“Put money in the retirement plan—get started early in life so you’ll have a bigger account when you get older.”
“Dollar cost average into the plan, so when markets go down, you’re buying cheaper.”
“You don’t pay any tax now; you pay it later, when you’re in a lower tax bracket…”
All this advice has been around as long as retirement plans, and for some, it’s true—including the last line about being in a lower tax bracket when you’re older.
But how do we know what the tax brackets will be in the future?
I regularly ask clients this question: “Do you think taxes will be lower, about the same, or higher in 20 or 30 years?”
The answer I always get is this: “They won’t be lower; you can count on that.”
If that’s what we believe, why would anyone accept the advice to put money in accounts that cause you to pay taxes later?
I believe it’s because “general” advice like this is just that—general, non-specific, guidance for the masses.
It’s directed at everyone, and the majority of “everyone” need to be encouraged to save and will probably be in a lower tax bracket when they retire. They’ll likely rely on Social Security as their primary source of income and will spend through their retirement savings, paying taxes at a lower rate due to their low standard of living.
However, if you’ve saved diligently and created a seven-figure retirement account, taxes might be one of your greatest expenses when you retire. In fact, some taxes are actually targeted at wealthy retirees. That’s why tax planning, tax management, and especially tax diversification are important parts of your retirement plan.
In short, the time to address taxes is now—not later.
Investing: Your Three Tax Options
When it comes to taxes, there are three basic types of investment accounts, and it’s beneficial to have money in all three.
- No tax today; pay tax later: Examples include traditional IRAs, 401(k)s, 403(b) accounts, deferred compensation plans, and even pensions.
- Pay tax today; no taxes later: Examples include Roth IRAs, Roth 401(k)’s, health savings accounts, and properly designed life insurance.
- Pay tax today and pay taxes on the profits as you go: These are also known as after-tax accounts. They can be owned in your name or by you and another person.
What you don’t want in retirement is to have all your retirement savings in an account where every dollar you withdraw is taxable.
To avoid this, you need the trio of tax planning, tax diversification, and tax management. If you follow this advice when you take distributions from your retirement savings, you’ll have some income that’s taxable, some that is tax free, and some that may be taxable, but is taxed as capital gain, not ordinary income.
Social Security Taxes
Taxes for retirees are a serious issue. There’s not only income tax on your retirement plan withdrawals, but there are also taxes on other income like Social Security (not to mention the additional taxes if your income is too high).
The tax on Social Security benefits is real, and it affects more and more retirees because the income levels at which benefits are taxed haven’t been adjusted since the early 1990s. Each year, inflation causes more recipients to have their benefits taxed.
Social Security benefits can be confusing, so ask an expert for help and review all your options.
As your income rises, so does your Medicare premium. This is because of the Income-Related Monthly Adjusted Amount, or IRMAA. This is another way you pay higher taxes because your income is too high during retirement. This surtax increases the premium from the standard $164.90 per month (in 2023) to as much as $560.50 per month—it all depends on your income each year (assuming filing jointly).
The Net Investment Income Tax
Another tax on investment income is the Net Investment Income Tax (NIIT). This tax can be complicated to compute, but it can be a real issue for people with a fair amount of investment income (e.g., retirees).
Investment income can come from rental properties, capital gains, dividends, and interest payments—income that retirees count on to support their lifestyle. You pay a flat 3.8% income tax on the lesser of net investment income or the excess of your MAGI over a certain amount ($250,000 for a married couple filing jointly or $200,000 for a single taxpayer).
(Wait—did that say MAGI? What’s MAGI?) That’s your Modified Adjusted Gross Income—yet another layer of confusion in the tax equation.
So contrary to popular belief, there aren’t a lot of tax breaks for retirees, and the factors that determine your tax might be more complicated than you expect. When you take a hard look at the numbers, you may discover that your income tax bill in retirement will be higher than while you were working.
But wait—there’s more!
When you turn 73, there is a “Required Minimum Distribution” (RMD) that must be withdrawn from your tax-qualified accounts. And that amount becomes a larger and larger percentage of the account each year.
So far, Roth accounts aren’t subject to an RMD—which is another reason to save money in your Roth accounts.
Many tax professionals I’ve spoken with encourage deferring taxes for as long as possible because they’re focused on the benefit today and ignoring the potential problems in the future. That’s traditional tax planning advice, but it may cost you by compounding extra taxes during your retirement (especially the later years).
It’s also important to consider the effects your tax strategies could have on others, such as a surviving spouse or your children. Without knowing it, you could leave them with much less after-tax wealth than you’d hoped.
Inherited Retirement Accounts
You might wonder: What about when I inherit a retirement account, like an IRA? For example, if my mom dies and leaves me her IRA account, how is that taxed?
The SECURE Act states that when an IRA is inherited, the beneficiary must distribute the entire IRA within ten years (with a few exceptions). This accelerates and increases income taxes for beneficiaries because the IRA distribution is added to the beneficiary’s taxable income each year.
To avoid this, one can convert a traditional IRA to a Roth IRA, empty a traditional IRA early in retirement, or use IRA withdrawals to fund life insurance (like second-to-die policies). But the most important strategy is to communicate with your beneficiaries; tell them how your plan has been built so they can continue your strategy.
Every year, I hold meetings where we include the family members, making sure everyone knows who to call and what to do, so the government isn’t the biggest heir to the estate.
For decades, the government has encouraged people to put away money for retirement by providing generous tax incentives. But remember, wherever there is a give, there must be a take. The federal government’s plan is to recover those tax breaks (and earn tax dollars on the growth of the money), as you go through retirement. You can reduce the government’s share by using a long-term strategy and working with your financial advisor to create an efficient tax plan for today and tomorrow.
Personal financial planning is just that—personalized—so make time to talk to someone who can help you develop a custom financial plan.