Sadly, tax planning doesn’t end when you retire.
The Internal Revenue Service (IRS) still wants its share of your retirement earnings. While many live on less in retirement, others may end up spending more. That could lead to higher tax bills, especially if tax rates are raised in the future.
Nothing is certain except death and taxes as the saying goes. How can you make the most of your life savings and keep more of your hard-earned money from the tax man? First, do what you can to avoid the following retirement tax mistakes that can wreak havoc on your financial independence. Avoiding them can help you wring every last dollar of enjoyment from your retirement nest egg. Ignoring them could result in paying more taxes and potentially running out of money before you run out of life.
Here are the 6 Retirement Tax Mistakes that can ruin your dream retirement.
Retirement Tax Mistake #1: Assuming you will pay less taxes in retirement
Many Americans are drastically unprepared to maintain their current standard of living in retirement. Additionally, paying less taxes and falling into a lower tax bracket doesn’t automatically happen once you retire. Sadly, many people who end up paying less taxes in retirement achieve this by just having a lower income. Leading to a lower standard of living and a lower tax bill.
If you have been paying attention, you’re aware that our national debt is skyrocketing. Some might say ballooning out of control. Ten-thousand baby boomers are leaving the workforce every day and moving onto the rolls of government programs like Social Security and Medicare. Providing those benefits costs money, lots and lots of money. Will the Federal Government be able to honor all of its obligations without raising taxes? This financial planner says no. Taxes will have to go up or benefits will have to be cut. Additionally, many of the tax-saving provisions in the Trump tax plan are set to expire within the next few years.
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 Keep in mind that taxes will be due once funds are withdrawn from those accounts.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 Social Security Taxation
Have you heard of a thing called provisional income? If you answered no, you aren’t alone. Provisional income is what the IRS uses to determine whether or not your Social Security benefits will be taxed. Yes, Social Security benefits can be taxable.
Distributions from your IRA or 401(k) accounts 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 or not you will be above those 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: Forgetting about Roth IRAs and Roth 401(k)s while you have the chance
The contribution limit for a Roth IRA is $5,500, per year. 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 $5,500, each year, into a Roth IRA isn’t likely to grow enough to help you achieve financial independence. Luckily, there is now a Roth 401(k) option with an $18,500 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 $199,000, per year, 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 withdrawal) 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, “That looks pretty good. I could live off that.”? But then you realized that the number shown 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 hard to make up the difference. It’s important to point out that for those with large retirement nest eggs, federal taxes can be as high as 37% (current tax rates for 2018). Additionally, state taxes can also be high. California’s tax rate is 13.3%. States with high 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 isn’t much tax planning needed. For everyone else, a penny saved is a penny earned as they say. Be proactive. Take the time to do some 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, or 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 actually 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 continue 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 of 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’s 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 time and paying as little as possible on each withdrawal.
Bottom line – don’t 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.
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