Director of Financial Planning at Blue Rock Dravo Bay. I’m strongly committed to the financial planning industry. I take great pride in empowering clients and becoming their financial confidant.
You’ve spent decades diligently planning and saving for retirement, and while you know at some level that taxes will be deducted from your monthly retirement income, it’s often a relief to understand the ‘bottom line’ when it comes to your retirement income expectations.
During your working years, proactive tax planning is a long term strategic approach to minimizing your tax liability each year so the taxes you pay over your lifetime are as low as possible.
Retirement income tax planning can provide a more concrete estimation of how much you will ‘net’ each month after Uncle Sam takes his cut.
The Basics of Retirement Income Tax Planning
Taxes are a reality even after we stop working. Once you retire, a proactive tax strategy becomes even more important; for many, their tax situation actually increases in complexity.
You may be surprised to learn, for example, that you won’t necessarily jump down to a lower tax bracket after you stop bringing home a paycheck. Even if you have your house paid off, for example, additional income streams in combination with Required Minimum Distributions (see below) can add up and keep you in your pre-retirement tax bracket.
Estimating your annual retirement tax bill with your financial advisor is part of creating smart tax strategies so you have more money “on hand” to fund your dream retirement.
How most retirement accounts are taxed
To best project your retirement tax situation, you’ll want a solid understanding of the account types you have, and how they are taxed. Let’s take a look at some common income channels.
Social Security: The Social Security Administration looks at your combined income to determine if your benefits will be taxed. Those with a pension, healthy 401(k), and/or IRA will have some portion of their benefits taxed, anywhere from zero to 85%. Retirees with income streams outside the United States can also expect a portion of their benefits to be taxed.
401(k) or Employer-Sponsored Retirement Accounts (including 403(b) and 457): Because these account contributions were tax-deductible when you made them, you’ll have to pay taxes upon withdrawal. Your tax bill will depend on your total annual income, deductions, and tax bracket.
Federal tax law currently requires that individuals make annual minimum withdrawals from these accounts as soon as they turn 72. These are referred to as Required Minimum Distributions or RMDs. (The CARES Act allows retirees turning 72 this year to defer RMDs in 2020).
Individual Retirement Accounts (IRAs): A Traditional IRA is taxed just like the employer-sponsored retirement account, where taxes are paid upon withdrawal, typically at ordinary income tax rates.
A Roth IRA, on the other hand, allows for tax-free withdrawals because you made after-tax contributions over the years. Another key benefit of a Roth IRA is that they are not subject to RMDs and allow the most flexibility with withdrawal timing.
If you can’t contribute directly to a Roth, now could be a great time to consider a Roth Conversion.
Pensions: Most pension income is taxable and the tax bill will depend on how contributions were made (pre-tax = taxable; after-tax = not taxable). Should your pension account have a blend of the two, a portion of your withdrawals would be taxable and some would not. Pension taxes will also vary depending on the type of pay-out you choose. Different annuity choices (single-life, joint, period-certain, etc.) will result in differing tax treatments.
Brokerage accounts: You may have a brokerage account with a significant amount of money in individual stocks or mutual funds, for example. Work with your financial advisor to determine the best time to sell these assets, realize a profit, and minimize your tax bill.
When you make a profit, you’ll pay short- or long-term capital gains, depending on how long you held the asset. Any asset held longer than a year qualifies for long-term capital gains, which is the more favorable of the two.
How do retirees pay their tax bills?
Most of the account types mentioned above allow you to elect to have taxes automatically withheld from your paycheck (Social Security, pension, some IRAs, etc.). This is often the most straightforward way to go about it. You can also make estimated quarterly payments. Work with your advisor and tax professional to determine which option makes the most sense for you.
The bigger picture: where do your taxes fit?
Now that you have a fundamental understanding of how each retirement account and income channel is taxed, how can you use this information to tactically reduce the taxes you pay? While we will dive into this topic a bit further in our next post, the main point we want to emphasize today is assessing your income in the context of your lifetime.
We can project your income stream for future years, proving a valuable insight into your tax liability year to year. A common myth is that once you retire, tax planning becomes simpler. But that couldn’t be farther from the truth. Your tax liability will vary year to year depending on the income streams you tap, added earnings from an encore career, your portfolio returns, and so much more.
As we project your income earnings and subsequent tax responsibilities 5, 10, even 20 years into the future, that enables us to estimate your tax liability and most importantly, recognize the trends in your finances.
These trends can reveal unique planning strategies or pinpoint areas to watch out for in retirement. Let’s look at an example. One trend we have seen is a significant decrease in income from when someone retires (often 65) to when RMDs kick in (72). This period of lower-income could be a great time to initiate a Roth conversion, as the tax burden would be significantly lower than when you were working.
We are able to devise the right conversion amount for you by analyzing factors like lifespan, income needs, income streams, your tax bracket, and more. This is simply one example of how capitalizing on a trend can reduce your taxes in retirement.
Analyzing trends and projecting income is all in an effort to bring a proactive approach to your taxes. We don’t take a reactive approach, instead, we work to devise the right plan for you well in advance to take advantage of any opportunity that comes your way.
Knowledge is power
Proactive tax planning is key to a seamless retirement income plan. With a strong tax strategy, your money can work for you to fund your retirement lifestyle. You’ve spent many years crafting a retirement savings plan to financially support your goals. Now it’s time to make a plan that puts more money toward those goals.
It’s never too early to start having these conversations with your financial advisor. Get in touch today to make an appointment. We’re here to ensure you feel confident and enthusiastic about your retirement dreams.