How much money have you saved for retirement?
How much of it is inside an IRA, or 401K?
Let’s say you’ve saved $250,000 in one of these tax-deferred accounts.
You know it’s not really 250 grand, right?
When you withdraw this money in retirement, you could lose a big chunk of it to Uncle Sam.
Most people ignore the significant impact taxes could have on their IRA and 401K because they think they don’t have a choice in the matter.
That’s simply not the case.
In fact, you have far more control over your taxes than you know, including
- Your IRA and 401K
- Your social security benefits
- Your investment income, and more
I’ll reveal how you could avoid 5 big tax mistakes as you plan for retirement, including
- How you could reduce, or eliminate paying taxes on up to 85% of your social security benefits.
- How you can use “tax diversification” to save a bundle
- Plus, the tax planning strategies to help you avoid getting gouged by taxes with your IRA and 401K.
Mistake #1: Ignoring the significance of taxes in retirement
What do you think will be your biggest expense in retirement? Most people think it will be their mortgage, or their healthcare expenses. But, it will likely be taxes.
Taxes on your IRA, 401K and other retirement accounts. Taxes on your Social Security benefits. And taxes on your investment income. It could be a field day for Uncle Sam, unless you take proactive steps to protect yourself now.
From Forbes “Retirement tax mistakes can wreak havoc on your financial independence. Avoiding them can help you wring every last dollar of enjoyment from your retirement nest egg. Ignoring them could result in paying more taxes and potentially running out of money before you run out of life.” s
The conventional wisdom claims that you will have lower taxes when retire. But we’ve found this to be wishful thinking at best. Your taxes could actually be much higher.
According to Forbes “Taxes could double in the next 10 years.” (Click Here)
According to CNBC your marginal tax rate could jump to as much as 46% when the Trump Tax cuts expire in 20-25.That’s a huge threat retirees overlook the threat of future tax increases. No one knows for sure what future tax rate will be, but it’s safe to say the stage is set for higher rates to come. Not only are Social Security and Medicare on shaky ground, but the country has $22 Trillion in national debt that keeps growing by the minute. The only way to solve these problems will most likely be higher taxes to come.
According to the Washington Times (Click Here)“Federal Debt To Reach 100 Trillion” within 30 years (2048). And “Social Security will become insolvent early in the 2030s.”
If you want to keep more of your hard-earned money, and ensure your success in retirement, you must have a plan for the taxes you could pay.
There’s a big difference between tax planning, versus tax preparation. Tax preparation is something you do with your Accountant, or CPA. You’re just reporting what happened last year. But if you want to pay fewer taxes, then this requires a forward-looking tax plan.
So what exactly is tax planning? According to Investopedia:
Tax planning is the analysis of finances from a tax perspective, with the purpose of ensuring maximum tax efficiency. Considerations of tax planning include timing of income, size, timing of purchases, and planning for expenditures. Tax planning strategies can include saving for retirement in an IRA or engaging in tax gain-loss harvesting.
How will you reduce your taxes when you withdraw money from your IRA and 401?
How will you navigate required minimum distributions?
Mistake #2: Not having a strategy for your tax-deferred accounts
Taxes on your IRA and 401K
One of the biggest retirement tax traps, is withdrawing money from your 401K, IRA, or other retirement accounts.
Retirement accounts like the IRA and 401K are extremely popular ways to save money for retirement. Most employers not only offer workers these accounts, they are willing to match a portion of the funds you contribute. It’s a no-brainer, right?
The icing on the cake is that these accounts offer tax savings to boot. The money you contribute is tax free.
What most people don’t realize, is that you could be creating a tax time bomb. Why? Because the IRS wants their cut. So when you withdraw that money, you have to pay taxes. And that could be a major problem you weren’t expecting.
The truth is, some people will pay through the nose in taxes in retirement. But a smart and savvy few will legally pay far less. That only happens by having a tax-efficient investment strategy.
According to Time Magazine“A $2 Trillion Tax Bill is Coming Due for Baby Boomers.” (Click Here). And that’s because Required Minimum Distributions (RMDs) could be your worst enemy (unless you take action).
Here’s how RMDs work: When you turn 70 and a half, RMD’s kick in, and you could be forced to sell your investments and withdraw money from your IRA, or 401K whether you want to or not. And you’ll never get this money back again.
If you ignore required minimum distributions, or don’t follow the rules “to a T,” you could face taxes, penalties and fees that could rob you of more than 50% of your IRA, 401K or other retirement accounts.
Kiplinger calls your IRA, 401K, or other “tax-deferred” retirement account a “sleeping tax bear” that“wakes up when we get into our 70s, and it growls loudly.” (Click Here)
According to Forbes, “some taxpayers over 70½ can find themselves subject to a 55% marginal income tax rate due to a combination of RMD income, Social Security benefits and capital gains.”
RMDs aren’t easy. They are often misunderstood, or totally ignored. The key is to address this issue early so you can get in front of any potential problems. Creating a withdrawal strategy in your late 50’s/early 60’s could prevent you from needlessly paying thousands in taxes, penalties and fees to the government.
Know what account are subject to RMDs
Mistake #3: Not having tax diversification
We’re not talking about asset allocation or investment diversification. We’re talking about tax diversification!
From Kiplinger (Click Here), “You don’t want to own too many assets that are taxed the same way or at the same time. This accentuates the significance of tax diversification. In my experience, it’s one of the most underrated financial planning concepts.”
There are three basic tax categories to diversify in:
- – brokerage accounts, checking and savings accounts. You pay tax on the dividends, interest, or capital gains.
- – 401(k), Traditional IRA, 403(b), real estate, or hard assets.
- – Roth IRA, interest from municipal bonds, and certain types of life insurance.
You have more control over how much you’ll pay in taxes in retirement, than any other time in your life. But you have to be proactive and get in front of this. BEFORE the tax bill comes.
Mistake #4: Not converting some of your money to a ROTH
From Kiplinger …“By strategically shifting assets out of your IRA before you turn 70½ through Roth IRA conversions during years in which your marginal tax bracket is low, you may reduce your RMDs and the amount of tax you pay.”
“Even if you convert only a small portion of your traditional IRA into a Roth, this may help you lower your tax bill in retirement, since Roth distributions aren’t taxed.”
What is a Roth?
An IRA or 401K allows tax-free contributions. But when you withdraw that money in retirement, you have to pay taxes on that money. But you could avoid by converting some, or all of your traditional IRA or 401K … to a ROTH.
Here’s how a ROTH works: A ROTH IRA or 401K doesn’t allow tax-free contributions (that’s the catch), but you pay zero tax when you withdraw money in retirement. And you don’t have to deal with RMDs either. That means you get tax–free growth – which could add up to tens of thousands of dollars in retirement, if not more. That could be a financial game-changer for you and your family.
Another benefit – there are no early withdrawal penalties to worry about. If you withdraw from a ROTH account before 59 ½, you only pay taxes on your earnings. If you withdraw any money from your Traditional IRA or 401K before you turn 59 ½, you’re slapped with a stiff 10% penalty on the amount you withdrew. This plan is not usually sponsored by your employer, and it’s NOT tax deductible, you might turn a blind eye to a ROTH IRA or 401K. But this is the only way to build tax-free growth and you could be missing out on a huge windfall of money in retirement. Think long term.
What’s the difference between a Roth IRA and Roth 401K? Good question. Here’s a great explanation from Investopedia (Click Here)
There is another 401(k) plan that combines the traditional 401(k) with a Roth IRA. Established in 2006, the Roth 401(k) offers participants a different tax-advantaged option. With these plans, you make contributions with after-tax dollars, but withdrawals are fully tax-free as long as certain conditions are met. In other words, while you do have to pay tax on your contributions to a Roth 401(k), you won’t have to pay any tax when you withdraw the money in retirement. All the money in your account grows tax-free. This type of plan is ideal for people who think they will be in a higher tax bracket in retirement than they are now. Additionally, unlike Roth IRAs, there are no income limits on being able to contribute to a Roth 401(k). You can only contribute to a Roth IRA if your income is below a certain threshold. (In 2016, that income max is $133,000 for single filers and $194,000 for married filers.) Therefore, Roth 401(k)s offer an avenue for high earners who want to invest in a Roth without converting a traditional IRA. The Roth 401(k) option is available in more than 50% of company 401(k) plans.
With the new Trump Tax plan, this could have a once in a lifetime opportunity right now that you can’t afford to ignore. Taxes may never be this low again, so a ROTH conversion could be a financial windfall for you in retirement.
The Trump Tax Plan is set to expire in 2025, so the time is now to make a conversion. With a skyrocketing deficit and national debt, combined with lots of pressure from the opposing party, there’s a good chance the trump tax cuts won’t be made permanent.
With the new Trump Tax Plan, there are some things to look out for when converting to a Roth IRA or 401K: Roth re-characterizations. This is the big change with the new Trump tax plan.
Retirees face a major hurdle when they do a Roth conversion. It’s hard to know exactly what tax impact a conversion might have until the year is over and you know what other income, deductions, and other factors will determine your overall tax liability. A conversion may have seemed like a smart move at first, until you get all the pieces of the puzzle. Now it’s going to cost you.
Before 2018, you could reverse your Roth conversion decision and pinpoint the smartest amount. Now you can’t. You are now stuck with your decision (which could be costly if you don’t plan it just right.)
This is why it’s more important than ever to seek the right financial advice.
Mistake #5: Forgetting about taxes on your social security benefits
Most people don’t realize they could pay taxes on as much as 85% of their Social Security benefits. And when the tax bill hits, it’s too late to do anything about it.
I’ve got some news for middle income retirees you’re about to get punished by the Social Security Administration. All that money you’ve contributed to the system could be significantly reduced unless you take serious action well in advance.
According to Fidelity (Click Here) If you are approaching retirement and think your Social Security benefit always comes tax-free, you’re mistaken. Today, 56% of Americans pay taxes on their Social Security benefits—up from 10% of Social Security recipients in 1984 when the federal government first began taxing the Social Security benefit.
According to MarketWatch (Click Here)“Because of the way Social Security benefits are taxed, many middle-income retirees face a ‘tax torpedo,’ where their marginal tax rate can more than double.” This should certainly get your attention.
Here’s how your benefits are taxed (Click Here) …
- If your income is over $25,000 a year, or if you’re a couple with over $32,000 a year you will face taxes on up to 50% of Social Security benefits.
- If you have over $34,000 in income, or $44,000 for couples you could pay taxes on up to 85% of benefits.
- Were you planning on paying taxes on up to 85% of your benefits?
Here’s a great article with some ideas for reducing your taxes on your social security benefits
US News: How to Minimize Social Security Taxes Click Here
- Stay below the taxable thresholds.
- Manage your other retirement income sources.
- Consider taking IRA withdrawals before signing up for Social Security.
- Save in a Roth IRA.
- Factor in state taxes.
- Set up Social Security tax withholding.
If you have any questions or concerns about what you’ve read here, please don’t hesitate to call us at 952.460.3260. We’re here to help!