Planning for retirement is a complicated process, and some important aspects can be overlooked — blind spots, if you will.
Taxes are one of the biggest blind spots when planning for retirement. Every year, you pay the U.S. government taxes on your income, including withdrawals from tax-deferred retirement accounts, and capital gains on assets sold. Retirement can be even more expensive if you don’t plan for your tax burden.
That’s why any retirement plan should be looked at through the lens of taxation before you make financial decisions. Everybody owes taxes, but that doesn’t mean you can’t be smart about how much you’re required to pay. Evaluate your tax picture and create efficient strategies to pay no more than your fair share.
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Understanding tax buckets
Before creating a tax strategy, you need to understand the three main tax buckets:
Bucket No. 1: Tax-deferred
This includes traditional 401(k)s, 403(b)s, IRAs and other retirement accounts in which you contribute pre-tax money and pay taxes when you withdraw from them. Many companies offer to match their employees' contributions to tax-deferred accounts, a big boost for employees. Most taxpayers can also get annual tax deductions on the contributions they make to tax-deferred accounts. These accounts are typically where retirement savers have most of their money. Starting at age 73 for most people, tax-deferred retirement plans require annual mandatory withdrawals, called required minimum distributions (RMDs). You’re required to pay ordinary income taxes on the withdrawals.
Bucket No. 2: Taxable
This bucket is most familiar because everyone pays taxes on the income they earn for their work, either through an employer or self-employment. This bucket also includes taxes on interest-bearing accounts (such as checking and savings accounts) and on capital gains from selling stocks and other investments. When you withdraw from your tax-deferred bucket, that money moves to this bucket and counts as taxable income. Your tax rate is based on your current income tax bracket. The more income you report, the higher your tax rate.
Bucket No. 3: Tax-free
This bucket consists of accounts that hold after-tax dollars — in some cases, taxes were paid when you contributed, and in others, your earnings are tax-free. Roth retirement accounts, municipal bonds, Section 7702 life insurance policies and more fit into this bucket.
Evaluating your tax picture
You have to ask yourself the right questions when planning for retirement. Which tax buckets do you have to choose from? What will your expected tax bill be throughout your lifetime, with and without a Roth strategy?
Most people have the majority of their money in the tax-deferred bucket, meaning they still owe taxes on a large portion of their retirement savings. Those taxes can be costly in retirement and significantly reduce the value of those assets.
You might consider taking advantage of today’s historically low tax rates to convert some of your tax-deferred savings to Roth IRAs. Many Americans with access to Roth retirement accounts don’t take full advantage of them.
The top federal income tax rate is 37%, compared to a high of 94% in 1944. With a large federal deficit and a shrinking Social Security trust fund, taxes are likely to increase in the future. Planning to take advantage of future tax rates without knowing what they’ll be is like signing a mortgage without knowing the interest rate. Kicking the tax can down the road now could lead to a larger tax bill later.
Creating a tax-efficient strategy
I haven’t met a single person who doesn’t like tax-free wealth in some way, shape or form. A good tax plan spells out how to efficiently move your money from the tax-deferred bucket to the tax-free bucket. It’s important to disinherit Uncle Sam from your retirement a little bit at a time.
While each financial situation is different, start crafting a strategy as soon as possible. Making strategic contributions to retirement accounts and doing Roth conversions can help you maximize your wealth by capitalizing on interest-free growth. For example, many employers will match a percentage of your retirement contributions into a tax-deferred account. If you’re five to seven years away from retirement, contribute enough to get the full match, then use the rest of your retirement contributions to diversify your portfolio and take advantage of tax-free opportunities.
Taxes need to be a part of your retirement planning process. The blind spot of taxation can cost you greatly in your golden years. The sooner you can plan for taxes, the more efficient your retirement plan will be. A financial professional can help evaluate your retirement plan and create efficiency that could lower your tax burden.
The commentary on Kiplinger.com reflects the personal opinions, viewpoints and analyses of the author, Matthew Eilers, and should not be regarded as a description of advisory services provided by Foundations Investment Advisors, LLC (“Foundations”), or performance returns of any Foundations client. The views reflected in the commentary are subject to change at any time without notice. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security, or any security. Foundations manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Foundations deems reliable any statistical data or information obtained from or prepared by third party sources that is included in any commentary, but in no way guarantees its accuracy or completeness.
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