Unfortunately, the idea that you’ll automatically pay a lower tax rate in retirement is one of the most common misconceptions about retirement planning in general.
The thinking has always been to defer taxes while you are working when you are at a higher tax rate and then pay taxes at a lower rate when you are retired and making less.
The way the tax code was written, retirees no longer have any deductions (children, mortgage interest etc.) and more of their income is exposed to taxes.
In fact, there are a number of tax traps in retirement that can increase your tax rate in retirement.
After all, working gives you the means to live your lifestyle and save for retirement. This includes any money you set aside in retirement accounts like a 401(k) or an IRA, as well as funds you saved or invested elsewhere.
During retirement, your finances will work much in the same way, although you won’t have a regular job or an income anymore. Instead, you’ll draw down the retirement accounts you worked several decades to build, and you’ll hopefully lean on other passive income streams you have set up.
But just like during your working years, you won’t necessarily get to keep all the money you are able to withdraw from your retirement accounts. You’ll also have to pay your tax bill, which will likely be the largest expense you’ll face during your golden years.
Planning For Your Largest Expense in Retirement – Taxes
Why are taxes the largest expense you’re likely to face in retirement? While this isn’t always the case, most people enjoying retirement have (hopefully) taken steps to pay off their primary home, their cars, and any other debt they have.
A common goal for most people is becoming debt free by the time they retire. Beyond the idea of being debt-free by the time you leave your job, taxes in retirement represent the largest opportunity and risk to your retirement income. They are impacted by the type of retirement account you use to save.
We all know that traditional 401(k) plans are the most popular plans for retirement. This type of account lets consumers save up to $20,500 on a tax-deferred basis in 2022, although those ages 50 and older can save another $6,500 in what is known as a “catch-up contribution’’.
Whichever type of retirement account you have, you don’t pay taxes on money saved in tax-deferred accounts upfront. Instead, contributions to 401(k) accounts, Solo 401(k) accounts, traditional IRAs, and other tax-deferred accounts are able to grow tax-free over time, and retirees don’t pay taxes until they begin taking distributions sometime after the age of 59 ½.
Ultimately, this means distributions from a tax-deferred account are taxed as ordinary income and that those with large nest eggs to pull from will take the biggest hit.
Also keep in mind that Required Minimum Distributions (RMDs) will come into play during the year you turn 72, so you’ll have to take distributions and pay income taxes on those amounts — even if you don’t need the money yet.
Taxes Can Deplete Your Nest Egg Faster
What happens when you owe a big tax bill during retirement? Generally speaking, retirees wind up taking larger withdrawals from their retirement accounts so they can have enough cash to live the lifestyle they planned for all along.
Unfortunately, taking larger withdrawals can deplete your nest egg faster than you planned. These larger withdrawals to cover the additional taxes mean your retirement savings may not last as long as you hoped and can even mean you put yourself in jeopardy of running out of money before you die.
In reality, nobody knows what tax rates will look like next year, let alone several decades from now. However, with the ballooning national debt, it isn’t a stretch to expect that taxes will rise in the future no matter which political party is in power. With that in mind, it makes sense to plan for the worst when it comes to taxes in retirement, even when you’re still hoping for the best.
Tax Traps Can Push You into a Higher Tax Bracket
There are also several tax “traps” that can push you into a higher tax bracket without you realizing it. For example, did you know that Social Security benefits can be subject to taxation by the Internal Revenue Service (IRS)?
The IRS has a range of rules they use to determine who pays taxes on Social Security and the percentage of income that’s taxable, yet couples with incomes over $44,000 per year may have to pay income taxes on up to 85% of the Social Security benefits they receive.
And, what about Medicare? According to the U.S. Social Security Administration, those with higher incomes are required to pay an additional premium amount for Medicare Part B and Medicare prescription drug coverage. This isn’t necessarily a “tax” per se, but it’s an additional cost to plan for in retirement, nonetheless. It’s not just the rich that are paying the Medicare IRMAA surcharges. We see retired state and city workers who have a pension and saved diligently for retirement paying these surcharges.
Forgetting about Required Minimum Distributions (RMDs) is another tax trap you want to avoid, and so is using your retirement accounts in the wrong order. They require you to withdraw a percentage from your tax-deferred retirement accounts so that the IRS can collect taxes on those accounts. This percentage increases every year as you age. So, you have to withdraw more every year even if you don’t need the money.
And if you miss your RMD? The IRS will impose a 50% tax penalty on the amount you should have withdrawn. And this is in addition to the taxes you will owe on the withdrawal.
Some retirees start withdrawing from after-tax accounts and Roth IRA’s early in retirement and postpone withdrawals from their tax-deferred accounts.
Unfortunately, this strategy can leave you with a giant tax bomb you’ll definitely have to deal with later on. And, depending on your other income sources and current tax rates, it could be more advantageous to take withdrawals from tax-advantaged retirement accounts first.
Tax-Free Is the New Debt Free
When it comes to dealing with burdensome taxes in retirement, an ounce of prevention is worth a pound of cure. Fortunately, there are an array of steps you can take now to pay less in taxes later on. Not only can these steps help you lower your actual tax bill during retirement, but they can free up more of your retirement savings for you to spend how you see fit.
It’s important to start as early as possible and put time on your side. The process of lowering your tax liability in retirement takes time. And you will want to work with a firm that can advise you both on taxes and investments.
Strategies to consider include investing in Roth accounts that let you pay taxes upfront now, and Roth IRA conversions. If you have highly appreciated assets such as stocks or real estate that you hold outside of retirement accounts, you may want to sell those sooner than later in order to pay the capital gains taxes before you start taking Social Security.
In the meantime, you’ll also want to think long and hard about the age you want to begin taking Social Security benefits because choosing the right Social Security Timing Strategy can increase your lifetime benefit and protect the surviving spouse.
It’s also important to plan for the impact of increasing RMDs rates and how that will impact your taxes.
If this sounds overwhelming, working with a financial advisor who has experience with tax strategies for retirement is your next best step. With a qualified professional on your side, you may be able to pay a lower tax bill now and later in life.
Here’s what getting a professional opinion can deliver:
- Software that analyzes Social Security rules and shows you how to optimally claim Social Security to maximize income now and later
- A personalized analysis of advanced claiming strategies, including 62/70, Start-Stop-Start, Claim and Grow, and limited-opportunity loopholes like File and Suspend and Restricted Filing
- A tax-smart income plan that shows you exactly how to structure withdrawals from retirement accounts and Social Security to minimize taxes
Financial Services for Real People
Founded for the benefit of clients, Echelon Financial is an independent Austin-based firm with a deep commitment to providing guidance that is free of conflicts of interest, based solely on the sum of our experience and expertise. We are committed to putting client interests first and to stewarding both wealth and well-being for those we serve. We have a singular measure of success: the results we get for our clients.
To learn how to optimize your Social Security, we’re offering a FREE Retirement Assessment to review your taxes, investments, and current financial strategies.
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Informational Brochure: Echelon Financial is a member firm of The Fiduciary Alliance, LLC which is an Investment Adviser registered with the Securities and Exchange Commission. The Fiduciary Alliance’s business operations, services, and fees is available at the SEC’s investment adviser public information website www.adviserinfo.sec.gov or from The Fiduciary Alliance upon request.
This material is for information purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. The content is developed from sources believed to be providing accurate information; no warranty, expressed or implied, is made regarding accuracy, adequacy, completeness, legality, reliability or usefulness of any information. Consult your financial professional before making any investment decision. For illustrative use only.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax professional.
Echelon Financial is a member firm of The Fiduciary Alliance, LLC which is an Investment Adviser registered with the Securities and Exchange Commission. The Fiduciary Alliance’s business operations, services, and fees is available at the SEC’s investment adviser public information website www.adviserinfo.sec.gov or from The Fiduciary Alliance upon request.