Ah, retirement. Carefree living, no more commute to a job, more time to spend with the family and lower taxes.
Well, I hate to break it to you, but that last item — the one about lower taxes — may not be true.
For the past couple of decades, Americans approaching retirement were advised to budget for living expenses totaling about 70 percent to 80 percent of their current spending levels.
But lately, the financial planning industry has been homing in on areas where retirement may be more costly. For example, many healthy and energetic baby boomers enjoy travel or immersing themselves in expensive hobbies.
But the issue of taxes doesn’t go away in retirement. If you maintain some kind of part-time work or consulting gig after you officially retire, you’re already aware of the potential to pay some income taxes.
But taxes also take a chunk from other retirement income, including Social Security, pensions and withdrawals from investments, such as individual retirement accounts.
When giving our Social Security seminars, we often frame the financial planning process as having two main phases. First, when planning for retirement, it’s helpful to view it as climbing a mountain. You need certain tools, such as retirement accounts, a savings strategy, a Social Security claiming strategy and a handle on the spending required to maintain your lifestyle.
All of that is fairly intuitive. But the process is different on the descent from the mountain. According to experienced mountain climbers, most accidents occur on the way down. I’ve anecdotally glimpsed this myself: After a weekend backpacking trip in the Sierras, one member of our group fell and twisted her ankle, when we were only a couple of miles from the base!
We can posit reasons why this may happen, but my guess is because people are tired after a strenuous climb, and are eager to get to the bottom of the mountain and relax.
Here’s the parallel with retirement: It’s easier to understand the path up the mountain. It’s thrilling to imagine the hard-earned view from the top. But what about the walk down?
Tax strategies after retirement can be just as important as those you apply during your working years.
Here are some ways to mitigate the tax hit in your golden years:
Strategize IRA withdrawals. When you reach the age of 70 1/2, the federal government requires that you begin taking required minimum distributions from qualified accounts, such as traditional IRAs. You’ve been saving tax-deferred for years, but now your withdrawals are deemed taxable income. If your account value is high, your required withdrawal amounts may be significant. That means your tax bill may be larger than you anticipated.
One way to plan for this taxable event is by using Roth IRAs. A Roth is funded with after-tax dollars, meaning withdrawals are generally free of taxes. In addition, you’re not required to take withdrawals simply because you’ve reached age 70 ½.
You may convert a traditional IRA to a Roth. Although the conversion itself is a taxable event, the benefits later often make the switch worthwhile. If you’re in a lower tax bracket immediately after you retire, you may use that window of time to convert a traditional IRA to a Roth, before required minimum distributions throw you into a higher tax bracket again.
Consider “buckets” for income. Before you retire — as in, several years before — make some accurate projections for your income needs. Assume you’ll want to travel and have fun once you stop working, and plan accordingly.
Part of the planning process is a forecast of the taxes you’ll face. If you have multiple sources of income, such as qualified accounts, nonqualified brokerage accounts, pensions and Social Security, you can determine the order in which you’ll make withdrawals from the various buckets of money. The tax differences between withdrawals may be significant.
Don’t overlook taxes on your Social Security benefits. Yes, Social Security is considered taxable income. In 2016, a married couple with annual income of $44,000 or more may see as much as 85 percent of their Social Security benefit treated as taxable income. For a single filer, that threshold is $34,000. You can easily see: It doesn’t take much to get to that higher threshold.
Retirees may not comprehend the full impact of taxes on their Social Security benefits, particularly when that monthly income is combined with other sources of income.
It’s easy to see how you can get hurt as you descend from the top of “retirement mountain.” By taking a few precautions ahead of time, you can have a more enjoyable and stress free journey!