Retirement planning and tax planning are intertwined. A retiree may have several buckets to draw money from for their living expenses. While the money from each bucket spends the same, the tax implications are not the same.
It is a delicate chess game to minimize your taxes and maximize your retirement assets. Here are the moves you need to know about each bucket or retirement asset.
Taxable buckets include:
Pensions and Deferred Compensation
These retirement benefits are provided by the employer. When they are received, they are fully taxable. There aren’t many of these buckets to be found. Few corporations offer pensions; it’s mostly government agencies with pension retirement benefits.
Pensions provide a good foundation for retirement. They give you a guaranteed monthly payment. You have little flexibility with pensions so this is your first building block in your retirement plan. You build around this bucket.
Defined Contribution Plans 401(k), 403(b), or TSP (Thrift Savings Plan)
These are employer sponsored. As an employee your contributions are tax deductible going in and grow tax free. However, distributions from these plans are 100% taxable. And if received before 59 ½ may have an additional 10% penalty.
Since this is a taxable bucket, you may think this is the last bucket you want to access in retirement. However, you want to max out your lower tax brackets of 10% and 12%. As a married couple that is about $104,000, singles $53,000 of taxable income.
For many retirees, their 401(k) is a big part of their retirement assets. When you reach age 72, you have a Required Minimum Distribution (RMD) – no exceptions. Reducing that asset ahead tax efficiently, will reduce your RMD and potential tax impact of Social Security benefits and Medicare premiums. (See Social Security below)
Traditional IRA (Individual Retirement Account)
These are initiated by an individual. Contributions may be tax deductible if within income guidelines. You may also “rollover” or move retirement plan monies to an IRA. The transfer generally is tax free, and the money grows tax free. However, they are 100% taxable income when distributed.
Traditional IRA’s have similar tax features as 401(k)s and 403(b)s. You want to maximize your 10% and 12% tax bracket. Even if you don’t need the cash flow, remove the money from this ticking time bomb. You might consider a Roth conversion of excess money (coming later)
Mixed buckets or partially taxable include:
Investment Brokerage Account
Investments pay interest and dividends that are taxable. Sales of investments at a gain are taxable, losses may offset gains. Not all of the sale proceeds are taxable. At this time capital gains and qualified dividends have a lower tax rate. That rate depends on your tax bracket but the maximum is 20%
Brokerage accounts are taxable and can help or hurt your retirement planning strategy. Have you ever received a hefty capital gain disbursement from a mutual fund and it increased your tax bill? That distribution is required by law. Exchange Traded Funds (ETF) are more tax efficient in that respect. An unexpected capital gains disbursement can put you into a higher tax bracket, tax more of your Social Security and increase your Medicare premiums.
An investment vehicle that is designed to shelter earnings on investments. As long as the annuity isn’t accessed, it grows tax free. A nonretirement (nonqualified) disbursement can be a combination of return of principal and earnings. A retirement annuity will be 100% taxable.
May be completely tax free or only partially taxable. It is dependent on your income as to how much Social Security gets added into your taxable income. Current tax law caps the inclusion at 85% of your Social Security benefits.
Delay taking Social Security. One, it allows your benefit to grow at 8% by delaying. You can also do the heavy lifting with disbursements from your retirement accounts without complicating your taxes. You have a window from age 60-70 to take retirement benefits without mixing in Social Security.
Tax free buckets include:
Savings Accounts and CD’s (Certificates of Deposit)
The interest from savings accounts and CD’s are taxable. However, the interest rates are so low, the taxable income may not amount to much. The value of a savings account is accessing money in an emergency. You don’t have tax implications and you don’t have to time the market.
Contributions to Roth accounts are not tax deductible. They grow tax free and come out tax free. Contributions to Roth IRA’s are restricted by your income. Currently married couples can contribute to a Roth IRA if their Adjusted Gross Income is under $198,000 and for singles the threshold is $125,000.
A 401(k) or 403(b) account with a Roth option does not have income restriction for contributing As in a Roth IRA, contributions to a Roth 401(k) are not deductible. Roth contributions do count towards your maximum allowed contribution of $19,500. An employee may want to consider contributing to both options in their 401(k) or 403(b), especially if they are over age 50 and eligible for the $6,000 catch up provision.
Roth accounts are a great bucket in retirement planning. If you need additional dollars for traveling, buying a car, or medical expenses, you can draw the money from your Roth account. You maintain the precarious tax balance and avoid the domino effect of increase taxable Social Security, increasing taxes and Medicare premiums.
Roth IRA’s do not have the Required Minimum Distribution (RMD). You can use this asset as you desire. It is a great asset to pass to your beneficiaries as there aren’t any taxes attached to the account.
Roth Accounts are a flexible, valuable planning tool for retirement. Tax laws allow for converting retirement accounts or Traditional IRA’s to a Roth account. Yes, you pay the tax on the amount you convert to a Roth. However, the assets then grow tax free and are distributed tax free.