Taxes in retirement: three tax planning tips



By: Christina Ioannou and Brad Gotto

Nowadays, thanks to medical and technological advances, people are seeing an improvement in their quality of life that will take them well beyond their sixties. A longer life offers great possibilities, but there are also challenges in balancing the desire to live a life that is both long and financially secure. Barriers like increasing health care spending and maintaining their lifestyle and independence will emerge as retirees navigate their way into retirement.

Whether you plan to work another decade or end your career in the near future, anyone considering retirement shouldn’t overlook the impact taxes can have on their retirement. Brad Gotto, owner / advisor of Fiat wealth management, found in talking about taxes with retirees that many are unprepared for the impact Uncle Sam can have on their wallets as they reach their golden years. He says:

Retirees arrive at the retirement stage where complexity skyrockets. Now it’s no longer: “Here’s your paycheck every month and we’ll automatically withhold taxes based on your income rate. When you get a paycheck, they’ll do it for you. But when you get into retirement, you have this huge amount of money, and it’s up to you to figure out how to pay your tax bill. It’s an intimidating thought process.

The good news is that a few careful planning strategies can make a big difference in the overall amount of money that is left in retirees’ pockets during their retirement years.

Understand the options.

The first part of planning for retirement taxes is understanding the account options available and the tax benefits each offers. Here is the breakdown:

  • Roth: Contributions to Roth accounts are made in after-tax dollars. Examples include Roth 401 (k) and IRAs. Although the income is taxed immediately, the retiree will not owe any tax on the money when they withdraw it in retirement. For a retiree to benefit from these advantages, he must wait five years after his first contribution to withdraw his income tax-free.
  • Taxable: These traditional accounts are made with after-tax dollars. Investments and withdrawals can be made at any time for any reason without penalty. Additionally, if funds increase, they are taxed at the capital gains rate, which is cheaper in almost all scenarios, and if losses are incurred, there are opportunities to write them off on your taxes.
  • Deferred tax: These include accounts like traditional IRAs, 401 (k), and 403 (b) s. These allow immediate tax deductions for the year the contribution is made, but future withdrawals will be taxed at the normal income rate. The IRS requires that at age 72, minimum distributions begin to be made from these types of accounts.

Many operate under the mistaken belief that deferral means they don’t have to pay taxes, and they are later shocked at the impact it has on their income. Gotto says every investment decision is a tax decision. Understanding this is the first step to smart planning for retirement:

There are only three tax brackets that exist for everyone. There’s the pre-tax compartment, which includes 401 (k), IRAs, 403 (b), 457s, etc. You choose not to pay the bill today, but instead pay it when the funds are withdrawn. Then you have the after-tax bucket, and that bucket confuses a lot of people. At the end of the day, it’s just the money that was in your checking account. You then decide to invest it. You hope, of course, that its value increases. And if it goes up in value, there’s always a tax bill, right? But that’s a different tax bill. It is the taxation of capital gains. This is what I call preferential or preferential tax treatment.

This is what is important to note, adds Grotto. Any money withdrawn from this pre-tax compartment is taxed as income, as if a retiree had a job, earned the income, received a paycheck, the government took their share, and the retiree took what was left.

Then there’s that last tax bucket – it’s the tax-free bucket. Once the tax money comes in, you choose to invest it. Gotto says:

Instead of the growth of that money being taxed at that prime or prime rate, there is simply no tax bill. So one of the first things I think people have to do is decide, out of their pile of money, how much is in what bucket? How much is in the compartment where they have already paid taxes on the money invested, but should they be worried about possible tax impacts like capital gains? How much is in that bucket after tax? They should be aware of how much to remove from each bucket and why.

[Related: Getting Ready To Retire? Check These Financial Tasks Off Your List]

Think about the future.

As many retirees are plan their future, they wonder where to put their money: stocks, mutual funds, bonds, etc. The reality is that each of these has a tax impact because, whether or not the money is saved in a retirement account, the IRS still owes money.

Retirees need to plan for their future income and the taxes owed on that income. For example, they should be wondering if their social security will be activated during distributions. For most, but not all, Social Security is taxable.

Other considerations such as pensions, spouse’s income, stock dividends, and other paychecks will impact the amount owed to the IRS. During the working years many are employed, but in retirement retirees tend to have multiple sources of income to consider when taxing, and all are affected differently.

Gotto and his colleagues have discovered that tax planning is very neglected when it comes to preparing for retirement. The decision to postpone planning for the future can have dire consequences and reduce the quality of life the experience of retirees later.

[Related: How Savvy Female Business Owners Can Take Advantage of Tax Planning to Save Thousands Off Their Tax Bill Each Year]

Remove taxes when it’s cheapest.

Gotto urges retirees to understand what tax codes exist today. For example, the Tax Cuts and Job Act, passed in 2018, essentially put taxes on sale for the majority of Americans. It would make sense for Americans to start paying taxes on their retirement funds at a lower rate, before that sale ends and the tax rate – and the bill – goes up. Gotto says:

If we start with the end in mind, the big picture, and look at the totality of retirement and figure out how to minimize the IRS in a retiree’s life not just for today, but for five years, ten years from now, and twenty years from now, that can have a huge impact on the overall value or how much money they can actually keep. Unless you take a proactive approach to figuring out how to control your taxes in retirement it can get really ineffective very quickly and quite frankly the IRS can be a much more important part of your life than you want it to be.

[Related: The Heartbreak of Student Loan Debt: How 529 Plans Can Help]

Christina Ioannou is an established professional with experience in advertising, marketing, the arts and design.

Brad Gotto, owner / advisor of Fiat Wealth Management, is part of a team of financial advisers based in the Twin Cities who provide comprehensive financial planning and asset management to their clients. They are independent and therefore teach their clients what is in their best interests. Gotto and his team take anxiety out of their clients’ financial lives. To find out how Gotto and Fiat Wealth can help you, visit Fiat wealth management.



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