One thing retirees may forget to leave off their cash flow plan is taxes, but effectively managing taxes in retirement is critical to insulating your nest egg.
Tax-saving strategies can help free up assets for holiday gifts, family trips, charitable donations, and even a lasting legacy for future generations.
So how can you avoid paying unnecessary taxes in retirement? It starts with proactive tax planning to keep more of your money funding your ideal lifestyle.
Why Proactive Tax Planning in Retirement Matters
Taxes can threaten the amount of income you can actually spend from your nest egg.
If you save a generous sum for retirement but the IRS takes an unnecessarily high percentage, it can hurt your overall financial plan.
You should be able to spend your hard-earned money on a long and healthy retirement in the ways that are meaningful to you. And you certainly don’t want to lose any money due to unexpected (or avoidable) taxes.
That’s why it’s essential to employ tax-efficient strategies when planning how to allocate your retirement funds, the types of retirement savings accounts you will use, and what age you will begin taking distributions.
Once you retire, taxes don’t work the way you’re accustomed to. You should know what portion of your retirement income will be taxed and how to create a strong plan that protects your finances.
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How Taxes Work in Retirement
You’re likely used to payroll taxes taking a percentage of your paycheck, but how does it work when your “paycheck” comes from multiple sources?
Let’s break it down.
In 2023, under SECURE Act 2.0, the age to begin taking required distributions from your tax-deferred accounts (like IRAs, 401(k)s, etc.) increased from 72 to 73. In 2033, the age will change to 75. Therefore, you must begin taking distributions from your retirement savings at age 73 in 2023, and most distributions from retirement plans will be taxed at the standard Federal Income tax rate. But certain investment accounts may be exempt if you invested after-tax dollars.
It’s important to note that all streams of retirement income (think Social Security, pensions, investments) will be added together to determine how much you will pay in Federal and State taxes.
So, if you have several streams of retirement income, your effective tax rate could end up being higher than it was on a salary.
Because of this, it pays to be proactive.
For many accounts, you can request that taxes be taken out preemptively. If you choose not to do this, you may have to start making estimated quarterly payments to avoid underpaying and being slapped with a penalty come April.
Top Retirement Income Sources and Taxes
In your career, you likely had one primary source of revenue, which makes planning for how much you’ll owe in taxes a whole lot easier. In retirement, it can be a bit more complicated.
That’s because retirement income can come from several sources, which fall under two major umbrellas: guaranteed income and personal investment income.
How the Government Taxes Guaranteed Income
Guaranteed income includes retirement plans that will give you monthly benefits (think pensions, Social Security, or annuities).
Pension
Pensions can be public and private retirement systems and are typically employer-based plans through which you will receive monthly benefits. Unfortunately, they are subject to Federal tax withholding.
Whether a public or private employee, you will pay a standard Federal tax rate on your pension (between 10% to 37%, depending on your total retirement income). The only way to avoid being taxed on your pension is if a portion of your distribution comes from an after-tax investment, such as a Roth IRA.
Social Security
Another top retirement income source is Social Security. AARP reports that 56% of Social Security recipients owe taxes on their Social Security benefits. However, the percentage of your taxable benefits is determined by your total taxable retirement income.
If you make more than $34k a year as an individual, or more than $44k if you’re married and filing jointly, up to 85% of your Social Security may be taxable.
Annuity
Annuities are another form of guaranteed income that is a popular, private alternative to a pension. You can buy an annuity for a large lump sum and receive distributions from it monthly for the rest of your life. Some or all of these distributions will be taxed as ordinary income (depending on whether the annuity was purchased with pre-tax or after-tax dollars), and a portion may even be withheld for taxes.
How the Government Taxes Your Personal Investments
While most guaranteed income is subject to income tax, personal investment income is a bit more complicated.
A 401(k) allows you to defer taxes, meaning you don’t pay taxes on the money up front. However, you will need to pay taxes on the money as soon as you begin receiving payments. The same concept is true for Traditional IRAs.
Brokerage accounts operate differently. Unlike tax-advantaged accounts like 401(k)s and IRAs, you don’t receive a tax benefit for contributing. You fund the account with after-tax dollars, unsold gains grow tax-free, and you pay capital gains tax (short- or long-term depending on how long you held the asset) when you sell securities for a profit. Dividends and interest payments are also taxed in the year you receive them.
Are Any Accounts Spared?
Yes! Roth accounts allow you to pay taxes on money up front and then save on when you withdraw. There are two major types of Roth accounts for retirement – Roth IRAs and Roth 401(k)s:
- Roth IRAs are personal investment accounts that allow you to invest after-tax dollars in the market. The 2022 contribution limit is $6,000 (or $7,000 if you’re over 50). There are fairly strict income limits on who can contribute to a Roth IRA.
- Roth 401(k)s are also taxed up front, but employers offer them. The 2022 Roth 401(k) contribution limit is $20,500.
Both accounts are instrumental because withdrawals don’t increase your taxable income. So if you get a higher percentage of your retirement income from Roth accounts, it can help you avoid paying more taxes.
Another type of account spared from taxation is a Health Savings Account (HSA).
The HSA is an investment account designed to help cover medical expenses and is available to anyone with a qualifying high-deductible health plan (HDHP). The money you contribute to your HSA is tax-exempt and can grow tax-free. The catch?
Withdrawals from the account are only tax-free if you use them to pay for qualified medical expenses. So if you use your distributions for anything else, you will have to pay income tax on the amount your account has grown. Fortunately, the definition of “qualified medical expenses” is fairly broad, and includes Medicare and Long Term Care monthly payments as well as flu shots, contact lenses, acupuncture and psychological services.
You can’t contribute to an HSA while on Medicare. But you can draw from the account and put those funds to good use.
Tips For a Rock-Solid Retirement Tax Strategy
As you can see, proactive tax planning in retirement is complex. So, how can you best prepare? Here are some ideas:
Know Your Projected Spending Goals (and Build a Custom Withdrawal Plan)
Start by understanding how much money you want to spend every month/year in retirement to get a sense of your projected tax bracket.
Many people follow the 4% rule, which suggests you withdraw 4% of your portfolio in your first year of retirement and adjust that number for inflation in the years to come.
The problem with this rule is it can be quite rigid. You can also determine the right percentage based on several factors, including your retirement timeline horizon, asset allocation, risk tolerance, and specific lifestyle goals.
Beyond just budgeting out your monthly expenses in a spreadsheet, it’s also a good idea to make a list of larger retirement goals you may have. It could be home repairs, a big family trip, or contributing to your grandkid’s college fund.
It’s a good idea to ask yourself questions to help you determine exactly how much you’ll need:
- How do I plan on spending my retirement?
- What hobbies will I pursue and how much will they cost monthly?
- Are there areas where I predict I’ll spend more – like healthcare, medication costs, or taxes?
- Are there areas where I will be spending less?
- Where do I plan on retiring? What are the cost of living projections?
- How will inflation affect my financial plan?
To calculate how inflation will affect the cost of living, you can use an inflation calculator.
Manage Your RMDs
You’ll also need to create a strategy for Required Minimum Distributions (RMDs). The IRS mandates RMDs for tax-deductible investment accounts like traditional IRAs and 401(k)s. You must start taking distributions by the age of 73 (and at age 75 beginning in 2033), but it’s often a good idea to begin taking distributions earlier.
Why? To manage your tax liability.
Waiting until you’re eligible could end up pushing you into a higher tax bracket than expected. This could have a domino effect on the taxable portion of your Social Security benefits, what you pay for Medicare premiums, additional investment taxes, and more.
If you’re looking to lower your RMD while also giving to charity, once you are over 70.5, you can implement a qualified charitable distribution (QCD) and transfer funds from an IRA to any registered 501(c)(3).
Consider Roth Conversions
An interesting strategy for early retirees to consider is a Roth conversion.
With a Roth conversion, you convert funds from a traditional account into a Roth. This can be a beneficial strategy for early retirees due to their lower tax bracket. Before collecting Social Security, pension income, annuities, and RMDs, there’s an opportunity to convert at a lower tax bracket.
Roth IRAs don’t have any RMDs, and you can pass on assets tax-free to your beneficiaries.
However, any pre-tax dollars you want to convert will be subject to income tax, and you’ll need to be mindful of the 5-year rule. If you withdraw gains before 5 years, you’ll have to pay the penalty.
Ongoing Tax Maintenance
There are additional strategies to help manage your ongoing tax liability, like:
- Tax-loss harvesting: sell assets at a loss to offset gains
- Portfolio rebalancing: realign investments with your preferred risk levels and goals
- Investing tax-efficiently: prioritize low-cost Exchange-Traded Funds (ETFs), make a plan for realizing capital gains, sell strategically, etc.
Creating a Strategy with Expert Help
It’s easy to see how retirement taxes might feel overwhelming. Working with an Abacus financial advisor can help organize your taxes, which in turn can ease anxiety and have you feeling prepared for a rich and exciting time of life ahead.
To learn what tailored retirement strategies your Abacus financial advisor would recommend, schedule a call today.
Disclosure:
This material is not intended to serve as personalized tax and/or investment advice since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances. Abacus Wealth Partners is not an accounting firm. Please consult with your tax professional regarding your specific tax situation when determining if any of the mentioned strategies are right for you.
