Tax Planning Shouldn’t Be an Afterthought

There are so many elements of a comprehensive retirement plan, such as claiming Social Security, investing, planning for long-term care costs and estate planning. The one thing they all have income is taxes. Tax planning touches on every element of one’s financial plan, which is why it should never be an afterthought.

The first thing to realize when planning for retirement is that taxes don’t stop when you stop receiving a paycheck. Taxes could still be one of your biggest expenses, which is why you need to integrate tax planning into your overall financial plan.

How Will Your Retirement Income be Taxed?

Although you paid into Social Security during your working years, you may still have to pay tax on your Social Security benefit. If your provisional income as an individual is between $25,000 and $34,000 or is between $32,000 and $44,000 as a married couple filing jointly, up to 50% of your benefit may be taxable. If your provisional income as an individual is over $34,000 or over $44,000 as a married couple filing jointly, up to 85% of your benefit may be taxable. Note that these income thresholds have not increased since they were first instituted in 1984 (opens in new tab), and there are no current plans to adjust them with inflation. If you’re near this threshold, consider that inflation could push you over and trigger this tax.

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If you have a private pension, your pension payments could be taxed at ordinary income rates. If you’re like most retirees these days, you don’t have a pension, but you may well have a 401(k) or IRA. These are tax-deferred accounts, which means that what you take out will be taxed as ordinary income, as well as a 10% federal penalty if you take a withdrawal before age 59½. Keep in mind that at age 72, you will most likely be required to take minimum withdrawals from your tax-deferred retirement accounts. These amounts are set by the IRS and may force you to withdraw more than you normally would in one year, causing an increase in your tax burden.

You may also have other sources of taxable income in retirement, such as investment gains and dividends, rental income from a property, or selling your home. There are potential tax-minimization strategies available for all of these with the right amount of planning and knowledge. For example, at any age, you can take $250,000 tax free from a home sale if you meet requirements, including that you’ve lived there for two out of the last five years – this doubles to $500,000 for married couples. The two years don’t have to be consecutive. This does not apply to other property sales, only primary residences.

Will Taxes Rise in the Future?

We could be living in a time of historically low income tax rates, but this could change soon. Government programs such as Social Security and Medicare are under strain, and government spending increased during COVID. We recently saw President Biden propose a new Billionaire Minimum Income Tax (opens in new tab), which could also affect many people who aren’t billionaires. While this is just one tax proposal, it could be indicative of the direction tax policy will go in the next 10 years.

At the end of 2025, we will likely see the expiration of the Tax Cuts and Jobs Act, and no one knows what will take its place. That’s why it’s important to plan for the tax rates of tomorrow, not just those of today.

Foresight is 20/20

Many of the most effective tax strategies out there require forethought and advanced planning – sometimes years in advance. For example, a Roth conversion is a strategy that could potentially pay off many years down the line. In exchange for paying tax on the retirement savings you convert from a traditional IRA to a Roth IRA at the known tax rates of today, you can enjoy tax-free income in five or more years’ time (after the account has been open for at least five5 years and you’re age 59½ or older).

Consider whether you think taxes will go up, down or stay the same in the next five years. Depending on your answer, a Roth conversion could be a viable long-term tax-minimization strategy.

A Roth conversion could especially be valuable if you have retired and are younger than age 72, the age at which you must start taking required minimum distributions (RMDs) from a traditional IRA or 401(k). Once you reach that “magic” RMD age, you cannot convert any dollars that are a part of your RMD – only dollars over and above your RMD. Many times, this severely restricts one’s ability to continue doing Roth conversions at all. Further, with rising tax rates anticipated in the near future, there is no time like the present to essentially “buy the government” out at today’s historically low tax rates.

If you are charitably inclined and at least age 70½, utilizing a Qualified Charitable Distribution (QCD) could be for you. Simply put, you can send contributions to qualifying charitable organizations directly from your IRA and bypass paying taxes on the amount given. If you would otherwise take the standard deduction, utilizing this strategy allows you essentially to take the standard deduction AND a charitable deduction by way of not having to report the QCD as income.

It's Not What You Earn, It’s What You Keep

As the saying goes, it’s not what you earn, it’s what you keep. When we think about our biggest expenses, we often overlook taxes because we assume there’s nothing we can do to change how much we owe. However, this often isn’t the case. Tax planning and developing tax strategies is one of the five major areas we address in our process of building financial plans for our clients. Viewing tax planning as an integrated part of an overall financial plan instead of a separate afterthought could make a big difference in retirement.