When people think about planning for retirement, they tend to focus on saving and investing so they have a good nest egg when they leave work. And that’s a good starting point. But it’s also important to pay attention to the impact of taxes on your retirement savings and any other sources of income you’ll draw upon in retirement.
Unfortunately, taxes don’t go away when you stop getting a paycheck. Even if you are no longer working, you will still earn income in the form of retirement account distributions, Social Security benefits, and possibly pension payments. And if you underestimate the impact taxes can have – yes, even when you’re retired – you could end up losing a significant chunk of your hard-earned cash.
The good news is there’s a lot you can do to make your retirement plan more tax-efficient. Here are four common tax issues you may encounter in retirement – and thoughts on how to prepare for each.
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Tax-deferred pension plans
The problem: Distributions from tax-deferred pension plans are taxed as ordinary income.
It makes me nervous when future retirees talk about the money in their pre-tax retirement accounts (401(k) plans, 403(b) plans, etc.) as if every penny will one day be theirs. It seems they’ve forgotten that Uncle Sam will eventually want his cut – and every withdrawal they make can be taxed as ordinary income.
What can you do about it: Consider using a Roth IRA or Roth 401(k) with (or instead of) your 401(k) or similar plan.
There are several advantages to owning a Roth account, but a big positive is that once you put your money in a Roth – either with direct contributions or by converting the money from a tax-deferred account existing – it can grow tax-free. You can withdraw contributions from a Roth IRA without paying a penalty at any age. And at age 59½, you can withdraw both contributions and earnings without penalty, provided your account has been open for at least five tax years.
If you agree with predictions that taxes will be higher in the future, strategically converting funds from your traditional IRA to a Roth IRA over time — and paying taxes in the year of conversion – could help you reduce your tax liability in retirement.
You can also transfer funds from a 401(k) to a Roth IRA when you leave a job or retire or if your 401(k) plan allows this type of transfer while you are still employed. Remember that a Roth conversion is a taxable event: if you transfer money from an employer’s plan, you’ll have to pay taxes on your contributions, your employer’s matching contributions, and your account earnings. . Depending on how much you convert in a given tax year, this process could push you into a much higher tax bracket.
Social security benefits
The problem: Part of your social security benefits could also be taxed.
Many people don’t realize that they may have to pay taxes on their Social Security payments. But if your combined income (adjusted gross income + non-taxable interest + half of your Social Security benefits = combined income) is above the IRS limits for your filing status, you can expect to pay taxes on a part of your benefits.
What can you do about it: Diversifying your retirement income (with taxable and non-taxable sources) can help reduce your tax burden.
Again, this is where having a Roth account can come in handy. Or, if you have money in a 401(k) and/or traditional IRA, you might consider withdrawing your retirement income from these tax-deferred accounts before applying for your Social Security benefits. Remember that you can start taking Social Security at age 62, but the longer you delay filing, the bigger your monthly payments will be.
You may also want to discuss with your financial planner the use of indexed universal life insurance as a source of tax-free retirement income. (This is a more complicated strategy, and it may require the help of trained professionals to get it right.)
Required Minimum Distributions (RMD)
The problem: If you have a tax-deferred pension plan, you must receive the required minimum distributions (RMD) from age 72 whether you need the money or not. And it will increase your taxable income.
Remember what I said earlier about Uncle Sam wanting his share of your retirement savings? It’s his way of getting it. If you don’t take your RMD, or if you withdraw the wrong amount, the IRS may impose a penalty.
What can you do about it: If you transferred some or all of your money into a Roth IRA, you may be able to avoid or at least reduce the amount of tax you would otherwise have to pay on those withdrawals. (The original owner of a Roth IRA doesn’t have to take an RMD — ever.)
Or, if you have a traditional IRA, you might want to talk to your financial advisor about the qualified charitable distribution (QCD) rule. This IRS rule allows anyone age 70.5 or older to donate up to $100,000 a year directly to charity from a traditional IRA — and the donation can be taken into account. account to satisfy this year’s RMD. (Unfortunately, this cannot be done with a 401(k).)
Defined benefit pension plan or retirement plan
The problem: Your defined benefit pension plan (annuity) is fully or partially taxable.
I doubt there are many people who would complain about having a pension – especially these days when private sector defined benefit pension plans are so rare. But these payments can have a downside when it comes to your taxes.
If you receive a lump sum payment when you retire and don’t transfer the funds to a traditional IRA, you could lose some of the taxes up front. And if you opt for monthly payments, it could affect your tax bill every year in the future.
What can you do about it: You can start by talking to your financial planner about which payment option best suits your overall retirement plan and goals. And if you opt for monthly payments, you might want to ask the company administering your pension to withhold income tax so you don’t have to worry about a big bill every year when it’s time to pay. taxes.
You’ve probably already realized that the best way to tackle any tax problem is to be proactive, whether you’re nearing retirement or have years to go. An experienced financial professional can help you assess the risks specific to your retirement income plan and suggest tax-efficient strategies that match your goals.
Kim Franke-Folstad contributed to this article.
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