Doing Some Tax Planning Now Can Pay Off Later in Retirement
For many people, retirement is not a time to slow down and stop. It’s a time to explore the next great chapters of your life and build upon everything you’ve learned and experienced so far. Another thing that doesn’t slow down or stop is taxes. Understanding how taxes could affect your future cash flow will help you create an effective retirement income strategy.
Know How Your Retirement Savings Accounts Are Taxed
Withdrawals from traditional 401(k) plan accounts and certain other employer-sponsored plans, as well as traditional individual retirement accounts (IRAs), will generally be subject to federal and state ordinary income taxes upon withdrawal.
On the other hand, contributions to a designated Roth 401(k) account or Roth IRA are federally tax-free when you withdraw those funds, as are the earnings, assuming the withdrawal is a qualified distribution, which generally means it is made after a five-year waiting period and the account owner is 59½ years or older.
As for your nonretirement accounts, bond income and some of the dividends you receive from stocks and mutual funds may be taxed at your federal ordinary income rate, but qualified dividends and long-term investment gains are generally taxed at lower long-term capital gains rates. State and local tax treatment may vary.
Develop a Thoughtful Distribution Strategy
For some people, it will make sense to consider tapping taxable accounts first, then tax-deferred. But, depending on the circumstances, this order may not be right for every person. If most of your investment gains are from long-term assets held outside of a traditional 401(k), IRA or other similar tax-deferred accounts, you’ll likely pay long-term capital gains taxes, which are generally lower than what you pay on distributions taxed as ordinary income from your tax-deferred retirement accounts.
You’ll also need to consider the impact of your retirement savings on your taxes once you reach age 73 (or age 75 after 2032). That’s when you must begin taking required minimum distributions (RMDs) from some of your retirement accounts, which is likely to boost your taxable income.
It’s prudent to consult with an advisor or tax professional regarding retirement income and tax planning strategies.
Avoid Moves That Could Put You in a Higher Tax Bracket
RMDs and other changes that bump up your income can result in what’s called “bracket creep,” which is unintentionally slipping into a higher tax bracket. For example, you might receive an inheritance or sell some real estate. You might also slip into a higher tax bracket by taking a large distribution from a taxable account to renovate your home or buy a new car. A higher income can also affect the taxability of your Social Security benefits and increase your Medicare premiums.
This is one reason you may want to consider funding different kinds of retirement accounts during your working years. For instance, you could diversify your retirement contributions and split them between a Roth and traditional (pretax) allocation. During retirement, you can manage the amount of taxable income you receive and make adjustments when necessary. You can also pay for qualified medical expenses
during retirement with any health savings account savings you may have. Those qualified withdrawals are tax-free and won’t affect your taxable income.
Disclosure: This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. Investment Advice and 3(38) Investment Fiduciary services offered through Diversified Financial Advisors, LLC, a Registered Investment Advisor. 3(16) Administrative Fiduciary Services provided by PISTL Service Corporation. Discretionary Trustee services provided by Printing Industries 401k Trustees. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.
GRP-316-1123 (Exp. 11/24)