If you're still working, you may not think much about the income taxes you pay until you're filing your tax return each year.
Thanks to direct deposit, many of us never even see our pay stubs anymore -- we just know the money is going into the bank regularly, minus a heap of deductions. Come April of the following year we settle up with the IRS and hope we don't owe too much!
Unfortunately, that means many people enter retirement with no real concept of how taxes actually work. Most retirees underestimate the impact taxes may have on their retirement distribution strategy. Doing this puts their retirement plan at risk.
That's why, when you're building your distribution plan, it is crucial to include tax strategies that will help protect the money you worked so hard to save.
Ultimately, it's about managing your tax bracket. Your goal should be to fill up the lowest bracket possible without spilling over into the next. Not only will this keep your tax rate lower, but you'll avoid triggering taxes that kick in at a higher income. For example:
- You may have to pay taxes on a portion of your Social Security benefits. If you file as an individual and your combined income exceeds $25,000, 50% of your Social Security benefits may become taxable. If you file a joint return, the threshold is only $32,000 before 50% of your benefits may become taxable.
- Wealthier taxpayers pay higher Medicare costs . If you are single and earning more than $85,000, or if you're married and earning more than $170,000, you'll pay more for Medicare Part B and Prescription Drug Coverage than people below those income thresholds.
- Short-term capital gains are taxed as ordinary income according to federal income tax brackets, but long-term capital gains are treated differently. You could pay nothing or up to 15% to 20%, depending on your income.
If you're working with a financial adviser, you probably already know the value of diversifying your investments to mitigate market risk. It's no different when it comes to taxes: You can maximize the tax efficiency of your portfolio, and manage your tax bracket year to year, by keeping your money in three different "tax buckets."
- The tax-free bucket holds accounts such as Roth IRAs and Roth 401(k)s . You'll pay taxes on the money before you put it into these types of investment accounts, but if you follow the rules, you won't have to give the IRS any money when you take income later -- and you don't owe taxes to the IRS on any of the growth! Properly structured life insurance policies also fit into this category.
- The after-tax bucket includes the savings and investments you pay taxes on every year, including bank and brokerage accounts, certificates of deposit, interest on bonds, etc.
- The tax-deferred bucket is for your 401(k) , traditional IRA or similar accounts. You won't pay taxes on the money as you contribute or as the money grows. But many retirees forget that Uncle Sam eventually will want his share. You'll pay taxes as you withdraw the funds -- and you'll be required to start taking distributions when you turn 70½.
There are pros and cons to each bucket, of course, but the important thing is to remember that tax laws change frequently, and you need to take advantage of opportunity. Having a good balance between each of the three buckets allows you to structure your retirement income in a way to minimize the taxes that you will owe each year.
Unfortunately, I see way too many retirees and pre-retirees who have every bit of their savings in their IRAs or 401(k)s. Who can blame them? Automatic payroll deductions and matching contributions from employers make it easy and worthwhile to go that route. But nobody warns these folks about the potential long-term effects these plans may have on their taxes during retirement.
This year's tax reform delivered new brackets, lower rates and a bigger standard deduction. Now is an exciting time to explore potentially converting some of your tax-deferred assets into the other two buckets to reduce your long-term tax liability.
By taking advantage of all the tax-efficient opportunities available to you, you'll be able to keep more of your hard-earned money in your pocket.
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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA .