Retirement planning is a complex process that requires careful consideration of various financial aspects, with tax planning being one of the most crucial.
“In retirement, your income may come from annuities, pensions, qualified retirement plans such as 401(k)s and IRAs, taxable savings, and Social Security. The tax treatment of all those assets varies widely,” says Merrill Lynch, which advises future retirees work with financial advisors and tax professionals to develop a tax-efficient retirement income plan.
As seasoned tax professionals, we at Powell Tax Law understand the significant impact that taxes on these different assets can have on your retirement savings and income.
Keep in mind, that if you wait until you retire to consider tax planning, it may be too late to maximize your finances for your Golden Years.
“Just as it’s sensible to pay attention to tax-efficient ways to save for retirement when you’re younger, you should start thinking about the tax implications of tapping your retirement accounts as far in advance as possible,” says David Koh, managing director and senior investment strategist, Chief Investment Office, Merrill and Bank of America Private Bank.
This article will explore key tax considerations that should be part of every comprehensive retirement strategy.
When it comes to retirement savings, the choice between Traditional and Roth accounts can have significant tax implications both now and in the future.
Traditional accounts include traditional IRAs and 401(k)s which – like pensions, annuity income, short-term capital gains, bond income, and non-qualified dividends – are all taxed at your ordinary income rate by the IRS.
The Difference: Traditional accounts offer tax-deductible contributions but taxable withdrawals, while Roth accounts provide tax-free withdrawals but no upfront tax deduction.
“Your current and expected future tax brackets play a crucial role in determining the most advantageous option,” says tax professional Steve Powell of Powell Tax Law.
|
Income Source |
IRS Tax Rate |
|
Traditional IRA, traditional 401(k), annuity or pension income, bond income, non-qualified dividends, and short-term capital gains |
Your ordinary income rate (note: additional taxes may apply if some funds are used under the age of 59.5) |
|
Roth IRA or Roth 401(k) qualified distributions |
Tax-free withdrawals |
|
Long-term investment gains, including qualified dividends |
Long-term capital gains rate (plus 3.8 percent net investment income tax for some income groups) |
|
Social Security |
Up to 85 percent of benefits may be taxed as the ordinary income rate. |
Conversion Strategies: Converting Traditional accounts to Roth can be a powerful strategy, but it's essential to consider the immediate tax impact versus long-term benefits. Factors to consider include:
“Does it ever make sense to pay taxes on retirement savings sooner rather than later? When it comes to a Roth individual retirement account (IRA), the answer could be yes,” explains Charles Schwab. “A Roth IRA is funded with after-tax dollars, and qualified withdrawals are entirely tax-free. Additionally, Roth IRAs aren't subject to required minimum distributions (RMDs), which gives you greater control over your taxable income in retirement.”
The optimal choice depends on individual circumstances. High-income earners might benefit more from Traditional accounts' immediate tax deductions, while those expecting higher tax rates in retirement might prefer Roth accounts.
Understanding and planning for Required Minimum Distributions (RMDs) is crucial for effective retirement tax management.
“An RMD is the smallest amount you must withdraw from your tax-deferred retirement accounts every year after a certain age,” says AARP.
When you are younger and put money into retirement accounts, it may seem like it’s “tax-free” but these accounts are actually “tax deferred” and RMDs are the government’s method of making sure you pay taxes on your contributions and earnings.
Current Rules and Recent Changes: The SECURE Act changed the RMD age to 72 (or 73 for those turning 72 after December 31, 2022). Failing to take RMDs can result in hefty penalties, making it essential to stay informed about these rules.
The IRS issued an explanation in December 2023: “The Secure 2.0 Act raised the age that account owners must begin taking RMDs. For 2023, the age at which account owners must start taking required minimum distributions goes up from age 72 to age 73, so individuals born in 1951 must receive their first required minimum distribution by April 1, 2025.”
The RMD rules require individuals to take withdrawals from their IRAs (including SIMPLE IRAs and SEP IRAs) every year once they reach age 72 (73 if the account owner reaches age 72 in 2023 or later), even if they're still employed.
Owners of Roth IRAs are not required to take withdrawals during their lifetime. However, after the death of the account owner, beneficiaries of a Roth IRA are subject to the RMD rules.
To reduce the tax burden of RMDs, consider:
Many retirees are surprised to learn that their Social Security benefits may be taxable. Understanding the thresholds and planning accordingly can help minimize your overall tax burden.
Up to 85 percent of Social Security benefits may be taxable, depending on your combined income. We can help you understand these thresholds and plan accordingly.
“You will pay federal income taxes on your benefits if your combined income (50% of your benefit amount plus any other earned income) exceeds $25,000/year filing individually or $32,000/year filing jointly,” says the Social Security Administration.
50 Percent of a Taxpayer’s Benefits May be Taxable if:
Up to 85 percent of Taxpayer’s Benefits May be Taxable if:
Careful planning of withdrawals from various retirement accounts can help keep your income below key thresholds, potentially reducing the portion of Social Security benefits subject to taxation.
Proper investment strategy can significantly impact your tax liability in retirement:
Estate planning is a critical component of retirement planning, especially for those with substantial assets.
As of 2023, the federal estate tax exemption is $12.92 million per individual. That figure should rise to $13.61 million in 2024. However, this exemption is set to decrease significantly in 2026 unless Congress acts.
“The SECURE Act eliminated the "stretch IRA" for most non-spouse beneficiaries. We can help you explore alternative strategies to pass on your retirement assets tax-efficiently, such as Roth conversions or life insurance trusts,” says Powell.
While Texas doesn't have a state income tax, it's important to consider state taxes in your retirement planning, especially if you're considering retiring to another state.
Texas offers several tax advantages for retirees, including:
If you're considering retiring to another state, it's crucial to understand how that state's tax laws might affect your retirement income and estate plans.
While we can't predict future tax law changes with certainty, we can help you build flexibility into your retirement plan to adapt to potential changes.
Effective tax planning is a crucial component of a successful retirement strategy. By considering these various aspects and staying informed about legislative changes, you can maximize your retirement savings and minimize your tax burden.
However, retirement tax planning is complex and highly individual – there's no one-size-fits-all solution.
At Powell Tax Law, we specialize in providing personalized, comprehensive tax planning strategies for retirement. Our team of experienced professionals can help you navigate these complex issues and develop a plan tailored to your unique situation and goals.
Contact Powell Tax Law today to schedule a consultation and take control of your financial future.