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Preparing for One of Retirement’s Major Expenses – Taxes

Preparing for One of Retirement’s Major Expenses – Taxes

As you plan for retirement, you’re likely considering the major expenses you may encounter, such as housing and health care. But are you overlooking something that may have a significant impact on your ability to achieve a financially secure retirement?

 

If the bulk of your retirement savings are in tax-deferred accounts (workplace plans and traditional IRAs), most or all of your distributions will be subject to ordinary income tax rates. This may leave you with less cash flow than you expect, which could impact your ability to meet your day-to-day expenses.

 

A starting point – spread your savings out

So how can you reduce the impact of taxes on your retirement portfolio? Just as portfolio diversification is recognized as a good approach to investing, tax diversification can play an important role in helping you potentially enhance your retirement savings when the time comes to withdraw money from your accounts. You may have the ability to stretch your retirement dollars further if you can manage retirement distributions in a tax efficient way.  Consider diversifying your savings into three different tax “buckets”:

•     Tax-deferred accounts – workplace savings programs (including 401(k) and 403(b) plans), traditional IRAs and annuities.

•     Tax-free accounts – Roth IRAs, cash value life insurance, municipal bonds, if appropriate

•     Taxable accounts – savings and investments outside of tax-advantaged vehicles

 

The biggest challenge is often directing enough money into tax-free accounts such as Roth IRAs. Because there can be tax consequences in that event, Roth conversion is not always a viable option for investors to consider – so keep in mind that if you choose this process, the earlier you begin the better. Also be aware that you are not able to deduct any contributions to a Roth, as they are after tax dollars.

 

In retirement – manage your distributions

Efficiently managing distributions from your tax-deferred accounts is important because most distributions from 401(k) plans and traditional IRAs are subject to ordinary income tax rates, and will increase your taxable income.  Investors with a tax-diversified portfolio, comprised of assets in taxable, tax-deferred and tax-free accounts, are often best positioned to manage cash flow during retirement.

 

For example, let’s assume you expect to use your 401(k) plan to meet your annual income requirements. You will need to pull out more than what you need as annual income from your plan – or tap your bank account – to cover the taxes you’ll owe on this income. (The actual amount depends on your income tax rate.) If you didn’t account for this in advance, your savings may be depleted more quickly than you planned. And depending upon where you are in the tax brackets, the actual amount you withdraw may push some of your income into a higher tax bracket, making it more important to manage your distributions.

 

If you have the ability to pull part of your necessary cash flow from a tax-free account, such as a Roth IRA, you may be able to reduce the amount of taxes you pay throughout your retirement, stretch out your qualified plan distributions and still meet your income needs. (Remember of course, that you did pay tax on the money that’s saved in your Roth account. You simply paid it before you invested it for retirement or at the time you converted it from a traditional retirement savings plan.)

 

Also keep in mind that there’s a common assumption that your income tax rate in retirement will be lower than it was during your working years. While that is true for some retirees, it is not true for all. Your individual retirement savings and distribution strategy needs to be based on how you intend to spend your retirement years, with the potential impact of taxes only being one piece of the puzzle.

 

Consider working with a financial advisor who can help you to plan for retirement and other long-term financial goals while keeping tax expenses in mind. Though your financial planner will not be able to give you direct tax advice, he or she will work with you and your tax advisor. By being proactive in the years when you are still accumulating wealth for retirement, you can achieve greater tax-diversification in your overall portfolio by the time retirement begins, giving you more flexibility with the money you’ve saved.

This post is contributed by a community member. The views expressed in this blog are those of the author and do not necessarily reflect those of Patch Media Corporation. Everyone is welcome to submit a post to Patch. If you'd like to post a blog, go here to get started.

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