Five Tax-Saving Strategies for Retirement
Wouldn’t it be terrific to think that once you retired, you could stop worrying about taxes? Unfortunately, that’s just not possible. When it comes to retirement and estate planning, there’s a lot to consider, such as:
- Social Security: Depending on your personal situation, some of your benefits may be taxable if you continue to work after you have begun collecting benefits. If you have other income such as benefits or earnings on investments, that can also impact how much of your Social Security benefits are taxable.
- How you take your retirement income distributions can affect your taxes. See Distribution Options: Taking Money from Your Retirement Plan for details.
- Estate tax planning for your heirs after your death.
Five Tax-Saving Strategies
The following five strategies can help to get you started as you consider ways to help you save taxes in retirement. But remember: In-depth tax planning should be done only with a qualified tax advisor.
Strategy # 1 – Never Forget, It's The "Net"
When it comes to retirement income, it’s not what you earn—it’s what you keep. Keep in mind that if your goal is to have a retirement income of $5,000 per month, or $60,000 per year, you’ll still need to pay taxes on whatever portion of that income is taxable. So if your desired amount of disposable income is $5,000 per month, you’ll need to generate more than that in retirement income in order to allow for the taxes you’ll have to pay.
Strategy # 2 – Distributions: How to Keep What’s Yours
Income distributions can be tricky and full of taxable pitfalls. You can help yourself avoid them by doing the following:
- Take an inventory of all potential sources of retirement income. These could include company pensions, 401(k), 457, or 403(b) accounts, Individual Retirement Accounts (IRAs), Roth IRAs, Social Security, annuities, and personal savings.
- Determine the current tax treatment for each and what it might be if you have changes to your income sources.
- Determine which assets are subject to required minimum distributions. These distribution rules apply to many retirement plans and generally start on the April 1 following the year you turn 70½. See Distribution Options: Taking Money from Your Retirement Plan for details.
- Create a plan for withdrawals to minimize taxes—now, and when you pass assets on to your heirs. For more information, refer to Develop a Tax-Smart Withdrawal Plan.
Strategy # 3 – Be Tax-Smart in Your Asset Allocation and Diversification
- Because you may spend as much as a third of your life in retirement, it’s not enough to simply generate an income stream. You have to make your retirement income last, because inflation will likely take its toll.
- Staying invested in a mix of assets—stocks, fixed income, cash/stable value funds—could help your retirement account fight the effects of inflation.
- You may want to consider putting as many of your assets as possible in tax-qualified accounts (such as Individual Retirement Accounts, 401(k), 457, or 403(b) plans), since:
- the federal (and sometimes, city and state) tax on income and gains is deferred until you have reached retirement age when, presumably, your distributions will be taxed at a lower marginal tax rate; and
- any gains that otherwise would have been eroded by current taxes would be left to accumulate, giving your account the potential to grow faster.
- On the other hand, you may prefer to have some of your retirement income be free of federal taxes when you retire. This may be an option if your retirement plan offers Roth contributions or if you are eligible to set up a Roth IRA. Here’s how it works:
- You pay taxes on your Roth contributions and then the money you contribute is applied to your retirement plan or Roth IRA.
- Roth contributions and any investment returns, like traditional contributions made to your retirement plan, grow tax deferred until retirement. But unlike before-tax contributions, Roth money can be withdrawn federal income tax free as long as you meet certain requirements.1 See Roth contributions...An Exciting Retirement Savings Feature for details.
Strategy # 4 – Be Tax-Smart if You Continue to Work
According to an Employee Benefit Research Institute (EBRI) survey2 conducted in 2011, 74% of Americans polled indicated that they planned to supplement their retirement income by working.
But you need to carefully consider the tax consequences of employment during your retirement years. For example, if you have not yet reached full retirement age (currently, between ages 66 and 67 for those born after 1942), Social Security benefits are reduced by $1 for every $2 of earned annual income over $14,640. If you have reached full retirement age, benefits are reduced by $1 for every $3 of earned income over $38,880 in the year you reach full retirement age for the months up until you reach full retirement3—after which time, there is no reduction in benefits because of earned income. Also, a portion of your Social Security benefits may be taxable if your modified adjusted gross income exceeds $25,000 for single people and $32,000 for couples.4 The annual earned income limits before you start having a reduction in benefits are indexed for inflation. The income limits for determining the portion of your Social Security benefits that are taxable are not indexed for inflation.
Strategy # 5 – Don't Go It Alone.
Investing and sorting through the tax implications outlined here can be complicated, particularly since there is no "one size fits all" solution.
With the right planning today, you can make the choices that can help you save money on taxes—and help protect your retirement income stream—tomorrow.
1 Qualified distributions are federally tax-free, provided the Roth account has been open for at least five years and the owner has reached age 59½ or meets other requirements. Qualified Roth IRA distributions may be subject to state and local income taxes.
2 EBRI 2011 Retirement Confidence Survey.®
3 Source: SocialSecurityOnline. April 9, 2012.
4 Source: Social Security Administration. "Paying income tax on Social Security benefits" April 6, 2012.