Tax-Free (Roth)
You can withdraw money from your designated Roth accounts without incurring a tax liability. There are some requirements that must be met first. In most cases, as long as you are over 59 ½ and the account is at least 5 years old, then you are good. Otherwise, earnings (not your contributions) in the account may be taxed, and you may owe a 10 percent penalty as well.
Taxable
Tax-advantaged retirement accounts, both tax-deferred and Roth, both provide a huge benefit by shielding your investments from taxes while they are inside the account. That means interest, dividends, and investment gains aren’t taxed along the way.
That isn’t the case for the savings and investments you have in taxable brokerage accounts. You’ll incur a tax liability in these accounts when you receive interest and dividends, and when you realize gains (meaning sell) regardless of whether you withdraw the money or not.
Pensions And Social Security
Pension and Social Security income is generally taxable.
A special note about Social Security retirement benefits is that they may not be taxable, and are never fully taxable. It depends on a measure called your combined income, which is your adjusted gross income plus half of your Social Security benefit, plus any tax-exempt interest you receive.
Depending on how high your combined income is, you may have to include none, half, or up to 85 percent of your Social Security in your taxable income.
2. Strategy For Distribution Based On Taxes
Once you have an idea of how your money is taxed in retirement, you can create a plan that allows you to navigate taxes efficiently.
The key to having a tax-efficient distribution plan is to consider how each source of income contributes to your tax bill. Rather than taking all of your withdrawals from a tax-deferred account, or completely from your Roth accounts, consider how blending your withdrawals from all sources might help you achieve your lowest possible average tax rate throughout retirement.
3. How Do Different State Taxes Play Into Retirement?
In addition to income taxation at the Federal level, there are currently 43 states that also have their own income taxes. Of course, if you live in one of these states, you’ll need to account for this as well.
Even in states that have a state income tax, most of them exempt Social Security retirement benefits. There are 12 states that don’t, however.
Even still, your state may have an income tax but exclude withdrawals from your tax-deferred retirement accounts and pension income. These are all important factors to consider
4. Hire A Tax Professional
If you’ve ever spoken with me about your retirement plan or read anything I’ve written about retirement taxes, you’ll quickly find that I am very “pro” hiring a tax professional to prepare your tax return. Even more so if you live in a state with an income tax — because you’ll want a tax professional that is familiar with your state code as well.
“But what if my financial planner helps me with my tax planning?” I often get this one from my own clients when we first begin working together. “So you’re my tax guy right?”
And it’s easy to see the confusion.
If you are working with a financial planner who incorporates heavy doses of tax planning, then my view is that you especially need a tax professional to file your tax return. Let me explain…
- Understand there is a difference between tax planning and tax preparation.
- Tax planning involves thinking through the tax consequences of different decisions beforehand and proactively deciding what you will do now and in the future to affect your tax liability at a later date.
- Tax preparation means gathering information, filling out forms, and producing a document or documents that describe what happened in the past (generally the prior year) to send in to the IRS to show a tax liability that you have already incurred.
Some professionals do both, but these are different skill sets and many professionals would find it very difficult to be really good at both. Plus, I think it is a good idea to have more than one set of eyes on the same problem, particularly when those eyes come from different perspectives.
If you are working with a tax-savvy financial planner, then the odds are you are probably also engaging in more involved tax strategies that make the filing more involved as well. It’s entirely possible that you can simply file something incorrectly — forget a form, check the wrong box — and ruin the tax strategy you thought you had in place. Sometimes the highest value of a professional tax preparer is in the mistakes they help you avoid.
5. The Biggest Tax Mistake For Retirees
The biggest mistake I see retirees make regarding taxes isn’t a single action, but more of an idea. So many retirees fail to have a plan for actively addressing their taxes.
