One of the expenses that many people underestimate in retirement is taxes. You will owe federal taxes on at least some of your retirement income and perhaps even state taxes depending on where you live. Planning for your taxes prior to retirement is important to make sure you do not end up paying much more than you had expected. Moreover, while some things like state tax policies are not changeable, you may be able to reconfigure your approach to withdrawals to limit your tax liability. Even if you are in your 50s or 60s and quickly nearing retirement, there are some things you can do now to give yourself more flexibility in the future. This flexibility can help you save a lot of money on taxes, which ultimately means having your nest egg last longer and having more funds to do the things you want.
The important thing to realize about retirement accounts is that they are tax-deferred, which is not the same thing as being tax-free. Many people automatically save for retirement and periodically check in on their nest egg rather than really thinking about what it means. The money in most IRAs and 401(k)s comes from pre-tax money, but they will be taxed once you withdraw them in retirement. Do not let that first tax bill from the government be a surprise. The amount that gets taken out depends on future tax rates, as well as your income level. Given the current national debt and deficit levels, tax rates are only likely to increase moving forward. Thus, the best strategy is to minimize your taxable income in retirement to keep yourself in a lower tax bracket.
The Key Points to Know about Roth Retirement Accounts
Fortunately, you can minimize your taxable income in your 50s and 60s without actually limiting the amount of money you have to spend while you are retired. The main tools for doing so are Roth accounts. Unlikely traditional retirement accounts, the Roth versions consist of contributions that are made after taxes. For that reason, you will not have to pay any taxes on withdrawals from this account during retirement. Moreover, the money that you withdraw from these accounts does not count toward your taxable income. Thus, if you are getting close to the threshold for another tax bracket with your traditional accounts, you can lean more heavily on Roth versions to ensure that you do not bump yourself up and end up owing much more money.
If you are still working, you can achieve tax diversification by varying the way in which you save for retirement. Ask if your company has a Roth 401(k) plan that you could contribute to instead of the traditional one. This sort of account allows money to grow tax-free for the rest of your life and can even be passed on to your beneficiaries without any sort of tax ramifications. In 2021, you can contribution up to $19,500 per year to a Roth 401(k) with an additional $6,500 in catch-up contributions for anyone over the age of 50. Depending on the specific rules of your plan, you may be able to contribute even more money.
Conversions and Other Approaches to Roth Savings
The next step is to begin thinking about conversions. You can convert an existing 401(k) to a Roth 401(k) or a Roth IRA. The downside of this is that you will owe taxes on the amount that you convert, but then you will not have to pay down the line. Consider your tax rate now and what it will likely be during retirement as you think about this conversion and ensure that you only convert what you can actually afford to pay taxes on so you do not end up owing money to the government. This tax bill can be shocking, but it is the only time you will even need to pay taxes on the money as it continues to grow in the account. Also, you need to understand that this conversion is permanent. Having some money in a Roth account is a great way to protect yourself from high taxes in retirement, but financial professionals generally advise that converting all your money is not a good idea if you are not absolutely sure you will face higher taxes in retirement.
You also have the option of converting current IRAs to Roth versions. Many people avoid doing this because they do not want to the pay the taxes now. However, it is important not to be shortsighted. Since the account grows over time and tax rates are likely to go up over time, you could save a lot of money by paying those taxes now. If you do not want to do any conversions, your other option is to simply open a Roth IRA now and focus your savings there, especially if you are still quite far away from retirement. Currently, individuals can contribution up to $6,000 per year with an additional $1,000 in catch-up contributions. In addition, you can open and fund an account for a spouse if that person does not currently work.
Outside of a Roth account, other options exist for minimizing your taxes in retirement, such as permanent life insurance. However, these products can prove quite complex, and you should consult with a financial professional before purchasing them. A professional can also help you figure out the ideal balance of Roth and traditional accounts to keep your retirement tax bill to a minimum.