One of the biggest expenses during retirement for many people is taxes. When retirement systems changed during the 1980’s, many workers lost the option of receiving a defined benefit pension. Under that system, companies funded the retirement of their workers. The companies bore the investment risk and guaranteed a certain benefit to workers usually based on years of service and salary.
To help replace defined benefit plans, a new 401k defined contribution plan was adopted by many workers. Under this plan, a worker defers some current income that is invested tax deferred for retirement. Many times, the company would provide some matching contribution. Most workers probably thought that their tax rates would be lower when they retired and so they would pay less in taxes. This assumption is probably not true, because the odds of higher taxes are on the horizon.
Pro-active tax planning is not a single event that can be done once and completed. It is a series of moves designed to lower your overall tax bill Sometimes this requires more to be paid in the short term to have the best outcome. Many people create their own tax time bomb, because they do not have an organized tax plan.
It is important to start saving for retirement at an early age. This allows compound interest to be your ally. However, not all savings should go into a qualified or pre-tax account such as a 401k or IRA. If you get an employer match, take advantage of free money by contributing the required amount. However, do not make this your only savings vehicle.
Contribute to after tax investments and tax preferred things such as a Roth and special life insurance products in addition to qualified accounts. This will help give you more control over taxes in the future and maybe reduce the amount of taxes you pay in the future. After tax investments such as brokerage accounts often receive favorable tax treatment such as receiving long term capital gains and preferred dividends which are taxed at a lower rate. All income from 401k is taxed at the higher ordinary income rate.
The steps we just outlined are important to manage the accumulation phase of saving. Now we will look at what you can do if a large of a percentage of your savings are already in qualified accounts. Social Security is a very important retirement income source. How much income you will receive is dependent on your earnings history and the age you begin to take the benefit.
Each year, you must be tax pro-active. This means taking action before the end of the year. Do you still have room in the 12% tax bracket before rates increase to 22%? Does it make sense to do a Roth conversion? Which type pf money should you withdraw funds from first?
If you have not began taking Social Security and have a large amount of qualified funds, it may make sense to delay starting benefits. If you are covered by Medicare, you have to be careful about creating an extra tax coming from higher Part B and Part D charges. Single tax payers will find it much more difficult to defuse a qualified tax dilemma than married filing jointly tax payers.
Work with an advisor that can help with tax complexities. Remember, it is not just how much you earn, but how much you get to keep that matters.