Saving for retirement is sadly only part of the battle. The last thing you want after saving for years and finally retiring is for the government to claim a considerable chunk of your then-primary source of income. Unfortunately, most people enter their retirement years with less money saved than they need. In such cases, it’s wise to minimize taxes.
What’s more, the tax season is already complicated enough without having to worry about your retirement planning. Being strategical in planning your retirement accounts is important to minimize your tax burden in the future. You need to review and plan for your taxes now if you want to maximize your nest egg and future spending.
Get Your Full Financial Picture
It is always best to know your full financial picture to better prepare for your retirement years.
First, you need to know what is taxable. The truth is that just about everything is – the difference is when the taxes are due. Investments outside of tax-advantaged retirement accounts are taxed annually, whether or not you’re retired. These include real estate, savings accounts, brokerage accounts, etc.
On the other hand, taxes on most retirement-designated income are not due until you retire. These include withdrawals from traditional IRAs, 403(b), and 401(k) accounts as well as payments from pensions, annuities, military retirement accounts, etc.
The assistance of a financial advisor is instrumental in helping you to lower your retirement taxes and identify which assets are taxable, exempt, or tax-deferred.
What to Expect in Retirement Income and Taxes
You have to pay taxes on:
- A chunk of your Social Security benefits
- The money you withdraw from your IRA and 401(k)
- Capital gains and dividends on your investments in a regular brokerage account
It’s best to start planning for your retirement taxes early. It’s also advisable to contribute to tax-efficient accounts that you are eligible for to help with your tax and retirement planning. Note that:
- A traditional 401(k) and IRA offers tax-deferred growth potential
- A Roth 401(k) and IRA offers tax-free growth potential
- A brokerage account offers taxable growth potential
Strategies to Help You Predict and Minimize Your Retirement Taxes
The following ideas could save you money in retirement and give you a more significant nest egg to make your sunset years a little less stressful.
1. Start With Traditional Retirement Accounts
Here, think 401(k), Roth IRAs, and SEP-IRAs when you are just starting or do not have a lot of disposable income to set aside for your retirement. It’s the best time to take advantage of tax breaks because investing in tax-deferred accounts like a SEP-IRA or 401(k) allows you to boost your savings.
2. Add a Taxable Brokerage Account as You Get Older
Add a taxable brokerage account as part of your investment assets as you get older or have a lot more disposable income.
However, do not stop contributing to your other traditional retirement accounts despite their drawbacks. For instance, you are subject to tax penalties when you withdraw money either too soon or too late from a tax-deferred retirement account – usually before 59 ½ years or after your early 70s.
Even if you make withdrawals on schedule, you must still pay ordinary income taxes to all your qualified retirement plans such as 401(k), IRA, SEP-IRA, 403(b), and Keogh accounts. Federal tax rates can reach 39.6%.
On the other hand, you only pay taxes on your earnings rather than the principal amount invested in your non-retirement investment accounts. Capital gains rates go as high as 23.8% and can drop to zero for those whose tax rates are 15% and below.
3. Convert to a Roth IRA
A Roth IRA refers to an individual retirement account where your money grows tax-free. Retirement withdrawals are also tax-free, subject to set rules. For example, you must hold cash in the account for at least five years and be over 59½ years old.
To open a Roth account:
- Contribute to a Roth IRA – only if you meet the income and contribution requirements
- Contribute to a Roth 401(k)
- Use a backdoor Roth IRA to convert a traditional IRA into a Roth
The downside is that the tax break for a Roth IRA comes later, which means you put money into the account after paying the taxes on it.
4. Diversify Your Assets
Asset allocation means deciding how much of a given asset investment to hold, such as stocks, real estate, cash, etc. In contrast, asset location is holding these assets in the correct investment and retirement accounts. A financial planner can help you match your time horizon and risk tolerance with the right investments. For example:
- Put your stock index funds in brokerage and savings accounts to enjoy lower capital gains taxes, deduct capital losses, and throw off minimal income from dividends annually.
- Put REITs, bonds, and similar investments that yield regular interest income in your retirement accounts like IRAs and 401(k) that defer tax until withdrawal.
- Put higher-risk, higher-return investments (think emerging market stocks) in Roth accounts with tax-free withdrawals.
5. Diversify Your Account Types
It’s best also to diversify your account types since tax brackets often fluctuate during various stages in your life. Some benefits include:
- When taxes are relatively high, withdraw money from a tax-free account. When they are relatively low, take your income from taxable accounts.
- You must have taxable income (such as a traditional IRA) to take tax deductions in retirement. Thus, you could withdraw enough to offset the eligible deductions and take the rest from your Roth account.
- You could also draw down your taxable accounts in retirement first to allow your other traditional IRA assets to grow tax-deferred.
6. Pay Off Your Mortgage and Reduce Huge Expenses
You lower your tax bill when you withdraw less income from your taxable retirement accounts like a traditional 401(k) or IRA. Therefore, ensure that you reduce your significant expenses like a mortgage early to get them out of the way.
7. Invest in Municipal Bonds
Municipal bonds are tax-exempt, which means you won’t owe any federal tax (or state tax in some cases) on any income you receive. Despite their lower interest rates, you get to control when to make tax-free withdrawals.
8. Manage Retirement Withdrawals
Another way to control your taxes is by managing your retirement withdrawals if you have multiple accounts like a traditional 401(k) or IRA and a Roth 401(k) or Roth IRA. Withdraw money from a taxable account in the years that you fall in a lower tax bracket and take from your Roth IRA when you fall in a higher tax bracket.
Get Professional Help for Your Retirement Taxes
Managing taxes in retirement takes some work. You must be proactive to ensure that you don’t fall behind on your payments. To do this, you could stay abreast of the IRS retirement taxes to learn about new laws and changes.
You can also make quarterly tax payments to remain on top of your retirement taxes and get prepared for tax seasons. Finally, you could hire a financial tax preparer or planner to help you manage your taxes and ensure that you have more than enough money left over for your twilight years. Contact us today for additional information or the best professional tax help.