When people think about retirement planning, they tend to focus on saving and investing so that they have a nice nest egg when they leave work. And that’s a good place to start. But it is also important to pay attention to how taxes affect your retirement savings and any other sources of income you will tap into once you reach retirement.
Unfortunately, the tax does not disappear when you stop getting a paycheck. Even if you are no longer working, you will still receive income in the form of retirement account distributions, Social Security benefits and possibly pension payments. And if you underestimate the tax about the district can take – yes, even if you are in retirement – you can end up losing a significant part 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 how you can 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 if every penny will be theirs someday. They seem to forget that Uncle Sam eventually wants to share it – and that every withdrawal they make can be taxed as ordinary income.
There are several benefits to having a Roth account, but the big positive is that when 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 penalty, as long as your account has been open for at least five tax years.
If you agree with the prediction 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 — can help you lower your tax liability in retirement.
You can too roll funds from 401(k) into Roth IRA when you leave your job or retire or if your 401(k) plan allows this type of transfer while you are still employed. Just remember that Roth conversion is a taxable event: If you transfer money from your employer’s plan, you will have to pay income tax on your contributions, your employer’s matching contributions and earnings in your account. Depending on how much you change in a certain tax year, this process can push you into a higher tax bracket.
Social Security Benefits
The problem: A portion of your Social Security benefits may also be taxable.
Many people don’t realize that they should 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 limit 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 comes 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 start taking Social Security at age 62, but the older you are delay filingyour monthly payments will be higher.
You may also want to talk to your financial planner about using index universal life insurance as a source of tax-free income in retirement. (This is a more complicated strategy, and may require some qualified professional help to get it right.)
Required Minimum Distributions (RMDs)
The problem: If you have a tax-deferred retirement plan, you should take it required minimum distributions (RMDs) starting at age 72 – whether you need the money or not. And that will increase your taxable income.
Remember what I said above about Uncle Sam wanting his share of your retirement savings? This is how he wins. If you don’t take your RMDs, or if you withdraw the wrong amount, the IRS may assess a penalty.
What you can do about it: If you have transferred all or part of your money to a Roth IRA, you can potentially avoid or at least reduce the amount of tax you have to pay on these withdrawals. (Original owners of Roth IRAs don’t need to take RMDs — ever.)
Or, if you have a traditional IRA, you may want to talk to your financial advisor about Qualified charity distribution rules (QCD).. These IRS rules allow anyone who is at least 70½ to donate up to $100,000 per year directly to charity from a traditional IRA — and that donation can count toward satisfying that year’s RMD. (Unfortunately, this cannot be done with a 401(k).)
Defined Benefit Retirement Plans, or Pensions
The problem: Your defined benefit retirement plan (pension) is fully or partially taxable.
I doubt there are many people who will 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 payment in your retirement and don’t roll the funds into a traditional IRA, you could lose a chunk of your upfront taxes. And if you choose monthly payments, it could affect your tax bill every year in the future.
What you can do about it: You can start by talking to your financial planner about which payment options are right for your retirement plans and goals. And if you decide on the monthly payment, you may want to ask the company that administers your pension to withhold income tax so you don’t have to worry about a big bill every year at tax time.
You’ve probably realized by now that the best way to approach tax issues 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 recommend a tax-efficient strategy that fits your goals.
Kim Franke-Folstad contributed to this article.
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