For most retirees, including those that have adequately planned their retirement income, the taxes they’re expected to pay is an unpleasant surprise. Chris Chen, a financial planner at Insight Financial Strategists, says most retirees think they don’t have to pay taxes on their income since they are retired. Most also believe that Social Security is tax-free and is surprised to find out it isn’t.
Chen says the major failing in being hit by these taxes is short-term planning. Instead of planning one year at a time, he suggests planning for multiple years to reduce taxes.
Evaluate Your Income Needs
Lauren Zangardi Haynes, a certified financial planner at Spark Financial Advisors, says it’s essential to evaluate your retirement cash flow and identify your income sources.
First, determine when Social Security will start. How much will be your pension income (if any)? She says you also have to be aware of the required minimum distribution, which forces IRA owners and qualified plans participants to withdraw from their retirement accounts.
Most people often make early withdrawals from their Roth IRA and taxable accounts to avoid taxes on traditional IRA withdrawals and then end up with an oversized RMD in their 70s. Haynes says you may find tax-advantages by making a charitable distribution from a traditional account.
Leverage tax diversification
According to Michael Troxell, a CPA and financial planner at Modern Financial Planning, having three buckets of account, taxable, non-taxable, and tax-deferred is a perfect way to position oneself for retirement. So you’ll have a traditional IRA, Roth IRA and brokerage accounts.
This way, you can cherry-pick when pulling out money from your retirement account. For instance, you can pull out money from your IRA account until you max out the 12% tax bracket, which is $77,400 for couples. Next, you can withdraw from your brokerage account before taking money off your Roth IRA.
Plan for the tax window
Adam Beaty, a certified financial planner, says retirees have to be prepared for a tax window when all the income sources in retirement can turn on at once. Beaty says you can be hit hard and miss out on lowering your tax bills if you don’t take advantage of this period.
He says at age 70, retirees would be required to take their required minimum distribution (RMD), and turn on Social Security if they haven’t already. And if the combined assets are high enough, the RMD can cause 85% of Social Security to be taxed, in addition to the taxes from the distribution.
This usually comes as a surprise tax bill and can be avoided with the right plan. The tax window allows retirees to move funds to lower their future tax bills if they are diversified with the three types of accounts; never taxable (Roth 401(k)/Roth IRA), sometimes taxable (brokerage accounts) and taxable (IRA/401(k0)).
Beaty says the tax window is the recommended time to take assets from an always taxable account and putting them in never taxable accounts. Since retirees are likely to have lower income during the tax window, they will save more money by paying taxes.
Lastly, if Social Security is not yet active, it’s an excellent time to spend money out of the taxable accounts and save to the never-taxable accounts.