Will you pay higher taxes in retirement?
It’s possible. But that will largely depend on how you generate income. Will it be from working? Will it be from retirement plans? And if it does come from retirement plans, it’s important to understand which types of plans will be financing your retirement.
Another factor to consider is the role Social Security will play in your retirement. When do you plan to start to take Social Security benefits? If you have a spouse, when do they plan on taking benefits? It’s critical to answer key Social Security questions so you have a better understanding of how it will affect your taxable income.
Not to throw a wrench into all this, but what about your Medicare premiums? Many people forget these are based on your Modified Adjusted Gross Income (MAGI), meaning the higher your income in retirement, the more you will pay. This can be seen as an "added retirement tax" as well.
What’s a pre-tax investment? And why does it matter?
Traditional IRAs and 401(k)s are examples of pre-tax investments that are designed to help you save for retirement. You won’t pay any taxes on the contributions you make to these accounts until you start to take distributions. Pre-tax investments are also called tax-deferred investments, as the money you accumulate in these accounts can benefit from tax-deferred growth.
However, when you decide to withdraw money from these investments, each dollar withdrawn will show up as income on your income tax return. Without proper planning, simply taking funds from your traditional IRA's and 401(k)'s in retirement can lead to excess taxes paid on those distributions. It can also lead to excess taxes on your Social Security benefits and also added premiums for Medicare coverage.
Keep in mind that once you reach age 73, you must begin taking required minimum distributions from a traditional IRA, 401(k), and other defined contribution plans in most circumstances. But simply kicking the can down the road until age 73, can leave you in a higher tax bracket than when you were working!
It is important to have an income and tax plan plan for each year in retirement. You should also have a general idea of your future tax situation. This way you can mitigate paying any excess taxes during your retirement. Remember, proper planning is key!
What’s an after-tax investment?
A Roth IRA is the most well-known. When you put money into a Roth IRA, the contribution is made with after-tax dollars. Like a traditional IRA, contributions to a Roth IRA are limited based on income. For 2024, contributions to a Roth IRA are phased out between $230,000 and $240,000 for married couples filing jointly and between $146,000 and $161,000 for single filers.1
To qualify for the tax-free and penalty-free withdrawal of earnings, Roth IRA distributions must meet a five-year holding requirement and occur after age 59½. Tax-free and penalty-free withdrawals can also be taken under certain other circumstances, such as the owner's death. The original Roth IRA owner is not required to take minimum annual withdrawals.
This is almost the opposite of a "pre-tax" investment. Therefore, some coordination can come into play when it comes to taking distributions from your various account during retirement. For instance, if you withdraw another dollar from your pre-tax account, will you suddenly find yourself in the highest tax bracket? If so, it may be time to think about a distribution from a Roth IRA or other account.
Are you striving for greater tax efficiency?
In retirement, it is especially important – and worth a discussion. A few financial adjustments may help you manage your tax liabilities. However, proper planning starts today. If you are ready to retire, but only have "pre-tax" investment accounts, there isn't much you can do. However, if you start the proper planning today, you can give yourself added flexibility in the future. Afterall, it's not what you have saved or made, it's what you get to keep after taxes!
If you need help devising a tax-efficient investment strategy for retirement, please do not hesitate to contact us today!
1. IRS.gov, 2024