Planning for retirement is critical when it comes to securing the latter years of life from a financial standpoint. If you start saving from a young age, you will stand in good stead and be able to build a significant retirement corpus provided you are consistent and invest in the right options. However, if you have started saving at a later stage in life, don’t lose heart. There are certain strategies you can use to make up for lost time and save enough for retirement.
That said, you must account for taxes at the time of retirement planning. Taxes can not only deplete your savings but can also affect your future retirement income. Consult with a professional financial advisor who can help you minimize your tax liability and educate you about different kinds of tax-savings strategies.
In this article, we will discuss some ways you can use to lower your taxability in your retirement years.
Why is tax planning important when it comes to saving for retirement?
If you think having saved enough for a comfortable retirement and amassing a substantial corpus means you are through with your job, it may not be entirely true. You need to consider the impact of taxes on your savings and withdrawals to ensure that you can minimize its effect and receive the bulk of your retirement money.
Taxes on retirement funds have been consistently rising over the past few years and this trend may continue in the future as well. This may have a twin effect of eating your savings at a faster rate and depreciating the value of your money if the tax rates continue to rise. Further, with the loss of a steady income in retirement, you would have to rely primarily on your withdrawals to meet your expenses. Poor tax planning, in this scenario, can wreak havoc on your finances. Thus, you need to ensure that you lower your taxability to live comfortably in your golden years without worrying about money.
Let us discuss different ways you can lower your tax obligations.
How to minimize your taxes in retirement?
An essential aspect of retirement planning involves timing your withdrawals to ensure you do not move up a tax bracket and attract higher taxes. Apart from that, you can also take certain measures and use strategies to lower your taxes. These are:
1. Understand what can be taxed and what not:
Contributions to different retirement plans are treated differently when it comes to taxes. While contributions to plans such as 401ks, traditional Individual Retirement Accounts (IRAs), and traditional 403(b)s, etc., are made with pre-tax dollars, the ones to Roth 401ks, Roth IRAs, and Roth 403(b)s, are made with after-tax dollars. This means that you do not pay tax on the former but have to do so at the time of making withdrawals in retirement whereas you pay tax at the time of making contributions to the latter but can make tax-free withdrawals in retirement provided you meet certain conditions.
Investments in real estate, stocks, mutual funds, ETFs, brokerage accounts, etc., attract tax on the capital gains made by you. If you know which investments are taxable along with how they are taxed, doing so will allow you to lower your taxability.
2. Rollover your traditional IRA account to a Roth IRA plan:
One of the major benefits of converting your traditional IRA account to a Roth IRA account is the ability to make tax-free withdrawals in retirement. However, to do so, you must be 59.5 years of age or older at the time and must have held your account for a period of at least 5 years. Moreover, if you expect to be in a higher tax bracket in retirement, switching to a Roth IRA account would be a wise move for you.
3. Diversify your taxes:
Similar to the diversification of investments, you can diversify your taxes as well. Doing so not only allows you to reduce your losses but also helps you lower your taxability. For instance, you can invest in tax-deferred accounts such as a 401k, traditional IRA, etc., where you can defer paying taxes. Herein, you do not pay taxes at the time of making contributions but at the time of making a withdrawal in retirement. You can use the saved money to meet your present expenses or for any other need you wish to fulfill.
In a similar vein, you can invest in tax-free accounts such as a Roth IRA, Roth 401k, etc., where you make contributions with your after-tax dollars. This means that you pay taxes at the time of contributing to your retirement account and can make tax-free withdrawals in retirement provided you meet certain conditions set by the Internal Revenue Service (IRS). Investing in a Roth account is beneficial if you expect to be in a higher tax bracket post-retirement.
4. Switch to a Roth 401(k) account:
Similar to a Roth IRA, you can roll over your traditional 401k account to a Roth 401k account. The switch will allow you to grow your funds on a tax-free basis plus make tax-free withdrawals in retirement. In addition, you will not be required to take out required minimum distributions (RMDs) when you turn 72. You can keep your funds invested for as long as you wish to do so.
SPONSORED WISERADVISOR
Need a financial advisor? Compare vetted advisors matched to your specific requirements.
Choosing the right financial advisor is daunting, especially when there are thousands of financial advisors near you. We make it easy by matching you to vetted advisors that meet your unique needs. Matched advisors are all registered with FINRA/SEC. Click to compare vetted advisors now.
5. Max out your catch-up contributions:
If you are 50 or above, you can make additional catch-up contributions to boost your retirement savings and save more for retirement. For 2022, you can contribute $20,500 annually to your 401k account. You also have the option of contributing an additional $6,500 if you are 50 years of age or up, meaning you can invest a sum of $27,000 per year. On the other hand, you can contribute $6,000 per year to your IRA account plus an additional $1,000 in catch-up contributions, bringing your total to $7,000 for the year.
By maxing out your catch-up contributions, you can make up for shortfalls during previous years of contributions and boost your retirement funds significantly.
6. Avoid making early withdrawals:
Making an early withdrawal not only depletes your retirement savings but can also attract a tax penalty of 10%. To avoid the aforesaid penalty, you must be 59.5 years or older at the time of making a withdrawal from your account. This is true for both 401ks and IRA accounts. However, there is an additional condition for Roth accounts. Apart from being 59.5 years of age, you must have held your Roth account for at least 5 years before you can make a tax and penalty-free withdrawal.
That said, there are certain exceptions to this rule. You can make an early withdrawal without incurring a penalty in the following situations:
- You are buying a home for the first time
- You have to pay your health insurance premium after the loss of a job
- You have to pay the college tuition of your children or grandchildren
- You have to pay medical expenses
7. Take out your RMDs in a timely manner:
RMDs refer to mandatory withdrawals that you must take out after you turn 72. Both traditional IRA and 401k accounts require investors to take out RMDs to avoid incurring a penalty of 50% of the amount that should have been distributed. Do note that this penalty would be in addition to any income tax that you will be liable to pay for that particular tax year.
8. Invest in tax-exempt instruments:
By investing in tax-exempt investments such as municipal bonds, treasury bills, notes, Treasury Inflation-Protected Securities (TIPS), etc., you can reduce your tax burden considerably. However, keep in mind that these securities offer lower returns compared to stocks or mutual funds.
To conclude
Tax planning is an integral aspect of retirement planning wherein you try and ensure that you pay the lowest taxes possible. You need to take into account several factors such as your income, the size of your investments, the timing of purchases, the choice of investments, and retirement plans at the time of making a tax-efficient strategy. Ensure that you make use of tax-saving strategies to lower your tax burden. You can also consult with a financial advisor who can help you find ways to reduce your taxes and boost your retirement savings at the same time.
Reach out to a professional financial advisor in your area who will be able to guide you effectively on how to lower your taxability with the help of tax-saving strategies. Use the free advisor match service to connect with 1-3 financial advisors based on your financial requirements. All you need to do is answer a few simple questions about yourself and the match tool will help connect you with advisors that suit your financial needs.