Why Tax Planning Should Be Part of Your Retirement Plan
When planning for retirement, most people are focused on saving and investing wisely—both very important elements of any retirement plan. However, beyond understanding just how much you need to save now for your future retirement, it’s also important to understand how future taxes may impact your retirement income. Tax planning is a crucial element in ensuring that your retirement years a financially stable and secure. Without a tax strategy, taxes in your retirement years can quickly eat up a large portion of your savings, leaving you with less money than you’d planned for. Here at The Accounting Guys, we can provide detailed consulting and planning for your taxes, both now and in the future. Keep reading to learn more about why this kind of tax planning should be a part of your retirement plan.
Understanding How Taxes Impact your Retirement
When financially planning for retirement, it’s essential to understand that taxes don’t simply stop because you’ve stopped working. Like most retirees, you’ll probably continue to have multiple sources of income throughout your retirement years, and taxes can impact each of them differently. Social Security, pension, retirement account withdrawals, and earnings on your investments can all be taxed, but will likely be taxed in different ways.
For example, many retirees assume that Social Security benefits are exempt from tax, but that’s not necessarily true. Depending on your total income each year, up to 85% of your Social Security benefits may be considered taxable income. Pension payments and withdrawals from tax-deferred accounts like traditional IRAs and 401(k)s are also taxed as ordinary income. Because these income sources are taxed differently, it’s important to have a thorough tax plan for your retirement years; this allows you to strategically time your retirement account withdrawals and manage your income to reduce your tax burden each year of your retirement. Should we use ordinary income not regular income. All income sources in this paragraph are taxed at ordinary rates, the yellow phrase makes it sound like there are different tax rates based on traditional, 401K, or SS. I made the changes to the paragraph.
Choosing between Tax-Deferred and Tax-Free Retirement Accounts
Did you know that the retirement accounts you contribute to now can directly impact how much tax you pay in your retirement years? Tax planning helps you to balance contributions between tax-deferred and tax-free accounts, and understand how those choices impact your current and future taxes.
Traditional IRAs, 401(k)s, and similar retirement accounts allow you to defer taxes until you withdraw funds during your retirement years. This will provide an immediate tax benefit by reducing your tax liability in your working years. However, this means that the distributions you receive from these accounts during retirement will be taxed at your ordinary tax rate. Because retirees’ income levels are generally lower than during their working years, this does mean that you’ll likely pay less tax on that income by being in a lower tax bracket. However, those distributions may push you into a higher tax bracket during retirement, making more of your Social Security benefits subject to taxes.
On the other hand, tax-free accounts like Roth IRAs and Roth 401(k)s are funded with post-tax dollars. Because you have already paid taxes on that income, your withdrawals during retirement are tax-free. This provides you with a source of income without worries about how much you’ll lose to taxes. However, it does mean that you likely paid more in taxes on the income, since you paid them while in a higher tax bracket.
Choosing between tax-free and tax-deferred accounts can be a careful balancing act—as can timing the withdrawals from each of them. A detailed tax plan to accompany your retirement financial plan can help you get the most benefit from both types of accounts.
Establishing Tax-Efficient Withdrawal Strategies
To continue with this line of thinking, tax planning now can help you to have a clear strategy for when to withdraw from which of your retirement accounts in the future, as well as when to start taking your Social Security benefits. This is one of the most critical components of retirement tax planning.
For example, you might start out your retirement years withdrawing funds from a taxable investment account). These early years of retirement are generally the most stable ones in terms of finances, and withdrawing from these accounts first allows your tax-deferred and tax-free retirement accounts to continue growing. You may also choose to delay Social Security benefits to reduce taxable income in the earlier years of your retirement and increase the amount you receive later on.
There are many different approaches and strategies to managing taxes in your retirement years; the only way to know which one is best for you is to take the time to meet with a tax planner, discuss your retirement finances, and put together a strategy that works for your future finances.
Meet with a Retirement Tax Planner
Here at The Accounting Guys, we can provide expert, in-depth guidance on tax planning for this year, the next, and into the future. Contact us today to meet with an experienced tax expert about your retirement tax planning in Provo. We’ll go over your finances with you and help you to establish a tax-effective strategy that will allow you to get more from your retirement savings. Schedule a free consultation with our tax experts today and start planning for a financially stress-free future!