The famous quote “nothing is certain, but death and taxes” rings true even during your retirement years. But some people don’t factor having to pay taxes once they stop working. But you still do. Therefore, you need to plan your strategy to minimize your tax burden while you’re still working.
It’s important to monitor your retirement savings and periodically analyze what your future tax situation will look like during retirement. Because it’s a moving target, you need to take the time to review your situation on an ongoing basis.
The goal is to not pay more taxes than you have to. Put together a strategy before retirement that will put you in the best position to minimize your taxes.
Lower your expenses
The first step in your strategy is to understand how much money you will need to live on. If you can lower your expenses before you retire, you will not need to withdraw as much from your traditional retirement accounts each year to live on. For example, perhaps you can pay off your mortgage or car. Then make a budget for what you will need to live in your current lifestyle. The bottom line is less you withdraw from your taxable accounts, the less you will pay in taxes.
Understanding how retirement income is taxed
Most people use 401(k) plans, IRAs and other investment accounts to save for retirement. In doing so, you put away retirement savings on a pre-tax basis. However, when you take that money out, it becomes taxable in the same way normal income is taxed. And after you reach the age of 72, you must take minimum distributions each year from most retirement plan accounts based on an IRS table. Roth IRA’s on the other hand do not require minimum distributions. And under most circumstances, you won’t pay any taxes on the amount withdrawn.
The goal of your strategy is to have access to different types of retirement accounts for withdrawals that can help minimize your taxes.
Diversify your accounts
Divide your retirement savings among tax-deferred, tax-free or taxable accounts. Put some of your retirement savings into a Roth IRA. Then, when you retire and need to begin withdrawing money, you can pull money out of the Roth IRA and 401(k). By doing so, it will keep your taxable income down. Why? Because Roth IRAs offer tax free withdrawals. It’s important to note Roth IRAs use post-tax money and there are income thresholds. So, if you have the financial ability to use post-tax money, but don’t exceed the threshold, this is a good tax mitigation strategy.
Create an after-tax investment portfolio
If you are unable to open a Roth IRA due to the thresholds, another strategy you can use to minimize your retirement tax burden is by creating an after-tax investment portfolio. Let’s say you just retired. You and your spouse decided you need $100K to live on. If you pull that money straight out of your 401k plan, then around $100K is what you’ll be taxed on. However, if you pull $50K out of your after-tax account and $50K out of your 401(k) plan, then approximately $50K will be your taxable income (barring deductions or gains). This strategy helps keep you in a lower tax bracket.
Consider converting your 401(k) to a Roth IRA
If you choose to retire early, another strategy is to consider converting some money from your 401(k) plan into a Roth IRA before having to withdraw the required minimum distributions. So although you would need to pay some taxes on the conversion, when you need money in retirement, you can withdraw what you need tax-free.
Keep an eye on inflation
Just as being cognizant of your tax liability is critical, you also need to keep a watchful eye on inflation. If you talk to elderly people who have been retired for a long time, they’ll tell you they’re surprised by how much things cost these days. It’s important to note the Federal Reserve has been trying to create an inflationary environment to reduce the government’s deficit. To date they haven’t been successful. This is concerning because once it does happen, they may not be able to control it. Thus, you need to be mindful of inflation rates to ensure you’ll have enough money to cover everyday expenses during your retirement.
What Can You Do Now?
No matter which strategy (if any) you choose to minimize your taxes during retirement, the most important thing you can do now is plan! By periodically analyzing your future tax situation prior to retirement, you help ensure there aren’t any surprises that will affect your financial position negatively after you retire. The same can be said for inflation. Plan now to ensure you have enough money to cover expenses during retirement.
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