When you retire, tax planning is likely at the bottom of the list of things you want to be spending your time on. We believe, starting tax planning for Retirement as early as possible is a great way to keeping taxes low or zero during retirement years. This means thinking about where and when to save your hard-earned income, learning the financial rules of retirement, and picking up some tax strategies to keep in your toolkit.
Diversify Account Types
The amount of tax you pay on your income in retirement depends on a few key factors. These include the type of account you are withdrawing from, your income bracket at the time of withdrawal, and the current tax rates.
While it’s impossible to predict the future, you can act now to ensure that you have the most flexibility possible during retirement. First, you need to understand how taxes work for different account types.
Each type of account has different benefits. For each type, it’s important to remember what the benefit is and when you get it.
When you think about retirement savings, accounts like a 401(k), 403(b), or an individual retirement account (IRA) probably come to mind. These are all examples of tax-deferred accounts.
You receive the benefit of a tax-deferred account when you deposit to the account. Typically, when you make contributions to your retirement fund from your paycheck, it reduces your taxable income, and this reduction lowers the amount of tax you will pay for the current year.
However, you will need to pay taxes when you withdraw funds from the account when you retire. The amount you will pay depends on your income in retirement and the tax rates at that time.
Unlike tax-deferred accounts, you pay taxes on the funds withdrawn from tax-exempt accounts during retirement. Benefits from tax-exempt accounts are realized during retirement, not when you make deposits into them.
However, you make contributions to tax-exempt accounts using taxable income, meaning you pay tax on the funds before they reach the account. If you’re looking to invest in tax-exempt accounts, you can begin by looking at various Roth accounts.
How to Decide
You can make informed decisions about what types of accounts to invest in now by comparing your current income to the income you anticipate having in retirement.
Remember, the lower your income, the less tax you will pay overall. You should select accounts to pay taxes when you have a lower income and realize tax benefits when you earn more.
For example, if you anticipate earning more in the future than you currently do, take advantage of lower tax rates now by saving to tax-exempt accounts.
However, don’t put all your eggs in one basket. Keep your portfolio varied with different types of accounts to give you flexibility and options during retirement. If you’re currently a high earner, take advantage of tax-deferred accounts and other tax reduction strategies.
Plan Your Withdrawal Timeline
When you retire, you gain access to several different income sources. For instance, you can begin making withdrawals on your retirement accounts, selling capital investments, or collecting social security.
Understanding when you will need access to these funds is integral to keeping your tax payments low. Withdrawing from retirement accounts before you retire can result in hefty tax penalties, so ensure that you modify your contributions to match your needs when approaching 65.
At the same time, you need to be realistic about the amount of money you will need to have saved for retirement. Age 50 is a great time to check in to ensure you are saving enough money for retirement without risking the need to withdraw early.
Understanding Your Annual Income
In retirement, there is no fixed annual salary that remains constant. Since the amount of taxes you will pay depends largely on your yearly income, balancing that income (and understanding its fluctuation) is vital to keeping taxes low.
To understand this figure, you’ll need to consider any payments you receive from social security, withdrawals from retirement accounts, and sales of your financial investments. Planning ahead to consider what funds you will need can help you plan when you should tap into each of these resources.
There are also some clever strategies to help you adjust your annual income, which might benefit you during retirement if you are nearing a higher tax bracket.
As one example, consider this: technically, you do not have any gain or loss on a financial asset until it is sold. So the timing of when you sell an asset can dramatically affect your income, and selling an investment that results in a capital loss can decrease your income and offer you tax breaks for that year.
Required Minimum Distributions
Starting at age 72, you are required to make withdrawals from your retirement accounts, even if you don’t need the income. These are called required minimum distributions, or RMDs, and are mandated by the IRS. These count towards your annual income and can affect taxes.
So, when you can, work to exhaust other sources of income before you are required to start taking RMDs. Again, this shows the importance of planning ahead so you are ready to adjust the sources of your income when you start taking RMDs.
Fortunately, there is a valuable exception to the RMD rule. If you are still working in your 70s, you might be able to defer your RMDs if you don’t own more than 5% of the business where you are working. (See the Internal Revenue Code, Section 401(a)(9)(C).)
If you really need money and have hardship, you can do an early 401(k) withdrawal from the 401k in limited cases.
Consult a Financial Advisor
As you can see, there are many moving parts to consider when it comes to tax planning for retirement. Although none of them individually can make or break your success, managing them all together is critical.
Fortunately, financial advisors are always available to help you plan for retirement. Retirement planners are a special kind of financial advisor that can help you prepare financially for retirement and consider how your retirement plans can affect and change other components of your financial strategy.
To best use the expertise of these advisors, make sure you first understand a few essential pieces of info that will determine your approach to reach retirement. These include:
- your tolerance for risk
- your experience and comfort with investing
- your expected time horizon
- your personal goals for retirement
Your retirement planner can offer you valuable suggestions to move forward with that information. Their advice often includes how to handle your mortgage, when to begin accepting social security payments, how pensions can affect your taxable portfolio.
They can even help give you a realistic expectation of how much income you can expect during retirement.
Be aware that most financial advisors will charge for their expertise, but many do so in different ways. Some planners will charge a flat fee, others bill hourly, and some take a commission on your investment gains. Select an advisor with a pay structure that fits your needs.
Learn more about other types of financial advisors, such as CPAs and CFAs, here.
Consider Health Expenses
Just as your income sources will change when you reach retirement, you also need to consider a shift in your expenses. After you leave the workforce, your health insurance options can change, meaning health expenses could increase.
Health can be one of the most significant expenses in retirement, so you will need to have sufficient funds available during retirement. Some estimates suggest that a retired couple could spend up to $300,000 during retirement.
Fortunately, there are tax-conscious options to begin planning for future healthcare costs. Begin with understanding what medicare can and cannot cover.
Setting up a Health Savings Account (HSA) is one of the best options for retirement if you are looking to minimize tax payments. These types of accounts offer tax-free withdrawals for certain medical expenses and tax-deferred growth. Plus, many also offer deductible contributions, meaning you receive some tax benefit upfront.
Depending on your financial and health situation, exploring long-term care insurance options may also be worthwhile.
Prioritize Tax Planning Early
The strongest piece of advice in retirement planning has always been starting early. Doing so can increase your time horizon and offer you more aggressive growth in your portfolio. Plus, it can increase your ability to overcome and outlast market fluctuations.
The mental preparation for retirement is easy (can you smell the salty breeze?), but the financials take work and time. You’ve taken an important first step by exploring essentials in tax planning. Keep this momentum going by continuing to seek out information and resources.