Defuse the Tax Bomb That Threatens Retirement
If a large part of your retirement savings is in an IRA or a 401(k), you could be facing a significant tax bill in the future. Here are some ways to minimize your taxes while maximizing your retirement income.
![](https://cdn.mos.cms.futurecdn.net/rzcTaHSRru3UbP4Kc4jm4T-415-80.jpg)
It makes sense that everyone’s retirement plans should be different and adjusted to personal circumstances. If you have lots of children and have already paid for several college bills, for instance, you might have less home equity than your neighbors. If you have built up large stock holdings, you will be thinking about how to manage market risk.
A constant for every portfolio, though, is taxes.
If you set aside a portion of your earnings in a 401(k) or IRA, that doesn’t mean taxes were forgiven — they were only deferred. You will still owe money to the IRS at some point in the future on any investment earnings on these savings accounts or on any deferred annuities that you might hold that were not taxed currently. Lastly, if you’ve got appreciated securities in your personal savings, you’ll owe taxes when you sell them.
![https://cdn.mos.cms.futurecdn.net/hwgJ7osrMtUWhk5koeVme7-200-80.png](https://cdn.mos.cms.futurecdn.net/hwgJ7osrMtUWhk5koeVme7-320-80.png)
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
I call it the “tax bomb.”
But the reality also includes this: By anticipating the different requirements of each stage of our working and retirement years — and by following IRS rules — we can maximize the after-tax income from these savings.
The tax bomb can be defused.
Understanding the impact of taxes
A friend of a friend contacted me recently with a unique situation. He had put money into his 401(k) diligently and for dozens of years. As he nears retirement, he has very little home equity, almost nothing in personal savings and more than $2 million accumulated in his 401(k) plans from two different employers.
Rather than being happy, he is justifiably worried about losing 30% of that money to taxes. Regulations will force him to begin taking required minimum distributions from his account when he reaches the age of 70½. As his circumstances stand now, he will be taxed at the highest rate. His $2 million, in other words, is worth $1.4 million to him.
His situation in an extreme example of the tax bomb.
How to maximize your after-tax income
Just as everyone’s retirement circumstances differ, the question of how to optimize your after-tax income in retirement does not have a one-size-fits-all answer. (By the way, most retirement calculators don’t even address taxes.) And, of course, taxpayers have the right to minimize the effect of taxes on their income while still obeying the tax laws.
Your personal solution will involve devising the most efficient way to convert each of your major sources of savings to income. Here are some tips that apply to everyone who has accumulated significant wealth in retirement savings accounts.
- 401(k) and rollover IRA. Consider using 25% of the account — up to $125,000 — to purchase a qualified longevity annuity contract, or QLAC. This is a form of deferred income annuity that starts paying you at an age you set, usually 80 or 85, in anticipation of late-in-retirement expenses. It also defers taxes until you start receiving QLAC payments. Once a QLAC is in place, consider a strategy that generates the highest income until the QLAC kicks in.
- Fixed and variable deferred annuities. When you withdraw money from deferred annuities, the income could be fully taxed for a period of years. However, if you move the accumulated value of these deferred annuities into an income annuity that pays regular, guaranteed income, the IRS will exclude a portion of the payment from tax. (You should shop around when you decide to “annuitize” your savings so that you get the annuity with the features you like at the best rates. It doesn’t have to be the original company that you bought the deferred annuity from.)
Additional ideas for other types of savings
Personal savings. Stock dividends are assessed at lower tax rates than regular income. In addition, your heirs – surviving spouse and children — will get the best tax benefit from this account because, upon your death, they receive a “step-up in basis” and pay no taxes on prior gains. So, if you can afford it, spend the dividends, but let the capital gains accumulate.
Equity in your home. For some people, this represents your largest source of savings and probably receives the most favorable tax treatment. You can tap that equity and receive tax-free cash with a reverse mortgage or home equity line of credit (with tax-deductible interest). Of course, you should have a long-term plan for paying interest and principal when required. That interest may or may not be deductible. Check with your tax adviser.
Addressing your tax liability requires thoughtful planning and careful decision-making, but when you take the time to understand your options, you can defuse a “tax bomb” with a reasonable tax-management approach that allows you to generate the highest amount of spendable, after-tax income. Of course, stay current on tax matters, because they’re subject to change in our present environment.
Get Kiplinger Today newsletter — free
Profit and prosper with the best of Kiplinger's advice on investing, taxes, retirement, personal finance and much more. Delivered daily. Enter your email in the box and click Sign Me Up.
Jerry Golden is the founder and CEO of Golden Retirement Advisors Inc. He specializes in helping consumers create retirement plans that provide income that cannot be outlived. Find out more at Go2income.com, where consumers can explore all types of income annuity options, anonymously and at no cost.
-
Visa Is the Worst Dow Stock Wednesday. Here's Why
Visa stock is down sharply Wednesday after the credit card company came up short of revenue expectations for its fiscal Q3.
By Joey Solitro Published
-
Another Analyst Moves to the Sidelines on Tesla Stock After Earnings
Tesla stock is spiraling Wednesday after the EV maker's big earnings miss and Wall Street has been quick to weigh in. Here's what you need to know.
By Joey Solitro Published
-
Confused by Annuities? Making Sense of the Different Types
Many investors aren't sure if annuities are a good option for meeting financial goals. Let's look at the different categories, along with their pros and cons.
By Kris Maksimovich, AIF®, CRPC®, CPFA®, CRC® Published
-
Talkin' 'Bout My Generational Wealth: Baby Boomers
With retirement, each generation has different priorities and challenges. For Baby Boomers, it's a matter of ready or not, here it comes.
By Alvina Lo Published
-
How to Avoid a Big Hassle if Your Financed Car Gets Wrecked
How an insurance check is made out for repairs can cause a world of problems if the lienholder is left out.
By H. Dennis Beaver, Esq. Published
-
Estate Planning Strategies to Consider as Election Nears
Are big changes in tax laws coming soon? Not likely, but you might want to take advantage of higher estate and gift tax exemptions well before the end of 2025.
By David Handler, J.D. Published
-
How to Get Your Money's Worth From Your Financial Adviser
A good financial adviser will focus on how your financial planning and investment strategy align with your lifestyle and aspirations.
By Pam Krueger Published
-
Think of Prenups and Postnups as Financial Planning Tools
These contracts provide a clear framework for asset management and protection and are especially useful if you get married later in life.
By Andrew Hatherley, CDFA®, CRPC® Published
-
Congratulations on Your Raise: Three Things to Do With It
We're not saying you shouldn't spend it on a new car, but there are some considerations to guard against lifestyle creep and to help ensure a comfy retirement.
By Andrew Rosen, CFP®, CEP Published
-
Check Off These Four Financial Tasks to Finish 2024 Strong
The new year is a popular time to set financial goals, but now is the ideal time to check how you're doing. Four tweaks could make a big difference.
By Daniel Razvi, Esquire Published