It's one thing to build up your retirement savings so you can retire. But remember, every dollar you save in tax-deferred plans, including 401(k)s and traditional IRAs, will be taxed when you withdraw money in retirement.
It’s also important to plan so that you can minimize that tax bite after retirement.
If you haven’t thought about tax planning yet, it’s not too late. Here are eight strategies to consider as you approach and enter retirement:
1. Know what you spend. Many people believe their expenses will go down in retirement, but the reality depends on the lifestyle you want. Do you plan to travel? Take classes or start a new hobby? Help out your children and grandchildren? These activities will cost money. And don’t forget about health care costs.
Understand what Medicare and supplemental health policies will provide and what you’ll be paying out of pocket. Once you have a firm grasp on your expenses, you can strategically plan your withdrawals.
2. Know your tax bracket. Staying in a low tax bracket can help retirees minimize the tax they pay on their withdrawals. When your income reaches specified thresholds, you pay gradually higher amounts of tax on the additional income.
Check out the tax rate schedules, tax tables and cost-of-living adjustments for certain tax items for the current tax year. If your withdrawal plan puts you into a higher tax bracket by a hair, you might want to lower the amount you plan to pull out.
3. Diversify. Having a variety of accounts that are taxed differently can provide flexibility when it comes to taking withdrawals in retirement. Your retirement savings may include a pension, IRAs, a 401(k) account, and stocks, bonds and mutual funds not held in tax-deferred accounts. Consider drawing from different buckets.
Taking funds from already taxed accounts, such as Roth IRAs or Roth 401(k)s, may be better than withdrawing from all accounts equally. Leaving your tax-deferred accounts, such as traditional IRAs, to grow reduces taxable income. One caveat: If you are 72 or older, you must take required minimum distributions.
If you don’t have a Roth IRA or Roth 401(k) you might want to consult an accountant, a CFP® professional or your human resources department about opening one, or even transferring some of your retirement savings into one. If you have had a Roth IRA for more than five years and are older than 59½, you can withdraw money tax-free.
4. Think about using a Roth IRA, but be careful. If you don't have a Roth, and you're a high earner and therefore precluded from opening a new Roth, you can still establish one by putting contributions in a traditional nondeductible IRA and then converting it to a Roth later on. But there's an important trap to avoid.
If you have other IRAs that were funded with deductible contributions, the amount converted to the Roth is considered to have come pro-ratably from all your IRAs, and not just from the nondeductible IRA you set up to convert to the Roth. As a result, some of your conversion may be taxable.
5. Plan to delay withdrawals. If financial markets are rising, enjoy the ride and wait to withdraw. You’ll pay taxes on the gains later. If you don't need to pull money from IRAs, 401(k) and other tax-deferred accounts, hold off as long as you can or until you must take required minimum distributions. Let those accounts continue to build up on a tax-deferred basis until you need them.
6. Know the rules for Social Security. The stark reality is it does not generally pay to claim Social Security retirement benefits before full retirement age. That's age 66 for people born between 1943 and the end of 1954. The retirement age increases in two-month increments until age 67, for those born in 1960 or later.
Here's why this is important. While you can claim a Social Security benefit as early as age 62, your benefit will be permanently reduced. For those whose full retirement age is 67, taking Social Security at age 62 would result in a 30% benefit reduction. In that case, if the full retirement age benefit is $2,000 a month, claiming at 62 would cut the monthly benefit to $1,400 a month.
If you are married, widowed, or divorced having been married for more than 10 years, your claiming strategy gets a bit more complicated, but making the right choice can be even more profitable.
Talk to a CFP® professional or another financial professional about strategies you should consider. Your Social Security income is also taxable, depending how much income you receive from other sources, including withdrawals from retirement accounts.
7. Decide where to live. For many, the ideal place to retire is someplace with a warmer climate, more affordable housing, and close to family or friends. But another important factor to consider is how your income and assets will be taxed.
Some states have no income taxes for individuals; others don’t tax Social Security benefits and most income from pensions and retirement accounts. Check out the 10 Most Tax-Friendly States for Retirees.
8. It all starts with a plan. It’s important to have a plan in place before you retire. But even if you’re close to retirement, it’s not too late to take advantage of the benefits of tax planning. A CFP® professional can help you identify your goals and develop a personalized plan that will maximize your income and reduce your taxes in retirement. A CFP® professional will also work hand in hand with your accountant to ensure your plan is executed properly.
But remember, unexpected circumstances can arise and tax laws are constantly changing. Meet with your advisors on a regular basis to make sure you remain on track. Balance your need for income against what you truly enjoy in life, so that you can avoid paying unnecessary taxes.