Assuming you still have some form of income, tax planning does not end once you retire. The Internal Revenue Service (IRS) will always expect you to pay taxes on your retirement income. For those who are well prepared to maintain their standard of living in retirement, many find their tax bills are similar to when they were working full time. Some of you may even find you are paying more in taxes; this is common for retiring business owners.
As the saying goes, nothing is certain except death and taxes. How can you make the most of your retirement investments and keep more of your hard-earned retirement income from getting sucked up by taxes? First, take the time to do the necessary tax planning to avoid the following retirement income tax mistakes that can drastically reduce your financial security as you age. Making tax-smart moves can help you get the absolute maximum enjoyment from your retirement income. Ignoring these retirement tax mistakes could lead to both paying more in taxes and running out of money earlier than necessary.
The Six Retirement Tax Planning Mistakes That Could Kill Financial Security
Retirement Tax Mistake #1: Assuming Your Taxes Will Be Lower in Retirement
Even if they were able to live tax-free, most Americans are not prepared financially to maintain their standard of living in retirement. Still, many assume their taxes will be lower once they leave the workforce. Those who do end up paying fewer taxes in retirement often do so by simply having a smaller retirement income, which is not likely the dream retirement.
After suffering through nearly four years of the Trump Presidency, we are in the midst of a global pandemic, and the national debt has skyrocketed. Tens of millions of Americans are out of work. Thousands of baby-boomers are reaching retirement age, leaving the workforce, and moving onto rolls of government programs like Social Security and Medicare. We have known for decades that changes will need to be made to keep these expensive government programs solvent. It is hard to see how that will happen without taxes being raised at some point in the future. As a financial planner, I know that cutting benefits would be untenable, politically, and devastating for the millions of retirees who rely on Social Security to meet their basic needs.
On a brighter note, Americans have saved trillions of dollars into tax-deferred retirement accounts like a 401(k) or IRA. Keep in mind that taxes will be due once funds are withdrawn from those accounts. If tax rates increase, you may have similar, or even higher, tax bills in retirement.
Retirement Tax Mistake #2: Not Planning for Taxes on Social Security
Have you ever heard of provisional income? I’m guessing most of you said, “No.” Provisional income is what the IRS uses to determine whether or not your Social Security benefits will be taxed. Yes, Social Security income can be subject to taxation from the IRS.
For those with distributions from retirement accounts like an IRA or 401(k), they count as part of your provisional income. These distributions are added to any 1099 forms you receive from your taxable investments and to one-half of your Social Security benefits for the year. If that income totals more than $34,000 for singles or $44,000 for a married couple, filing jointly, a whopping 85% of your Social Security benefits will become taxable at your highest marginal tax bracket.
Talk to your financial planner to determine whether you will be above those relatively small retirement-income numbers in retirement. There are a variety of ways to strategically minimize the taxes on your Social Security benefits. Lumping IRA withdrawals into one year and diversifying your retirement savings into taxable and non-taxable accounts are a couple of ways. Higher earners (above $200,000 per year) may want to check out the Rich Person Roth IRA for even more tax-free income in retirement.
Retirement Tax Mistake #3: Not Contributing to Roth IRAs and Roth 401(k)s While Eligible
The contribution limit for a Roth IRA is just $6,000, per year, in 2020. For the average American, only saving that amount each year, and only having one type of retirement account, will most likely not be enough savings for retirement. Yes, you read that right. Solely contributing the maximum amount of $6,000 each year into a Roth IRA will not likely grow enough to help you achieve financial independence. Luckily, there is now a Roth 401(k) option with an annual $19,500 contribution limit. However, your employer has to offer this option as part of the employee benefits package.
Many of you reading this will likely make too much money to contribute to a Roth IRA. Married couples making more than $203,000, per year, in 2020 are not eligible to contribute to a Roth IRA at all.
Some of you might be asking, “Why is ignoring a Roth IRA a problem?” The reason is that having both a Roth IRA account and traditional IRA or 401(k) allows you to diversify some of your tax-rate risk in retirement. If you have a big-income year, or taxes are higher in one year, you can pull more money from the Roth (tax-free withdrawals) and less from the 401(k) (taxable withdrawal).
Retirement Tax Mistake #4: Ignoring Taxes All Together
Have you ever looked at a retirement calculator, or projection, and said, “I could live off that amount of retirement income.”? Perhaps you did not realize that the retirement income estimate was before taxes? This problem is easy to fix when you are years away from retirement. When you have already left the workforce, it will be much harder to make up the difference. It is essential to point out that for those with large retirement nest eggs, federal taxes can be as high as 37% (current tax rates for 2020).
Additionally, state taxes can also be high. California’s tax rate is 13.3%. States with lofty tax rates often cause people to ask themselves, “Should I move from my high-tax state after I retire?”
Retirement Tax Mistake #5: No Strategy to Minimize Taxes
For retirees relying solely on Social Security, there is not much tax planning needed. For everyone else with higher retirement incomes, a penny saved is a penny earned, as the saying goes. Be proactive with tax planning. That will help you keep more of your hard-earned money out of Uncle Sam’s hands. If you need a little push, contact a Certified Financial Planner who can help you develop a strategy to minimize taxes.
Retirement Tax Mistake #6: Taking Withdrawals from your retirement accounts in the Wrong Order
Throughout this article, we have been talking about putting off taxes as long as possible and how to minimize taxes in retirement. This often leads people to spend down their post-tax investment accounts first, in retirement. This can lead many to feel like they have more money than they do. Without taxes being due on withdrawals, you will take home more money from a post-tax investment account compared to IRA or 401(k) accounts.
You may see your net worth continues to grow even after withdrawals. That has been especially true over the last few years of the bull market. If that has been the case, you could be sitting on a tax time bomb. Once the post-tax money is gone, all your retirement income will be taxable (assuming funds are held in IRA or 401(k) accounts). You will have little to no options to minimize taxes once that happens.
While it is a bit more complicated, most people will benefit from taking some money from accounts like a 401(k) now. Yes, you would pay taxes when you withdraw the money, but the goal would be to minimize taxes over your entire retirement while paying as little as possible on each withdrawal.
Bottom line – Do not forget about taxes when planning for retirement. A little proactive tax planning will help you earn income in your golden years as efficiently as possible. Also, you want to pay the least amount of taxes as possible so you can keep as much of your hard-earned money as you can.