When people think about retirement planning, they tend to put their focus on saving and investing so they have a nice nest egg when they quit working. And that’s a great place to start. But it’s also important to pay attention to how taxes affect your retirement savings and any other sources of income you’ll tap into once you reach retirement.
Unfortunately, taxes don’t go away when you stop getting a paycheck. Even if you’re no longer working, you’ll still be earning income in the form of retirement account distributions, Social Security benefits and possibly pension payments. And if you underestimate the bite taxes can take — yes, even when you’re in retirement — you could end up losing a significant portion of your hard-earned money.
The good news is there’s a lot you can do to make your retirement plan more tax efficient. Here are four common tax issues you may run into in retirement — and thoughts on ways you might prepare for each.
Tax-Deferred Retirement Plans
The problem: Distributions from tax-deferred retirement plans are taxed as ordinary income.
It makes me nervous when soon-to-be retirees talk about the money in their pre-tax retirement accounts (401(k) plans, 403(b) plans, etc.) as though every penny will be theirs someday. It seems they’ve forgotten that Uncle Sam will eventually want his share — and every withdrawal they make can be taxed as ordinary income.
There are several benefits to owning a Roth account, but a big positive is that once you get your money into a Roth — either with direct contributions or by converting money from an existing tax-deferred account — it can grow tax-free. You can withdraw contributions from a Roth IRA without paying a penalty at any age. And at age 59½, you can withdraw both contributions and earnings without a penalty, as long as your account has been open for at least five tax years.
If you agree with predictions that taxes will be higher in the future, strategically converting funds from your traditional IRA to a Roth IRA over time — and paying taxes in the year you convert — could help you lower your tax obligation in retirement.
You also can roll funds from a 401(k) into a Roth IRA when you leave a job or retire or if your 401(k) plan allows this type of transfer while you’re still employed. Just remember that a Roth conversion is a taxable event: If you move money from an employer’s plan, you’ll have to pay income taxes on your contributions, your employer’s matching contributions and the earnings in your account. Depending on how much you convert in a given tax year, this process could push you into a much higher tax bracket.
Social Security Benefits
The problem: A portion of your Social Security benefits also could be taxed.
Many people don’t realize they may have to pay taxes on their Social Security payments. But if your combined income (adjusted gross income + nontaxable interest + half of your Social Security benefits = combined income) is above the IRS limits for your filing status, you can expect to pay taxes on some portion of your benefits.
What you can do about it: Diversifying your retirement income (with both taxable and nontaxable sources) can help you lower your tax burden.
Again, this is where having a Roth account can come in handy. Or, if you have money in a 401(k) and/or traditional IRA, you might consider taking your retirement income from those tax-deferred accounts before filing for your Social Security benefits. Remember, you can begin taking Social Security at 62, but the longer you delay filing, the larger your monthly payments will be.
You also may want to talk to your financial planner about using indexed universal life insurance as a source of tax-free income in retirement. (This is a more complicated strategy, and it may require some qualified professionals help to get it right.)
Required Minimum Distributions (RMDs)
The problem: If you have a tax-deferred retirement plan, you must take required minimum distributions (RMDs) starting at age 72 — whether you need the money or not. And that will boost your taxable income.
Remember what I said above about Uncle Sam wanting his share of your retirement savings? This is his way of getting it. If you don't take your RMD, or if you withdraw the wrong amount, the IRS can assess a penalty.
What you can do about it: If you’ve moved all or a portion of your money to a Roth IRA, you may be able to potentially avoid or at least reduce the amount of tax you would otherwise have to pay on these withdrawals. (The original owner of a Roth IRA doesn’t have to take RMDs — ever.)
Or, if you have a traditional IRA, you may want to talk to your financial adviser about the qualified charitable distribution (QCD) rule. This IRS rule allows anyone who is at least 70½ to donate up to $100,000 per year directly to a charity from a traditional IRA — and the donation can count toward satisfying that year’s RMD. (Unfortunately, this can’t be done with a 401(k).)
Defined Benefit Retirement Plan, or Pension
The problem: Your defined benefit retirement plan (pension) is fully or partially taxable.
I doubt there are many people who would complain about getting a pension — especially these days when defined benefit retirement plans in the private sector are so rare. But those payments can have a downside when it comes to your taxes.
If you take a lump-sum payout upon your retirement and don’t roll the funds into a traditional IRA, you could lose a chunk to taxes upfront. And if you opt for monthly payments, it could affect your tax bill every year going forward.
What you can do about it: You can start by talking to your financial planner about which payment option is the ideal fit for your overall retirement plan and goals. And if you decide on monthly payments, you may want to ask the company that administers your pension to withhold income taxes so you won’t have to worry about a big bill each year at tax time.
You’ve probably realized by now that the ideal way to approach any tax issue is to be proactive — whether you’re nearing retirement or still years away. An experienced financial professional can help you assess the unique risks in your retirement income plan and suggest the appropriate tax-efficient strategies that fit your goals.
Kim Franke-Folstad contributed to this article.
The appearances in Kiplinger were obtained through a PR program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.
Investment advisory services made available through AE Wealth Management, LLC (AEWM). AEWM and Mueller Retirement Planning, Inc are not affiliated companies. Insurance products are offered through the insurance business Mueller Retirement Planning, Inc. Mueller Retirement Planning, Inc. is also an Investment Advisory practice that offers products and services through AE Wealth Management, LLC (AEWM), a Registered Investment Adviser. AEWM does not offer insurance products. The insurance products offered by Mueller Retirement Planning, Inc. are not subject to Investment Advisor requirements. AEWM and Mueller Retirement Planning, Inc. are not affiliated companies. Investing involves risk, including the potential loss of principal. Any references to protection benefits, safety, security or lifetime income generally refer to fixed insurance products, never securities or investment products. Insurance and annuity product guarantees are backed by the financial strength and claims-paying ability of the issuing insurance company.
Neither the firm nor its agents or representatives may give tax or legal advice. Individuals should consult with a qualified professional for guidance before making any purchasing decisions. Our firm is not affiliated with the U.S. government or any governmental agency. 10/22-1488325
Shawn Mueller is a Financial Planner and the owner of Michigan-based Mueller Retirement Planning, who has earned the Chartered Retirement Planning Counselor SM-CRPC® designation. His mission is to give his clients targeted, comprehensive financial advice with the highest level of personal service and professional integrity. Mueller passed the Series 7 and Series 66 securities exams and has his life, health and annuity insurance licenses. He has a bachelor’s degree from Oakland University and an MBA from Texas A&M University-Commerce. Mueller spends his free time with his wife, Lauren, and their two children.
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