How To Stop Taxes From Harming Your Retirement Goals

When people consider retirement planning, they often prioritize saving and investing so they can retire with a comfortable nest egg. And that is an excellent starting point. However, it is equally essential to consider how taxes will impact your retirement funds and any other sources of income you may rely on after you reach retirement age.

Unfortunately, taxes remain even if you no longer receive a paycheck. Your retirement account distributions, Social Security benefits, and pension payments will continue to provide income even if you stop working. And if you misjudge the impact taxes might have — even in retirement — you could lose a substantial chunk of your hard-earned cash.

Several things can be done to make your retirement plan more tax-efficient. 

Here are four major tax difficulties you may encounter during retirement and suggestions for how to plan for each.

Tax-Exempt Retirement Accounts

Regular income taxation applies to distributions from tax-deferred retirement plans. When future retirees talk about their pre-tax retirement accounts, such as 401(k) plans, 403(b) plans, or even a traditional IRA, they seem to have forgotten that Uncle Sam would ultimately want his part and that each withdrawal is taxable as regular income.

What can be done about it: Consider utilizing a Roth IRA or Roth 401(k) in addition to (or as a replacement for) your 401(k) or similar plan. A Roth account offers several advantages, but one of the most significant is the tax-free growth of funds once deposited into a Roth via direct contributions or by converting funds from an existing tax-deferred account. At any age, contributions to a Roth IRA can be withdrawn without penalty. And if your account has been active for at least five tax years, you can withdraw contributions and profits at age 59.5 without penalty.

Regular IRAs can be converted into Roth IRAs over time – and paying taxes in the year of conversion — might help you reduce your tax liability in retirement if you agree with future tax forecasts.

You can also roll assets from a 401(k) into a Roth IRA if your 401(k) plan permits this transfer while you are still employed. Taxes must be paid on your contributions, your employer’s matching contributions, and your Roth conversion profits if you move money from an employer’s plan. If you convert too much during a tax year, you could be placed in a much higher tax bracket.

Social Security Advantages

A part of your Social Security income may potentially be subject to taxation.

It is possible to be taxed on Social Security benefits for many individuals. However, if your combined income exceeds the IRS thresholds for your filing status, you can anticipate paying taxes on a portion of your benefits.

What can be done about it: Diversifying your retirement income (with taxable and nontaxable sources) can reduce your tax liability.

Roth accounts can be helpful in this scenario as well. Or, if you have funds in a 401(k) and/or a regular IRA, you might withdraw your retirement income from these tax-deferred accounts before applying for Social Security. The longer you wait to receive Social Security benefits, the higher your monthly payments will be, and you can begin receiving benefits at age 62.

You may also choose to discuss with your financial counselor the possibility of utilizing indexed universal life insurance to generate tax-free income in retirement. (This is a more complex technique that may require the assistance of skilled specialists to execute well.)

Minimum Distributions Required (RMDs)

The difficulty: People with tax-deferred retirement plans must take required minimum distributions (RMDs) at 72, regardless of whether or not they need the money. This will increase your taxable income.

Uncle Sam desires a portion of your retirement savings, which is his method for obtaining it. Taking an incorrect RMD or not withdrawing your RMD could result in penalties from the IRS.

Solution: Moved the required RMD or a portion of the money to a Roth IRA; you could potentially avoid or at least reduce the tax you would otherwise have to pay on these withdrawals. (Requirements for withdrawing from Roth IRAs don’t apply to original owners — ever.)

Or, if you have a conventional IRA, you may wish to discuss the qualified charitable distribution (QCD) regulation with your financial advisor. This IRS regulation permits anybody over 70.5 to give up to $100,000 yearly straight from a regular IRA to a charity, with the amount counting against the RMD for that year. (Unfortunately, this is impossible with a 401(k) account.)

Pension or Defined Benefit Retirement Plan

Your defined benefit (pension) retirement plan is entirely or partially taxable, and these payments may have a negative impact on your taxes.

If you take a lump-sum distribution upon retirement and do not roll the money into a regular IRA, you may pay taxes on a portion of the cash upfront. And if you choose monthly payments, it might affect your annual tax bill in the future.

What you can do: Consult with your financial adviser to determine which payment choice best fits your overall retirement strategy and objectives. And if you choose monthly payments, you may want to request that your pension administrator withhold income taxes, so you don’t have to worry about a large tax bill each year.

You’ve likely recognized by now that the best way to address any tax situation, whether you’re nearing retirement or still have years to go, is to be proactive. An experienced financial advisor can assist you in evaluating the risks associated with your retirement income plan and recommending tax-efficient methods that align with your objectives.