Most people ignore the significant impact taxes could have on their IRA and 401K because they think they don’t have a choice in the matter. This is simply not the case.
You have more control over your taxes than you realize, including your IRA and 401K, Social Security benefits, and investment income. Come along as we discuss how to avoid four big tax mistakes as you plan for retirement.
Mistake #1: Not Having a Strategy for Your Tax-Deferred Accounts
Taxes on Your IRA and 401K: One of the biggest retirement tax traps is withdrawing money from your 401K, IRA, or other retirement accounts. These accounts are very popular for saving money because of employer matching and tax-free contributions. However, withdrawing this money can lead to unexpected taxes, as the IRS will want its share.
Required Minimum Distributions (RMDs): When you turn 73, RMDs kick in, requiring you to withdraw a certain amount from your IRA or 401K each year. Failure to comply with RMD rules can result in severe taxes, penalties, and fees. These accounts have been called “sleeping tax bears” that wake up and growl loudly in your 70s. Creating a withdrawal strategy in your late 50s or early 60s can help you avoid paying thousands in unnecessary taxes and penalties.
Mistake #2: Not Having Tax Diversification
Tax diversification involves spreading your investments across accounts with different tax treatments to better manage your tax liability in retirement. There are three basic tax categories to diversify in:
- Taxable accounts: Brokerage accounts, checking, and savings accounts. You pay tax on dividends, interest, or capital gains.
- Tax-deferred accounts: 401(k), Traditional IRA, 403(b), real estate, or hard assets.
- Tax-free accounts: Roth IRA, interest from municipal bonds, and certain types of life insurance.
By putting investments in accounts across the categories, you’ll likely significantly impact your retirement tax bill. But it’s important to do so proactively – BEFORE the tax bill comes.
Mistake #3: Not Converting Some of Your Money to a Roth
An IRA or 401K allows tax-free contributions. But when you withdraw that money in retirement, you have to pay taxes on that money. However converting some, or all of your traditional IRA or 401K to a Roth can lower your tax bill since Roth distributions aren’t taxed.
How a Roth IRA Works: Unlike traditional IRAs or 401Ks, Roth IRAs don’t offer tax-free contributions, but you pay zero tax when you withdraw money in retirement. And you don’t have to deal with RMDs either. That means you get tax–free growth – which could add up to tens of thousands of dollars in retirement, if not more. Another benefit is the lack of early withdrawal penalties, which makes Roth IRAs a flexible option for retirement planning.
A Few Watch-Outs: All of this said – Roth conversions can be tricky. Knowing the exact tax impact can be challenging until the year is over, and you’re not able to reverse your conversion decision. It’s important to seek financial advice to navigate the complexities of Roth conversions effectively.
Mistake #4: Forgetting About Taxes on Your Social Security Benefits
Taxation of Social Security Benefits: Many people are unaware they could pay taxes on as much as 85% of their Social Security benefits. This tax bill can be a shock if not anticipated and planned for in advance. Here’s how your benefits are taxed:
- If your income is over $25,000 (or $32,000 for couples), you will face taxes on up to 50% of your Social Security benefits.
- If your income exceeds $34,000 (or $44,000 for couples), you could be taxed on up to 85% of your benefits.
Planning for these taxes can help you avoid unexpected reductions in your Social Security benefits.
Tax laws are subject to change, and staying informed about new legislation is crucial. Working with a tax professional can help you adapt your retirement strategy to any changes in the tax code, so you know you have the latest information and strategies to maximize your retirement savings and minimize your tax liability.
For your complimentary review meeting – step one of our Taxsmart Retirement Program™– to get your taxes on track for retirement, call us today: 952-460-3290.
