When people think about their retirement plans, they often focus on saving and investing so that they have a good nest egg when they retire. And that’s a good place to start. But it’s also important to consider the tax implications of retirement savings and other sources of income you can use when you reach retirement.
Unfortunately, taxes don’t go away when you stop getting paid. Even if you no longer work, you will still receive income in the form of retirement account distributions, Social Security benefits and possibly pension payments. And if you underestimate the potential tax liability – yes, even in retirement – you could be losing a large portion of your earnings.
The good news is that there are many things you can do to make your retirement plan more effective. Here are four common tax issues that can arise in retirement – and thoughts on how you can prepare for each one.
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Tax Deferred Retirement Plans
The problem: Distributions from tax-deferred retirement plans are taxed as ordinary income.
I cringe when soon-to-be retirees talk about the money in their pre-tax retirement accounts (401(k) plans, 403(b) plans, etc.) as if it’s for them. those one day. They seem to forget that Uncle Sam will want his share — and that any withdrawals he makes are taxable as ordinary income.
What you can do about it: Consider using a Roth IRA or Roth 401(k) along with (or instead of) a 401(k) or similar plan.
There are several advantages to having a Roth account, but the best is that when your money goes into a Roth — either with direct contributions or by transferring money from a tax-deductible account — can grow tax-free. You can withdraw contributions from a Roth IRA without paying a penalty in any year. And at age 59½, you can withdraw contributions and earnings without penalty, as long as your account has been open for at least five years.
If you accept the assumption that taxes will be higher in the future, strategically shifting money from a traditional IRA to a Roth IRA over time – and paying taxes later the age at which you convert – may help you reduce your pension liability.
You can also roll money from your 401(k) into a Roth IRA when you quit your job or retire or if your 401(k) plan allows this type of rollover while you’re still working. . Just remember that a Roth conversion is a taxable event: If you transfer funds from an employer’s plan, you must pay taxes on your contributions, your employer’s matching contributions, and the income in the your account. Depending on how much you’ve changed in a tax year, this step may push you into a higher tax bracket.
The problem: A portion of your Social Security benefits are also taxable.
Many people do not realize that they may have to pay taxes on their Social Security payments. But if your income exceeds the IRS limit for your filing status (earnings + tax-free interest + half of your Social Security benefits = gross income) you can expect to pay you are taxed on a portion of your benefits.
What you can do about it: Maximizing your retirement income (with both taxable and non-taxable sources) can help you reduce your burden.
Again, this is where you can have a Roth account. Or, if you have money in a 401(k) and/or traditional IRA, you may want to consider withdrawing your retirement income from these tax-deferred accounts before filing. your social security benefits. Remember, you can start collecting Social Security at 62, but the longer you delay your application, the larger your monthly payments will be.
You can also talk to your financial planner about using universal life insurance as a source of tax-free income in retirement. (This is a more complex strategy, and may require some expert professional help to accomplish.)
Required Minimum Distributions (RMD).
The problem: If you have a deferred retirement plan, you must take minimum distributions (RMDs) starting at age 72 – whether you need the money or not. And that will increase tax revenue.
Remember what I said above about Uncle Sam wanting his share of the retirement fund? That’s the way he got it. If you don’t take your RMDs, or make incorrect withdrawals, the IRS can assess penalties.
What you can do about it: If you’ve transferred all or part of your money to a Roth IRA, you may be able to avoid or at least reduce the tax you have to pay on those withdrawals. (Roth IRA owners don’t need to take RMDs — ever.)
Or, if you have a traditional IRA, you can talk to your financial advisor about the rules for charitable distributions (QCD). This IRS rule allows people at least 70½ to give up to $100,000 a year directly to charity from a traditional IRA – and the donation can count toward satisfying the RMD that year. (Unfortunately, this is not possible with a 401(k).)
A defined benefit retirement plan, or pension
The problem: Your defined benefit pension plan (pension) is fully or partially taxable.
I doubt many people will complain about getting a pension – especially these days when defined benefit plans are rare in the private sector. But these payments can have a negative impact on your taxes.
If you receive a lump sum in retirement and don’t roll the money into a traditional IRA, you may lose a portion of your early taxes. And if you choose to pay monthly, it can affect your annual tax bill.
What you can do about it: You can start by talking to your financial planner about the best payment options for your retirement plan and general goals. And if you decide on monthly payments, you can ask the company that manages your pension to withhold income tax so you don’t have to worry about big bills. every year at tax time.
You probably know by now that the best way to deal with tax problems is to be proactive – whether you’re close to retirement or many years away. An experienced financial professional can help you evaluate the unique risks of 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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