When you think of taxes, what comes to mind?
It’s probably a once-per-year scramble to get all of your paperwork to submit to the IRS. But taxes are so much more than a one-time thing.
Tax planning can change the balance and strategy of your overall financial plan. It can inform decisions to help maximize your assets and help you reach your goals in a more strategic and efficient way.
Tax planning is important throughout each phase of your life, and it can make a big difference in retirement. But many people get confused about what it means to be tax efficient in retirement. For example, people are afraid to even touch their IRA because of taxes. We want to change that. You never want to have a plan that backs you into a corner—now is the time to think further ahead.
Today, we would like to show you what it means to be tax efficient in retirement and how it can empower you to take your financial plan to the next level.
Diversify Your Portfolio for Maximum Tax Efficiency
Diversification is one of the most important tools for an investor. It allows them to divide their assets into varied categories in order to reduce risk while also maximizing return. The specific division of assets is a complex process that relies on the risk tolerance and goals of the individual investor.
What is right for one person may not be right for you and that is ok. The most important thing is that you make smart choices that are in line with your goals, values, and priorities and diversification can help you do that.
While it is important to diversify your assets, it is also important to be tax diversified as well. But what does that mean in the context of taxes? When you are tax diversified, you have your assets in accounts that aren’t all taxed the same. Your profits will be taxed on a unique structure depending on the type of investment or account. Some retirement accounts are tax-deferred while others are tax-exempt. Let’s look at each of these and what they mean to you.
Tax-Deferred Accounts
When an account is tax-deferred, the contributions are not subject to taxes, instead, the distributions are taxed as ordinary income.
Popular tax-deferred accounts include 401(k)s and Traditional IRAs. With each of these accounts, you contribute pre-tax dollars. This is an excellent benefit as it allows you to lower your taxable income for the year, which can be helpful come tax time. Tax-deferred accounts can also allow you to save more throughout your working years.
But once you are in retirement, your distributions will be taxed at your ordinary-income rate. Planning for your taxes in retirement is important as your income streams will change. If you are in a higher tax bracket when you retire, you will end up paying more taxes on the money than you may have expected.
Tax-Exempt Accounts
Tax-exempt accounts require that your contributions be taxed at ordinary income, leaving the distributions tax-free. This is a unique set-up and one that many people overlook. A Roth IRA and Roth 401(k) are the best examples of tax-exempt accounts.
With these accounts, the benefits are discovered in the future leaving them overlooked by many investors. But a tax-exempt account can be an incredible asset in retirement, as the distributions won’t bump you up into a higher tax bracket. Contributing to a tax-exempt account is a great way to prepare and help mitigate your tax bill in retirement.
For your distributions to remain tax-free, you must have held your account for at least 5 years and wait to take distributions until you are age 59 ½ to avoid the 10% early withdrawal penalty.
Brokerage Accounts
Your investments that are held in a taxable brokerage account are subject to taxes. By holding your investments in a brokerage account for at least a year, you will be able to pay long-term capital gains tax on the sale which often comes at a much more favorable tax rate which can be 0%, 15%, or 20% depending on your income. If you sell an investment before having it for a year, you will need to pay short-term capital gains which come at a rate of 10%, 12%, 22%, 24%, 32%, 35%, and 37% depending on your income.
However, it’s important to remember that a gain isn’t guaranteed. If your investments have a loss, you may be able to use that strategy to offset gains in other investments or brokerage accounts.
It is important to keep an eye on your investment strategy and the role taxes play in it to help you keep a tax-efficient strategy going throughout retirement.
Social Security and Taxes in Retirement
It is important to know how your Social Security benefits will be taxed in order to plan when you want to enroll. There was a time when benefits were tax-free for everyone, but that law changed in 1983. Now, Social Security benefits are taxed by your provisional income. This includes your adjusted gross income, any tax-exempt interest, and a portion of your Social Security benefit.
Here is the income breakdown. Your benefits won’t be taxed if you make $25,000 or less. But if you make anywhere from $25,000 to $34,000 (single filer) or $32,000 to $44,000 (married filing jointly), up to 50% of your benefits could be taxed. Anything over those income thresholds can result in up to 85% of your benefits being taxed.
If your benefits are subject to taxes, it doesn’t mean that 50% or 85% of your benefit disappears. Instead, it is the portion that you’ll pay taxes at your ordinary-income rate. The Social Security Administration has a guide to help you estimate your taxes.
How Your Pension is Taxed
Most pensions are funded with pre-tax dollars, meaning that all distributions will be taxed at your ordinary-income rate. But if you make after-tax contributions to the plan, you will need to factor that into the taxes you actually owe. Be sure to check with your particular plan to see how it is funded.
Assess Your Tax Strategy For Retirement
Retirement can be an exciting time. But it is also a time filled with change and uncertainty. It is important to us that you feel empowered and confident in your financial plan.
Taxes are confusing enough and they can get even denser in retirement. Implementing tax-efficient strategies into your retirement plan is a great step to helping you live the retirement you want and deserve.
You’re doing yourself an injustice by not planning it out as perfectly as possible. It is never the perfect time to do something, and there won’t be a “perfect” tax plan. It’s more about discovering and implementing the best plan for your unique goals and situation.
Updated 2/2023.
