Don’t assume that when you retire your tax liability automatically shrinks. You should start planning tax-efficient strategies now to ease your future tax burden in retirement.
Taxes are one of the most overlooked challenges of retirement finances. We typically think about outliving our assets, the high cost of health insurance and nursing home care or needing to help adult children or other family members financially. However, taxes are a major threat to retirement finances, and advance planning is necessary to deal with their impact, says Kiplinger in “Taxes Can Be a Real Threat to Your Retirement.”
You may have been told that, when you retire, you’ll be in a lower tax bracket compared to when you were working full-time. We’re told to invest as much as we can in our 401(k)s or other plans to get a tax deduction now. When we retire, presumably a home mortgage will be paid off and we won’t be contributing money to retirement accounts, so we won’t need as much income. Because we won’t be earning a salary, our tax burden will be less. But that may not be the case for some.
There are three reasons why some Americans may not get a tax break when they retire:
- Maintaining current standard of living. Most people want to live the same way when they retire, so they need about the same amount of monthly income they had while they were working. That comes with similar tax consequences. Expenses will change, but retirees have extra time on their hands. That time usually gets filled with things that cost money, such as travel, or spending on a new hobby.
- Tax deductions. When you retire, you won’t have the same tax deductions. For example, retirees are no longer contributing to tax-deferred 401(k)s or IRAs. When you stop contributing to retirement accounts and start making withdrawals from them, you will lose a reliable tax deduction and have to pay taxes on the withdrawals in most cases. At age 70 and a half, you are required by law to start making at least minimum withdrawals from your traditional IRA, SEP IRA, Simple IRA, and most 401(k) and 403(b) retirement plan accounts. These withdrawals, if not carefully calibrated, can put you in a higher tax bracket and trigger higher taxes.
- Higher taxes in the future. We can’t predict the future. Our current individual tax brackets are about as low as they’ve ever been. But when political power shifts, changes to tax laws at the federal or state level often follow. Social Security, Medicare and Medicaid are unfunded liabilities that also could require tax increases.
To help prepare for these possibilities, plan now to have as much money as you can in tax-free accounts, like Roth IRAs, Roth 401(k)s, and investment-grade insurance strategies. Always contribute to employer-sponsored 401(k) programs to get any company match available. And talk to a qualified estate tax planning attorney about retirement tax planning.
How Are You Taxed in Retirement?
You still need an income to live after you retire, and you still pay taxes on your income. Retirees tend to draw on multiple sources of income, rather than one or two paychecks from full-time jobs. The question becomes, how are different types of income taxed?
Consider these five common sources of retirement income and how they are taxed:
- Social Security retirement income. Up to 85% of Social Security retirement income is taxed depending on how much your “combined income” of Social Security and other money is. If your Social Security and/or Supplemental Security Income benefits are your only source of income, you probably will not have to pay taxes. If you have other taxable income, such as a pension, you’ll likely pay a tax rate of 15-45% on up to 85% of your annual Social Security retirement income. The IRS provides a worksheet, Notice 703, to help you determine whether you owe income tax.
- IRA / 401(k) withdrawals. The advantage of putting money into a standard 401(k) and similar retirement investment accounts, such as a 403(b) or 457(b) fund, is that contributions are not taxable income. But the money distributed from these accounts years later is taxed as income as it is withdrawn. Once you reach age 70 1/2, most retirement plans require you to withdraw at last a prescribed minimum amount each year. You may withdraw more than the minimum. How much tax you’ll pay depends on your total income for the year, your deductions and your tax bracket.
In contrast, the Roth IRA is a tax-exempt investment program, meaning it is funded with after-tax dollars and when money is withdrawn during retirement, there is no tax. In other words, earnings from a Roth IRA account are tax-free.
- Most pensions are funded with pre-tax income, so the proceeds are taxable. Some programs include pre-tax and after-tax dollars. In this case, only a portion of pension payments will be taxed. When you apply for pension payments, you will be asked whether taxes should be withheld. If they are not withheld, they will be due with each year’s tax return.
- Investment income. Money earned from investments – dividends, interest, or capital gains from asset sales – is taxable. The financial institution that holds each investment account will report the year’s income from the account by sending you a 1099 tax form.
- Home sales. Many retirees downsize for a cash infusion as well as to adjust to their living space needs. If you sell a house you have lived in for at least two years, you will most likely not pay taxes on gains from the sale unless your gains exceed $250,000 and you are single, or $500,000 and you are married.
How Can I Reduce My Retirement Taxes?
Don’t wait until you have to take required minimum distributions from your IRA or 401(k) to start your retirement tax planning. There are options for reducing taxes in retirement. A knowledgeable estate tax planning attorney from Brady Cobin Law Group can help you with tax considerations that could make the difference between struggling to meet monthly expenses and enjoying a pleasure-filled retirement.
Some moves you can make now on your own include:
- Opening a Roth IRA. Build your nontaxable retirement income by investing today. You can contribute up to $6,500 a year to a Roth IRA or $7,000 if you are 60 years old or older. Later, you can adjust your retirement account withdrawals to manage your tax burden by taking more from the Roth in higher income years and more from other plans in years of less income.
- Opening a Health Savings Account. If you have a high-deductible health insurance plan (at least $1,350 for an individual plan and $2,700 for a family plan) you can put pre-tax money into an HSA, which grows tax-deferred and, as long as you spend the money on qualified health costs, is never taxed. In 2019, you can contribute up to $7,000 for a family plan and $3,500 for an individual.
- Reduce expenses. Many retirees expect their expenses to automatically be lower, but active retirees may see the opposite. It takes concerted planning that should begin now. The lower your expenses, the less income you need to live well. Paying off a mortgage is a substantial expense reduction for most households. In the latter years of a mortgage, payments are mostly principal, not interest, so the mortgage tax deduction becomes less of a benefit. Paying your mortgage off as fast as possible as you near retirement is a good preparation for changes in income and taxes that retirement brings.
For more retirement tax planning ideas tailored to your situation, needs and desires, contact the Brady Corbin Law Group today.