When we sit down with client
s to talk about planning their retirement, we hear a lot about what their dreams – travel, vacations, helping kids – and we get a lot of questions about whether their assets will make those dreams possible.
What we almost never hear is questions about a big piece of the retirement puzzle – taxes.
Nationwide does an annual Retirement Income Survey, and they’ve found that 41% of retirees surveyed reported wishing they had been better prepared for taxes leading up to retirement.1
And by better prepared, they mean positioned to pay less and keep more of their retirement nest egg to themselves.
The reason being is that tax laws change frequently, and different types of income are subject to different tax treatments, so many people either forget or overlook the changes that come when they move into retirement.
Taxes are complicated. Laws change, different types of income get different treatment, and your financial picture is different. But if you’re strategic enough, proactive tax planning can save thousands of dollars throughout your retirement. You just need to understand the rules and take the right steps.
First things first, tax rates aren’t always lower when you move into retirement.
Many assume this will be the case when they stop working, but often, you could end up with a similar tax rate to when you were employed.
Picture this – when you’re working, you have specific tax deductions such as a 401(k) plan and HSA account. This helps lessen the blow at the end of the year when it comes to paying taxes.. If you’ve made the push to pay off your home, you’ll benefit from lower expenses, but you also lose the mortgage interest deduction.
When you shift into retirement, you lose these tax deductions, and as the source of your income shifts from salary to investment plan withdrawals, your taxation shifts from ordinary income to capital gains. .
This put more emphasis on the need for proactive and strategic tax planning.
Second, you must consider your RMDs.
RMDs are the minimum amount you have to withdraw from your tax-deferred accounts each year in retirement.
They start 72 and currently, you’re required to withdraw 3.65% in the first year and this percentage increases each year throughout retirement.
This has the effect of not only limiting the potential growth of your investments but can create a higher income – and therefore higher taxes- than you would like. It can also have impacts on Social Security and Medicare, which we’ll get to in a minute. One solution is to do a Roth conversion during the retirement “Sweet Spot” – the window where your income is lower because you’ve stopped working but before you hit age 72. It’s essential to find a balance between investing in different account types because they each have their own advantages.
And finally, you can’t forget Social Security and the Medicare Part B premium surtax.
Most people think of Social Security as tax-free income – after all, it’s a tax you paid while you were working.
That’s unfortunately not the case. In 2021, up to 85% of social security benefits can be taxable, depending on your income level.
In addition to the taxation of social security, higher income retirees may also be subject to an additional tax on investment income: the Medicare surtax. This is a surcharge on your Medicare Part B premium that applies over certain income levels. This is why managing your income levels in retirement is critical. You want to understand how much you need, and how to structure your accounts and any asset sales so that you have a consistent, year-to-year plan.
Couple of other things to remember.
Taxes on estates may be changing.
Given the likelihood of some changes to estate plans in the future, it may a be a smart idea to think through gifting strategies, whether to family or charitable institutions.
This could mean exploring the use of a trust as trusts are extremely flexible and have the added benefit of avoiding probate. If you have appreciated stock – you can gift that directly to a charitable organization. You won’t incur capital gains, and if done correctly it can count as your RMD for the year.
And how you file matters.
In recent years, the standard deduction and became an attractive option for those who may have typically itemized their tax deductions.
The reason is that the standard deduction allows you to save time and simplify your taxes. If you don’t have a mortgage, or property taxes, or charitable contributions – standard deductions may be the way to go.
It simply comes down to running the numbers.
At the end of the day, taxes in retirement play a big role in overall expenses and must be managed carefully.
By knowing how different types of income are taxed and what your available options are, you can begin developing a strategy that helps you keep more money in your pocket.
If you are looking to navigate the big retirement questions, reach out to our team if you have any questions.
- The Harris Poll. 2021 Nationwide Retirement Institute® Tax-Efficient Retirement Income Survey. March 25, 2021. Nationwide Financial.
The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
This content not reviewed by FINRA