People often do not prepare adequately for taxes during retirement. Since retirement involves a fixed income, you should work to limit the number of surprise taxes you face. Moreover, you should plan strategies for reducing your overall tax burden while not working. This will make your hard-earned savings last longer. Luckily, there are a number of strategies you can employ to reduce the amount of money the IRS wants from you and your retirement accounts. These strategies involve a bit of planning, so it is important to have them in mind as you map out your plan long before you actually retire. The strategies for reducing taxation of your retirement savings include:
Choose the right kinds of accounts for your money
As you save for retirement, you should focus on using tax-advantaged accounts, which have many advantages outside of traditional taxable brokerage accounts. Contributing to an IRA or a 401(k) gives you a tax advantage in the year that you make the contribution and allows the money to grow tax-free even though you will eventually owe the IRS when you make withdrawals from the account. The other option is contributing to a Roth IRA or ROTH 401k account. While this does not provide the same tax breaks in the year that you make the contribution, you will be able to withdraw money from the account in retirement without paying any taxes.
Think about your current and future tax brackets as you choose between traditional and Roth accounts. If you think you will be in a lower tax bracket when you retire than you are now, then traditional accounts make sense since you will pay less later than you would now. On the other hand, if you’ll be in a higher tax bracket in retirement, a Roth account makes sense. However, a Roth account may make sense in the first case if you have reached maximum contributions to traditional accounts. You need to pay close attention to annual contribution limits for these accounts as you make your decision. Given the country’s financial condition, and rapidly aging population, the odds of seeing higher, or much higher, taxes in the future are strong, and there is a lot of historical precedent for much higher tax rates looking back to 1913. So, if we have some foresight, we can see that the odds are that pursuing a ROTH IRA/401K contribution strategy during your working years will be quite wise.
Borrow money instead of making early withdrawals
You may need cash as you approach retirement for a variety of reasons. When this happens, you should avoid making an early retirement account withdrawal at all costs since you will face a 10 percent penalty if you are under 59½ years of age. This gets waived for some qualifying reasons, such as large medical expenses. However, a tax-deferred retirement account will also come with taxes on the money that you decide to withdraw. Thus, even if the large penalty gets waived, you will still end up paying taxes. If you do not get the penalty waived, you could end up losing up to a quarter of the amount taken out to taxes.
Another option is to borrow from your 401(k), which is not quite as damaging provided that your plan administrator allows it. You will not owe taxes as long as you repay the loan back plus interest within the predetermined time frame. However, keep in mind that doing this reduces your overall retirement savings and you will need to save more each month to get yourself back on track. Plus, if you do not have the ability to pay back the loan on time plus interest, then you may end up facing more penalties and fees. Ultimately, you are often better off getting a traditional loan than borrowing from your retirement account.
Convert some or most of your tax deferred retirement accounts to Roth IRAs
If you are getting worried about your tax burden as you get closer to retirement or even after you have already retired, you can consider converting accounts to Roth IRAs. All retirement accounts have required minimum distributions without the exception of Roth IRAs. These mandatory distributions can increase your tax bill if the money you take out ends up pushing you into a higher tax bracket. Additionally, if you have large RMDs, because you have a large amount of money in the tax deferred world, those larger distributions can also negatively affect your state income tax levels, your Medicare premiums, and potentially the amount of your Social Security that is includable each year as taxable income. All minimum distributions must be taken annually in the year that someone turns 72. If you convert to a Roth IRA, you will not have the same requirement to take money out of the account and can thus have better control over your annual income. In fact, depending on how much money you convert and how early you start, it is quite possible to reach a 0% tax bracket status, or a single digit effective tax rate status in retirement! We do it for clients all the time. Roth conversions are our single most powerful tax planning tool for retirement.
Of course, since Roth IRAs allow you to take money out without paying any tax, you will need to pay taxes on the amount you convert in the year that you do it. Most people wait until the end of the year to do this and look at the current tax bracket they occupy. Make sure that the conversion does not bump you into a higher tax bracket. You may need to do the conversions over the course of several years to do so in a tax-conscious manner. Importantly, Roth 401(k)s do have required minimum distributions even though they are Roth accounts. You can convert a Roth 401(k) to a Roth IRA to avoid these distributions and without paying any taxes since the savings has already been taxed.