. Don’t worry. In this article,
I’ll give you a gentle overview so you can be aware of what you need to think
about.
1. What Income Is Taxed, And How?
Just like during your working years, you’ll receive an
“income” in retirement. You may not have thought about it yet, but your
retirement income will likely come from a few different sources — retirement
savings and Social Security, for example.
That income is still subject to income taxation, and you can
benefit by thinking about that as you plan. What makes it loads of fun is that
some sources of retirement income are taxed differently than others. A good
first step is to familiarize yourself with what gets taxed, and how.
Savings
Let’s start by looking at savings and investments. There are
three basic ways that withdrawals from your retirement savings will be taxed,
depending on the type of account.
Tax-Deferred
The most common type of retirement account is tax-deferred.
This includes 401(k), 403(b), and IRA accounts. Tax-deferred means the taxes are
deferred until you withdraw from the account. At that point, every dollar
you take out is included in your taxable income.
Tax-Free (Roth)
You can withdraw money from your designated Roth accounts
without incurring a tax liability. There are some requirements that must be met
first. In most cases, as long as you are over 59 ½ and the account is at least
5 years old, then you are good. Otherwise, earnings (not your contributions) in
the account may be taxed, and you may owe a 10 percent penalty as well.
Taxable
Tax-advantaged retirement accounts, both tax-deferred and
Roth, both provide a huge benefit by shielding your investments from taxes
while they are inside the account. That means interest, dividends, and
investment gains aren’t taxed along the way.
That isn’t the case for the savings and investments you have
in taxable brokerage accounts. You’ll incur a tax liability in these accounts
when you receive interest and dividends, and when you realize gains (meaning
sell) regardless of whether you withdraw the money or not.
Pensions And Social Security
Pension and Social Security income is generally taxable.
A special note about Social Security retirement benefits is
that they may not be taxable, and are never fully taxable. It depends on a
measure called your combined income, which is your adjusted gross income plus
half of your Social Security benefit, plus any tax-exempt interest you receive.
Depending on how high your combined income is, you may have
to include none, half, or up to 85 percent of your Social Security in your
taxable income.
2. Strategy For Distribution Based On Taxes
Once you have an idea of how your money is taxed in
retirement, you can create a plan that allows you to navigate taxes
efficiently.
The key to having a tax-efficient distribution plan is to
consider how each source of income contributes to your tax bill. Rather than
taking all of your withdrawals from a tax-deferred account, or completely from
your Roth accounts, consider how blending your withdrawals from all sources
might help you achieve your lowest possible average tax rate throughout
retirement.
3. How Do Different State Taxes Play Into Retirement?
In addition to income taxation at the Federal level, there
are currently 43 states that also have their own income taxes. Of course, if
you live in one of these states, you’ll need to account for this as well.
Even in states that have a state income tax, most of them
exempt Social Security retirement benefits. There are 12 states that don’t,
however.
Even still, your state may have an income tax but exclude
withdrawals from your tax-deferred retirement accounts and pension income.
These are all important factors to consider
4. Hire A Tax Professional
If you’ve ever spoken with me about your retirement plan or
read anything I’ve written about retirement taxes, you’ll quickly find that I
am very “pro” hiring a tax professional to prepare your tax return. Even more
so if you live in a state with an income tax — because you’ll want a tax
professional that is familiar with your state code as well.
“But what if my financial planner helps me with my tax
planning?” I often get this one from my own clients when we first begin working
together. “So you’re my tax guy right?”
And it’s easy to see the confusion.
If you are working with a financial planner who incorporates
heavy doses of tax planning, then my view is that you especially need a tax
professional to file your tax return. Let me explain…
Understand there is a difference between tax planning and
tax preparation.
Tax planning involves thinking through the tax consequences
of different decisions beforehand and proactively deciding what you will do now
and in the future to affect your tax liability at a later date.
Tax preparation means gathering information, filling out
forms, and producing a document or documents that describe what happened in the
past (generally the prior year) to send in to the IRS to show a tax liability
that you have already incurred.
Some professionals do both, but these are different skill sets
and many professionals would find it very difficult to be really good at both.
Plus, I think it is a good idea to have more than one set of eyes on the same
problem, particularly when those eyes come from different perspectives.
If you are working with a tax-savvy financial planner, then
the odds are you are probably also engaging in more involved tax strategies
that make the filing more involved as well. It’s entirely possible that you can
simply file something incorrectly — forget a form, check the wrong box — and
ruin the tax strategy you thought you had in place. Sometimes the highest value
of a professional tax preparer is in the mistakes they help you avoid.
5. The Biggest Tax Mistake For Retirees
The biggest mistake I see retirees make regarding taxes
isn’t a single action, but more of an idea. So many retirees fail to have a
plan for actively addressing their taxes.
The default for most is to simply defer taxes for as long as
possible. That may seem smart on the surface, but in reality, usually means
paying more than you otherwise had to.
Don’t neglect taxes in your retirement plan. Think ahead,
and navigate taxes proactively so that you can have the most tax-efficient
retirement possible.
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