One of the biggest surprises many retirees encounter is the taxes during retirement. While many people do see lower tax rates after retiring, it’s not the guarantee that many were led to believe. In fact, the more you save for retirement, the greater the likelihood that you will be in a higher tax bracket once you’re retired!
The good news is that it doesn’t have to be this way. You can think of planning for taxes in retirement like a game of “would you rather”: pay taxes now, pay as you go, or pay them later. As the proverbial saying goes, you reap what you sow; choosing carefully can mean the difference in thousands of dollars saved or spent on taxes after you’re retired. Let’s break it down.
Pay Later: Tax-Deferred Retirement Accounts
Tax-deferred retirement savings vehicles are perhaps the most widely used plans for one simple reason: as we mentioned above, most people are sold on the idea that they’ll be in a lower tax bracket after retiring. The most popular accounts that fall into this category are traditional IRAs and 401(k)s, but they also include qualified annuities, 403(b)s, and 457(b)s. These accounts essentially let you and the IRS pretend you don’t have the money until you use it in retirement; you’ll get a tax deduction on contributions for the year, invest the funds and allow them to grow, and only realize them as taxable income once you make withdrawals in retirement. If you’re in a lower tax bracket in retirement than you are when contributing, you’ll end up paying less taxes overall.
While this is true for many, it’s not guaranteed across the board. Think about all of your income sources in retirement: you may have a pension, social security, and a 401(k) or IRA. There will come a point in retirement when the IRS requires you to take regular withdrawals (RMDs) from all of those accounts. The withdrawal amounts are calculated as a percentage of your total account balance, so If you’ve accumulated significant retirement savings, you’ll have higher withdrawals. When factoring in all of your retirement income and the fact that you HAVE to start using it, your retirement income could be substantial–which is a good thing, unless you’ve utilized tax-deferred accounts. Those sizeable savings just landed you in a higher tax bracket and earned a hefty tax bill.
Pay as You Go: After-Tax Accounts
After-tax accounts are also called non-qualified assets. These savings vehicles are purchased with after-tax dollars and taxed on the growth. Some examples of this type of asset are non-qualified annuities, bonds, REITs, and CDs.
There are a few advantages to these types of investments. Firstly, if you’re not sure what your taxes in retirement will be, they allow you to get most of the taxes out of the way when you can predict your tax bill. They also don’t have the same restrictions that most tax-deferred accounts have: you can contribute as much as you want, whereas 401(k)s and IRAs have annual contribution limits. You can also access the funds in some of these accounts whenever you want to without incurring a penalty; early withdrawals from a tax-deferred account are always subject to a penalty. Keep in mind, however, that you’ll still be taxed on the gains.
Pay Once and Done Forever: Tax-Free Assets
Roth IRAs and Roth 401(k)s, indexed universal life insurance policies, variable life policies, and whole life insurance policies are tax-free/tax-favorable assets, and they’re our favorite ways to save for retirement, especially for high-net-worth individuals. You pay taxes upfront when purchasing them, and that’s it! There are no more taxes ever, and the growth from these assets is tax-free.
We don’t always know what the future will hold as far as tax rates, which is why the predictability of tax-free assets is so valuable. And, if you will have substantial assets and/or income in retirement, any income that comes from a tax-free asset is, naturally, untaxed. You don’t have to worry about paying a huge tax bill on a fixed income! It’s a natural stress reduction on top of the overall tax savings. They’re also much better for estate-planning purposes since you won’t be leaving a taxable inheritance to your loved ones.
Finding the Sweet Spot: All Three
While tax-free assets certainly have the most benefits if you don’t want to leave your savings vulnerable to fluctuating tax rates or have significant savings, they are more expensive upfront. If you’re already a high earner, or if you want to convert your traditional IRA to a Roth, you could face some tax-induced sticker shock. Thankfully, you don’t have to take an all-or-nothing approach.
Using all three of these assets can provide you with much-needed flexibility for now and later. By diversifying your tax strategy, you can spread out your tax obligation and make life a little easier while still owing less taxes overall. For example, low-income working years are a prime time to purchase tax-free assets, since you’ll be in a lower tax bracket. In high-income-earning years, you may want to switch and contribute to a 401(k) or IRA, deferring those taxes until retirement. After-tax accounts can be funded anywhere in between.
Once you reach retirement, the strategizing isn’t over; you should talk to your financial advisor and tax preparer about a withdrawal strategy that allows your investments to continue growing as much as possible without also increasing your tax burden.
Keep an Eye On The Forest AND The Trees
Tax-advantaged retirement planning can be a tricky business. On the one hand, you need to make your life and finances work for you right now, but on the other hand, you don’t want to put off paying all of your taxes until retirement. It’s a balancing act that benefits from a personalized approach combining short-term comfort with long-term stability, which is exactly what we specialize in.
You can learn more about how to balance these three types of assets by watching or attending one of our signature Parady Learning Lounge® presentations called “The Trees.” And if you’d like to learn how we can help tailor this strategy to your situation, simply reach out to us here.
Sources
https://www.northwesternmutual.com/life-and-money/how-is-an-annuity-taxed/
