By Pete Benson, Co-founder of Beacon Capital Management.
What excites you most about retirement?
Less obligation? More travel? Kissing your day job good-bye?
I bet what doesn’t make your list is paying taxes. Unfortunately, taxes follow us into retirement—but proper planning can keep them from stealing from your hard-earned income when you need it most. Here’s how to reduce taxes in retirement:
1. Diversify Your Tax Buckets
Most people understand the importance of diversifying their investment portfolio, but forget to diversify their taxes. Here’s what I mean:
There are two different tax buckets your investments may fall in. Since each bucket has a different advantage, proper planning can minimize the taxes you pay, either annually or in the future.
The two types of tax buckets are:
Taxed Now
The “taxed now” bucket holds investments where you pay the taxes as you go. You will receive 1099 forms for these investments at the end of each year and pay taxes on them, just like the rest of your income.
That means by the time you retire, this income will be tax-free and your money is all yours!
“Taxed now” investments include:
- Roth IRAs
- Roth 401(k)s
- Certificates of Deposit (CDs)
- Non-qualified accounts (via capital gains)
- Municipal bonds
- Appreciation of capital assets held until death
- Life insurance (if properly structured)
There are limits on how much you can put in some “taxed now” investments. For example, you can only contribute up to $7,000 in a Roth IRA per year (or $6,000 if you’re under 50 years old), per the IRS.1
Taxed Later
“Taxed later” refers to many traditional retirement investments which are tax-deferred. Even though you’re saving on taxes today, you’ll have to pay up later on—likely in retirement.
“Taxed later” investments include:
- Traditional IRAs
- 401(k), 403(b), or 457(b) accounts
- Qualified and non-qualified annuities
- Appreciation of unsold mutual funds and securities
- Savings bonds
Investments in this bucket are advantageous in the present because they save you from owing taxes on that money at the end of the year. While your accountant may like this strategy, those of us in the retirement space don’t love it. That’s because if you keep pushing off your taxes to the future, you’ll owe in retirement. Keep reading to understand why that could hurt you. . .
The Threat of Tax-Deferred Investments
There are two major risks with choosing “taxed-later” investments during your working years:
- Once you’re retired and withdraw income from your investment assets, the tax rate may very well be higher than it is now.
- You’ll be forced to pay the tax bill at a time in your life when you don’t have a full-time job and your income may be strapped.
So, you can either pay your taxes now and reap the harvest later, or wait to pay on the harvest when that time comes.
We have reason to believe the cost of taxes will only go up. The government will need to pay for our growing national debt, plus countless social and infrastructure programs, somehow. Uncle Sam’s favorite income generator tends to be raising taxes.
Therefore, deferring most or all of your tax payments until you’re no longer working is a potentially risky tax strategy. Again, the major advantage you have in your working years is your income—so, you’re in a better position to pay those taxes. You don’t want to be surprised by a huge tax bill when you’re already retired and on a fixed income.
2. Use a Roth Conversion
Now that we’ve covered the importance of utilizing your “taxed now” bucket, maybe you’re re-thinking some decisions you’ve made up until this point. Thankfully, even if most of your investments are currently in a “taxed later” bucket, there’s something you can do: you can use a Roth Conversion.
With a Roth Conversion, you can convert a traditional IRA into a Roth IRA, making the proactive decision to go ahead and pay those taxes now. There are some factors to consider before making the switch, like your age and stage of life. Be sure to talk to a trusted financial advisor to see if this is a good option for you and your specific goals.
3. Get a Tax Reduction Analysis
You probably want to minimize the amount of taxes you pay in retirement and keep as much of your money as possible to enjoy for yourself, right? After all, you didn’t save and invest that money so diligently for Uncle Sam to swoop in and take more than he should.
That’s why it’s critical to look ahead at your tax bill and create a tax-savings strategy today. If you have at least $250,000 saved for retirement, it’s well worth it to take advantage of our free Tax Reduction Analysis. This analysis looks at your future at your tax situation to help you put tax strategies in place today and potentially reduce what you pay in retirement.
Make sure you’re not leaving any money on the table. Get our free Tax Reduction Analysis for a deep dive into your portfolio to explore your options.
4. Avoid Early Withdrawal Penalties
Want to retire early? That sounds great—until you realize you could lose 10% of your retirement income. If you choose to withdraw from a traditonal IRA before age 59 ½, or a 401(k) before age 55, you’ll likely have to pay a 10% tax penalty.
You can avoid the early withdrawal penalty by using the funds for:
- The purchase of your first home (up to $10,000)
- College costs
- Large healthcare expenses
- Health insurance if you’ve been laid off
You can also withdraw funds from a Roth IRA without paying a penalty if it’s at least five years old. Funds can be withdrawn before the five years, but you’ll pay taxes and penalties. It’s best to speak to an experienced financial advisor before making any moves that could trigger a penalty.
5. Take the Correct Required Minimum Distributions
You will be required to start withdrawing from your IRAs and most 401(k)s when you turn 73. These withdrawals are called RMDs, or required minimum distributions—and they’re calculated by the IRS. Once you take them, you’ll need to pay income tax on any withdrawals that came from your “taxed later” bucket.
The year you turn 73, your first RMD will be due the following April 1. After that, RMDs are due Dec. 31 annually. Beginning in 2033, the age for taking RMDs will increase to 75.
Don’t miss taking your RMDs! If you forget to take them, or don’t take enough, you’ll owe a 25% penalty on the amount that should have been distributed.
Reduce Your Taxes in Retirement Today
In his retirement planning book, “Retiring Well,” Michael Reece, CFP, makes the case that a Certified Financial Planner is better suited to create a tax plan for your retirement than a regular CPA would be. That’s because a financial planner will be looking and planning ahead.
Tax planning isn’t one-size-fits-all. There are many factors to consider when determining the best tax strategy for you, like when you’re going to claim Social Security, the amount of money in your investments, when you’re going to retire, and more. My team is ready to help you navigate the challenges of creating a strong retirement income plan. Give us a call any time: 615-716-2061.