I'm a Financial Adviser: This Is the Retirement Tax Assumption That Could Cost You
Income from multiple sources such as pretax accounts and Social Security can result in a tax bill that might surprise you … and not in a good way.
Many people believe their tax bill will drop once they retire, and while that might be the case for some families, it's not a guarantee.
The thinking is logical. If you're no longer earning a paycheck, you should fall into a lower tax bracket, right? Not exactly.
Once they've left the workforce, retirees often start drawing income from multiple sources, such as Social Security, pensions and retirement accounts, all of which can be taxed.
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A new set of tax considerations
For many retirees, a large portion of those retirement savings is also held in pretax accounts, which means withdrawals can be taxed as well. This can create a new set of tax considerations many retirees didn't need to deal with in their working years.
Without proper tax planning, or a clear understanding of how these income sources might be taxed, retirees could be surprised when the tax bill comes.
Although no one can predict future tax policy changes, taking time to plan ahead can give you a better understanding of how your income will be taxed under the current law. From there, you can make adjustments before retirement begins.
Estimating future income and understanding which tax bracket you'll likely fall into can help you evaluate strategies that might help reduce lifetime tax liability.
Where to start
Reviewing the balance between pretax, after-tax and tax-free accounts and determining whether certain tax strategies make sense for you is a great place to start.
If you find a majority of your retirement savings is in pretax accounts, future withdrawals might create a larger tax bill.
At the same time, converting everything into tax-free accounts isn't necessarily the right answer either.
The goal is to find the right balance between pretax, after-tax and tax-free assets so that income in retirement can be generated as tax-efficiently as possible.
A strategy that often comes up in retirement tax planning is a Roth conversion. This allows you to move money from a pretax retirement account into a Roth account by paying taxes at the time of the conversion.
Roth conversions aren't always the right decision for everyone. The more important question to consider is whether it makes sense based on your current income, expected retirement income and long-term tax strategy.
Retirement might be the end of your career, but that doesn't mean it's the end of financial planning.
Understanding how different sources of retirement income are taxed and taking time to develop a tax-efficient plan before you retire can help reduce tax burdens while giving you peace of mind and a sense of preparedness ahead of your next chapter.
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