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Avoid Getting Entangled by Taxes in Retirement

It’s important to understand how taxes can affect you in retirement based on your tax bracket, your filing status and other factors, including Social Security and pension benefits.

If you’re not careful about planning ahead, taxes could trip up your retirement plans.

Taxes should never be overlooked in retirement planning. Fifty years ago, most Americans would have their homes as their largest assets. But now, with millions of Americans using IRAs and other retirement accounts, their retirement savings are often their biggest assets.

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Too often we assume that our taxes will go down when we retire, but that’s not always the case. Even when you are doing the right things and planning ahead, you might be setting yourself up for a tax trap down the road. You might be paying into a retirement account and enjoying the immediate tax benefits, but that money could be taxable in the future.

It’s important to understand how those taxes can affect you in retirement based on your tax bracket, your filing status and other factors, including Social Security and pension benefits. You might even end up in the same or possibly a higher tax bracket in your retirement than you were while you were working.

All of this underscores the importance of planning ahead for your retirement. You need to figure out which tax breaks, exemptions and deductions you will be able to qualify for when you have retired. When you start receiving Social Security, you will have to calculate your provisional income to see how much of it will be taxed.

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Social Security can also muddy the waters as you try to figure out what your taxes will be in retirement. One thing to keep in mind in your retirement planning is that Social Security is taxed based on your other income, meaning you have to look at the tax rates and tax brackets to know how much of your Social Security will be considered as provisional income. With Social Security in the mix, you also have to understand what your effective tax rate is when you reach retirement. Throw in non-taxable interest, capital gains, dividends and other income, and the taxes can add up. This often requires some drilling down.

Too many of us are under the wrong impression that Social Security isn’t taxable. That’s simply not correct as up to 85% of your Social Security benefits can be taxable. The more income you pull in, the more taxes you will pay. If you file as an individual, you have to pay taxes if your combined income, including half of what you take from Social Security, is more than $25,000. In that case, as much as 50% of your Social Security benefits can be taxed. If your combined income is more than $34,000, you might have to pay taxes on 85% of your Social Security benefits. If you and your spouse have a combined income of more than $32,000 in combined income, you will have to pay taxes on what you draw from Social Security, with as much as 50% being taxable. If you and your spouse earn more than $44,000 in combined income, up to 85% of your Social Security benefits may be taxable.

Often people who decide to start taking Social Security benefits at 62, the earliest age to opt in, and continue to earn good incomes are hit the hardest when it comes to paying taxes on Social Security.

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There are other factors to calculate as you plan ahead to your retirement. When you reach age 70½, you have to start taking required minimum distributions (RMDs) from your IRAs and other retirement plans. The RMDs are based on calculations from a life expectancy table. More often than not, RMDs are taxed as ordinary income, though you can choose to send the funds to charity, making it a qualified charitable distribution (QCD) instead of taking the withdrawal. That can often prove an advantageous tax strategy in retirement. As you get older, RMD rules require you to take an ever-increasing percentage out of your retirement accounts, starting at 3.6% when you’re 70 and rising to 5.3% at 80 and 8.8% at age 90.

While it’s unpleasant to think about, your filing status also comes into play. Surviving spouses are often confronted with higher tax burdens going into a less favorable tax bracket after the loss of their loved ones.

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You might have spent decades stashing your hard-earned income into retirement accounts. But you might also find that you will pay more taxes when you pull that money out of those retirement accounts than you saved when you put it in.

It’s daunting to think about. Nobody wants to pay higher taxes in retirement than they did during their years in the workforce. Thankfully, there are plenty of alternative strategies to help avoid some of these taxes and reduce your tax burden in retirement. These include diversifying your retirement savings in tax-deferred accounts like traditional IRAs and 401(k)s and tax free ones including Roth IRAs. You can also look at alternatives including life insurance policies, annuities, real estate investment trusts (REITs) and other investment possibilities.

It’s important to bring in an experienced financial adviser who specializes in helping with retirement planning to ensure your retirement isn’t entangled by taxes and more of your money stays in your pocket.

Kevin Derby contributed to this article.

About the Author

Don Ross, RFC

President and Founder, Ross Wealth Advisors

Don Ross, founder and president at Ross Wealth Advisors, has more than 25 years' experience in the insurance and financial services industry. He has passed the Series 7 securities exam and holds a life insurance license in Ohio. Retired from the military after more than 20 years of service as a pilot in the Ohio National Guard, Ross lives in Upper Arlington, Ohio, and enjoys traveling, yard work and cycling. He and his wife, Joni, have three children: Judith, Ryan and Lance.

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