You already know that your income might change considerably when you retire. But have you also thought about your future tax bills? Because your income is derived from different sources in retirement, you could notice a big difference in taxes during that first year of retirement. Hopefully it’s a happy surprise, but sometimes retirees are dismayed by tax bills that are larger than expected. That’s why retirement planning should include not only income and budgeting issues, but also the tax implications of those decisions.
Taxable income. If you saved money for retirement using a 401(k) or traditional IRA, you enjoyed the benefits of stashing tax-free money that accumulated tax-deferred for years. Of course, the IRS wants their cut at some point, so the money will be taxed as regular income when you begin taking withdrawals from those funds. If your annual withdrawals fall into a modest tax bracket, you won’t have to worry too much. However, if you saved a considerable amount for retirement and you’re taking large distributions, your income tax bill might surprise you.
Non-taxable income. On the other hand, there are ways to establish tax-free income in retirement. When you save money in a Roth account or cash value life insurance policy, that money has already been taxed. Therefore, your distributions from those accounts in retirement will not be taxed any further. It might be wise to consider a tax diversification plan, in which you save money in both types of accounts to prevent your tax burden from being so heavy in the future.
Convert to a Roth account. At this point, you might be wondering if it’s possible to convert a traditional retirement account to a Roth account. That way, you can avoid income taxes on distributions throughout retirement, right?
Sure, but the IRS will make you pay taxes on any amount that you convert during the year that you convert it. This might still be a good plan, if you might be moving up a tax bracket in retirement. It might also be a smart move to make during a year in which you have extra tax deductions, or when your income is lower for some reason. This is an issue to discuss with your tax professional during the year in which you expect to convert funds.
Tax deductions. When you plan for future taxes, keep in mind how deductions (or loss of deductions, rather) might affect you. For instance, many people hope to pay off their mortgages before retirement. It’s a good plan, but you will lose your mortgage interest deduction. If you’ve been enjoying that deduction for years now, remember to consider the impact of losing it when you estimate future income taxes.
As with all issues pertaining to retirement, always consult a professional before making big decisions. It’s easier to plan for financial success when you anticipate possible problems and avoid them, rather than trying to fix them after they have already occurred.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.
Traditional IRA account owners should consider the tax ramifications, age and income restrictions in regards to executing a conversion from a Traditional IRA to a Roth IRA.