During retirement, taxes are likely to be one of your biggest expenses. After years of working hard and saving, lowering your taxes in retirement can help you make your money last longer, boosting the amount you get to spend on yourself instead of paying in taxes.
You may believe that all income is taxed at the same rate, but when you get to retirement you will soon find out that distinct types of incomes have different tax rates, and your timing on when you choose to have your income show up can have drastic effects on your finances.
Read below to learn how these three things impact your taxes and how you can use that to your benefit:
- Where you place your money
- Which account you take money from
- When you take your money out
Now, every tax situation is different, and we simplified examples and rounded numbers to highlight the concepts, so please work with a tax professional to make these suggestions work best for you. Also, here are a couple of definitions that will be helpful:
Important Definitions
Traditional 401(k)/IRA: Accounts you get to save into that give you a tax deduction when you put money in and show up as taxable when you take money out.
Roth 401(k)/IRA: Accounts you get to save into that give you no tax benefit today, but grow tax-free into the future and after meeting some rules you can take money out tax-free.
Regular taxable account: These have no special tax rules like a Traditional or Roth account. If you earn interest, receive a dividend, or sell investments and make a gain, then you will pay taxes on those earnings, whether you took the money out of the account or not.
Where you place your money can impact your taxes:
You may know how Traditional 401(k)/IRA withdrawals work. If you earn bond interest or stock gains, you do not pay taxes until you take it out. If you take money out it shows up as income and you pay income tax rates.
Now what happens when you earn bond interest or stock gains in a regular taxable account? With interest, you pay taxes on those earnings whether you use it in that year or not. For gains, you do not pay taxes until you actually sell that stock, AND if you held it for more than 12 months then you pay a lower ‘long term capital gains’ tax.
Placing bonds inside of your Traditional accounts instead of your regular taxable account lets you control when you pay taxes on the interest. Holding stocks inside of your regular taxable account, instead of your Traditional account could help you pay a lower long-term capital gains tax. For many people this could mean a rate of 0% instead of 12%, or 15% instead of 22%!
I don’t know about you, but I’d prefer to have more control over when I pay taxes, and I’d prefer to pay lower taxes.
Which account you take money from is important:
Say you have $10,000 and it doubles. If you take that $20,000 out of your Traditional account, you will pay taxes on all of it. If you take it from your Roth accounts and meet the rules you will pay taxes on none of it. If you take it from your regular taxable account you will pay taxes on only the $10,000 gain because the initial money had taxes paid on it previously. Because of these tax differences, you would rather increase your Roth accounts, and draw down your Traditional accounts.
What do most retirees do though? They try to avoid taxes this year and wait as long as they can to take money out of their Traditional accounts, which only creates a bigger tax problem in the future. Look at where you are in the tax brackets and try to draw down your Traditional accounts and let your Roth and taxable accounts grow. This will reduce the amount of money you have that is taxable and increase the amount of money you have that is tax-free.
Perhaps you take money out of your Traditional accounts first for living expenses. Another option might be to plan out something called a Roth conversion to move money from Traditional to a Roth account, paying taxes on purpose so that the money can grow tax-free into the future.
When you take your money out can make a big difference:
When you are working, taxes are somewhat simple. You earn money, it goes into your checking account, you spend it and at the end of the year you pay our taxes on it. In retirement you get more freedom and control on when you pay your taxes. You can use this to your advantage.
Let’s assume you have money in a savings account and money in your Traditional account. If you move money from savings to checking and spend it, then you feel like you had “income”. But the government doesn’t tax that money you spent because it’s already post-tax.
The opposite is true for your Traditional 401(k)/IRA. If you take money out, put it in savings and don’t spend it then it doesn’t really feel to you like you had “income”. But the government will tax you on the money you withdrew in that year.
You used to think that earning/spending/taxation all happened in the same year. However, when you are withdrawing money in retirement that’s not necessarily true, and you can use that to your benefit. Let’s say you are a couple who is normally $10k away from the top of the 12% tax bracket each year. If you plan to take out money to buy a car next year for $20k then you would see $10k in the 12% bracket and $10k in the 22% bracket for $3400 of Federal Taxes.
What if instead you chose to take out $10k in December and $10k in January? That would mean you use up the remaining amount in the 12% bracket for both years, paying $1200 in each year, which is $2400 total. Splitting the taxable income over 2 years could have saved you $1,000 in taxes! And if you are on Social Security, because of the complex way its taxed, the difference could be even greater.
When taking money from your Traditional and taxable accounts make sure you are aware of your tax bracket, how far away you are from the next tax bracket, and your options to take money out of specific accounts at specific times.
Plan your way towards a lower tax retirement
Retirement planning isn’t just about buying stocks and bonds. To maximize your retirement, you would be wise to create a withdrawal strategy that pays attention to how your decisions impact your taxes.
Don’t just focus on how much you are spending and which investments you are in. Make a plan for where you hold different investments, which accounts you will be taking money from each year and when you plan on taking your money out.
Jeremy Keil, CFP®, CFA is a retirement focused financial planner with Keil Financial Partners, and host of the Retirement Revealed blog and podcast.
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