Why Planning for Retirement Taxes Is Just as Important as Saving
People often don’t account for the federal income taxes they’ll have to pay during retirement, either when saving for this phase of life or when taking withdrawals. But not accounting for those taxes – when saving or withdrawing – could reduce the value of your retirement assets and the dollars you have left to spend.
Getting ahead of retirement taxes starts with the realization that the amount of taxes you’ll pay is directly related to the types of retirement accounts you have and how you use them.
There are measures you can take to manage your retirement tax bill, both now when saving and later when making withdrawals. Not all retirement assets are taxed in the same way, so it may benefit you to save your money in a blend of different account types or assets. And, how and when you draw on those assets can be staged in ways that benefit your tax bill.
Begin with Diversified Assets
Most retirement savings come in two main flavors – assets that are rarely, if ever, taxed in retirement; and others that generally are.
Rarely taxed and untaxed assets: Investments like Roth IRAs, interest from municipal bonds, HSA contributions and withdrawals, and life insurance cash-out plans won’t usually affect your taxable income.
Setting these up may involve a larger outlay of capital or taxes at the front end, but you’ll reap the rewards during retirement. Namely, as long as certain conditions are met, you can draw on these funds at any time without increasing your tax bill. For this reason alone, many people find peace of mind in building assets like these.
Taxable assets: Many other types of retirement investments are taxable, although the taxes can be deferred.
Such is the case with traditional IRAs, 401(k) plans and annuities purchased with pretax dollars. These tax-deferred investments are great for reducing your taxable income when you’re still working and as the assets grow, since the taxes are delayed until withdrawals begin.
Other types of taxable assets include dividends, mutual funds and savings accounts that are not part of a 401(k) or Roth IRA. These types of investments make a useful addition to just about any portfolio. But as they grow or become liquid, they also generate taxes.
Together, income from all of these types of assets may constitute the larger portion of your taxable income, and will affect the amount of federal taxes you’ll owe. The more income these assets generate in a given year, the higher your taxes – and your tax bracket – are likely to go.
Given the relative advantages of untaxed and taxable assets, you may find it beneficial to have a mix of both. A diversified set of assets gives you options in retirement, enabling you to control the portion of your income that’s taxable.
Build a Smarter Withdrawal Strategy
If you have retirement assets in both taxable and nontaxable sources, it pays to consider in advance how staging your withdrawals could affect the taxes you’ll pay.
For some, stretching out your taxable income sources over a longer period of time during retirement may help you reduce your taxable income from year to year. Then, you can supplement your annual income with assets not subject to taxes, like Roth IRA withdrawals.
When it comes to tax-deferred assets, such as 401(k) plans and traditional IRAs, minimum distributions can now begin as late as age 72, a result of the SECURE Act passed in December 2019. Previously, minimum distributions had to begin by 70½.
Waiting to begin taking distributions until they’re mandated, however, can put you at a disadvantage from a tax standpoint because your distributions are likely to be larger each year. If you’re able to begin taking withdrawals from these sources at an earlier age, with smaller distribution amounts each year, you may be able to keep your taxable income lower over your lifetime. As always you should consult your tax advisor before beginning this or any other withdrawal strategy.
Managing One-Off Withdrawals
Consider, too, that large, unplanned withdrawals from your taxable accounts during retirement could negatively affect your tax burden. Say you need a large amount of money for a new roof. If you withdraw this from your 401(k) plan, it will likely increase your taxable income and may even bump you to a higher tax bracket.
Having the ability to pull some or all of these funds from a Roth IRA instead means that your taxable income and tax bill will not suffer.
Making the Best Use of Social Security
Social Security income is another variable you can use to control your taxes in retirement, particularly if you wait longer to claim this benefit. Those eligible for Social Security can begin claiming it at age 62, but the benefits increase for those who wait. In fact, for every month you wait, the benefit will increase up to age 70. Depending on the year you were born, you may be able to receive 30% more Social Security at age 70 than you could at 62.
If you have other sources of income, your Social Security benefits may be taxable, but in most cases only partially – usually just 50% to 85% of those benefits are subject to tax. Waiting to claim your Social Security benefits means you’ll receive a higher amount, with a potentially lighter tax burden, as compared to, say, the same income from a 401(k) or IRA, which is taxable in its entirety. Knowing this ahead of time allows you to take a more holistic approach to crafting your income strategy over your retirement years, helping you to draw on different sources of income in proportions that are the most advantageous to you.
Rolling into a Roth
If you like the idea of having a Roth IRA or other nontaxable account to supplement your retirement income, but feel you haven’t saved up enough, you may be able to roll over funds from a 401(k) as retirement nears or early in retirement. While you’ll be taxed upfront when you make this transfer, you’ll be able to enjoy the tax-free benefits later.
Consult with Your Financial Advisor
These are just a few tactics you might consider to manage your retirement income, but they help illustrate a key fact about taxes during retirement: They’re determined not just by how much you have saved, but also by where it’s saved and how you manage withdrawals.
If you’re nearing retirement or between the ages of 45 and 65, this may be a great time to connect with a financial advisor who can help you set up the right type of accounts or work through the finer points of your retirement tax strategy.
About Tina A. Myers, CFP®, CPA/PFS, MTax, AEP®
As a senior financial planner with Key Private Bank, Tina offers her clients sophisticated financial planning advice and a comprehensive set of strategies to grow and preserve their wealth. She collaborates with her team’s Relationship and Portfolio Managers, coordinates strategies with attorneys and accountants and follows up on a regular basis to ensure the plan is performing optimally. Tina received the 2016 Exceptional Service Award from the Cleveland Estate Planning Council and 2016 Circle of Excellence Award by Key Private Bank.