Failing to Plan for Taxes Could Mean Planning to Fail in Retirement

Think about all the money you have in your tax-deferred savings accounts (like IRAs) and in company-sponsored plans, such as 401(k)s and 403(b)s.

Now think about having a loan against them. That loan is the money you will owe the IRS when you start taking distributions from those accounts.

How much interest will you pay on that loan? In other words, what tax rate will you pay on the money you take out of your tax-deferred accounts in retirement? With proper planning, you can have a say in that number. If taxes are not part of your financial plan for retirement, then your plan is incomplete, and perhaps it’s time to interview a financial adviser who prioritizes tax planning.

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Taxes will go up by law when the Tax Cuts and Jobs Act of 2017 expires after 2025. There’s a good possibility taxes will increase further because of the huge national debt we’ve accumulated. Therefore, you need to ask yourself these questions:

• Do you know your tax liability?
• Do you know how much the amount that you owe the IRS will grow in the near future?
• Do you know what the tax impact will be when your spouse inherits your tax-deferred accounts, or when your children inherit them?

If one spouse passes away and leaves those tax-deferred accounts to the surviving spouse, that surviving spouse becomes a single taxpayer, and their rates are significantly higher. And when children inherit a tax-deferred account, their tax burden can increase as well. Due to the SECURE Act (opens in new tab), most beneficiaries are required to withdraw assets within 10 years following the death of the account holder, rather than over the rest of their lifetime. So, at the age at which most children inherit their parents’ money, they’re probably in the highest tax bracket of their lives.

On the plus side, when working with a tax-licensed financial adviser, you can create tax-free accounts for retirement, reduce your tax load overall and lessen the burden on your beneficiaries. Here are some effective ways of tailoring your retirement plan to tax considerations:

• Roth IRA. The best way to have tax-free income is to pay the taxes on retirement accounts before withdrawing the money. And the best way to do that is by contributing to a Roth during your working years. While your contributions to a Roth IRA are not tax-deductible as they are with a traditional IRA or an employer-sponsored 401(k) plan, distributions made after age 59½ are generally tax-free. The specter of higher taxes in the future compels many people to do Roth conversions — taking some money from a tax-deferred account and putting it into a Roth IRA. The maximum annual Roth contribution in 2021 and 2022 is $6,000, plus $1,000 if you turn 50 by the end of the tax year.
• Health Savings Account. HSA contributions are tax-deductible, gains in the account grow tax-free and withdrawals used to pay for qualified medical expenses are also tax-free. You can contribute $3,600 to an HSA in 2021 ($7,200 for family coverage). If you’re 55 or over, you can contribute an extra $1,000. For 2022 those limits rise to $3,650 and $7,300, respectively.
• Municipal bonds. These are issued by counties, cities and states to fund public projects. The interest you earn on municipal bonds generally is not subject to federal tax. And if the bond is issued in your state of residence, it may be tax-free at the state level.
• Gifting. A smart way to ensure your money stays in the family is to give it to your heirs while you’re alive. For 2021, the IRS allows individuals to give a maximum of $15,000 per person, per year in gifts, and in 2022 that number rises to $16,000. That money is tax-free for recipients.
• Charitable donations. This is another effective way to reduce one’s estate value and related taxable amount. The Qualified Charitable Distribution (QCD) rule allows traditional IRA owners of at least 70½ years of age to deduct their required minimum distributions on their tax returns if they give the money to a charity. Any traditional QCDs must be made directly to the charity and are capped at $100,000 annually per person.

Learning the tax rules and strategies ahead of retirement can make a significant difference in how much you owe the IRS, how much you keep and how much you enjoy your retirement.

Dan Dunkin contributed to this article.