Most people are focused on their investment returns, but they’re ignoring the one thing that could have an even bigger impact on their nest egg.
Taxes will likely be your biggest expense in retirement. Below are 4 retirement tax traps you should get in front of before you start planning that retirement party.
Retirement Tax Trap #1: Claiming Social Security could trigger higher taxes.
Claiming your Social Security benefits could be one of the most important financial decisions of your life. How and when you claim Social Security could impact far more than just the amount of your benefits check. It could also trigger paying taxes on as much as 85% of your benefits.
Don’t make your decision solely based on maximizing your benefits. Instead, consider how it could impact your taxes, Medicare premiums and spousal benefits.
Retirement Tax Trap #2: Taxes on your IRA, 401K (and other retirement accounts)
Contributing money to your IRA and 401K is easy. But withdrawing this money in retirement is complicated and confusing.
Remember, you must pay taxes when you withdraw this money in retirement. And Required Minimum Distributions will further complicate matters. When you turn 70 ½, “RMD’s” force you to start withdrawing money from these accounts, whether you want to or not. And this could result in paying more and more taxes every year
The key is to create a strategy for RMD’s in your late 50’s or early 60’s.
Retirement Tax Trap #3: Not having tax diversification
According to Kiplinger Magazine, “For the average individual, diversification has always focused on equities, and equities alone. And that’s a problem.”
Your money should be invested in different categories to diversify your tax risk.
Most financial accounts fall into 3 categories: taxed always, taxed later and taxed rarely. If you have too many eggs in one basket, it could spell serious financial trouble in retirement.
Retirement Tax Trap #4: Not switching to a ROTH IRA or 401K
An IRA or 401K allow tax-free contributions. But you must pay taxes when you withdraw this money in retirement unless you convert some, or all your traditional IRA or 401K to a ROTH.
A ROTH IRA or 401K doesn’t allow tax-free contributions (that’s the catch), but you pay zero taxes when you withdraw money in retirement. ROTH accounts are not subject to RMDs either. That means you get tax-free growth, which could add up to tens of thousands of dollars in retirement (possibly more).
Meet with a qualified financial advisor to see if you should convert your IRA or 401 to a ROTH.
The good news is you have more control over how much you pay in taxes in retirement, than any other time of your life. But this doesn’t automatically happen. It requires a forward-looking tax plan.