Have you strategically planned for taxes you may have to pay on your retirement income?
A well-rounded retirement plan includes not only strategies for setting aside money before you retire but also how you will receive or create income once you’re retired. A key consideration for both aspects of retirement planning? Taxes.
As you consider the best ways to save and withdraw money for retirement, make sure you factor in how you will pay your taxes. Christina Williams, senior wealth strategist at Wells Fargo Wealth & Investment Management, shares these steps to consider before and during retirement.
10+ years before retirement: Consider both tax-deferred and taxable investment options
Common retirement accounts such as company-sponsored 401(k) plans and (if you meet certain qualifications) Traditional IRAs let you deduct your contributions (that would otherwise be taxed as ordinary income) and defer your tax obligation on any appreciation of the assets. While that means you aren’t paying taxes now, it can potentially create a significant tax burden in retirement. Once you start taking distributions in retirement, the entire distribution amount is taxed as ordinary income. Withdrawals may be subject to an IRS 10% additional tax for early or pre-59½ distributions.
For added flexibility, you may also want to save in a taxable account. Keep in mind that some investments have built-in tax advantages, even in a taxable account. For example, the interest on certain municipal bonds is generally federal-tax-free and state-tax-free if the issuer is in the state in which you reside. While the interest income is tax-free, capital gains, if any, will be subject to taxes. Income for some investors may be subject to the federal alternative minimum tax (AMT). And if you purchase a stock that doesn’t pay dividends, you can delay paying any taxes until you sell — perhaps in retirement. At that point, you may owe capital gains taxes if your proceeds are greater than your cost basis. Currently, long-term capital gains are taxed at lower rates than ordinary income.
Age 50 or older: Proceed smartly with catch-up contributions
If you’re 50 or older, you can make additional catch-up contributions to 401(k) plans and IRAs. Many companies now have the option for employees to make contributions to a Roth 401(k) plan. You could consider using a portion of your annual maximum retirement contribution amount to allocate contributions to both a Roth 401(k) plan and a traditional 401(k) plan (this strategy can be employed even before you attain age 50). Though this means you’ll use after-tax money to fund the Roth 401(k) now, distributions (withdrawals you make) are tax-free as long as you are 59½ or older and have had the account for five years or more or meets other requirements. Withdrawals may be subject to an IRS 10% additional tax for early or pre-59½ distributions.
Once you’re in retirement
Consider liquidating your taxable assets first to fund your lifestyle needs before making distributions from your IRAs and employer-sponsored plans (you can start taking distributions from these accounts without tax penalties starting at age 59½). When you reach age 72 (73 if you reach age 72 after December 31, 2022), you will be required to start taking distributions (known as required minimum distributions, or RMDs) from your Traditional IRAs and employer-sponsored plans. Once you attain your RMD age of 72 or 73, dependent upon your birth date, first take your RMDs and then consider funding your remaining cash flow needs with taxable investment assets.
Also, consider delaying receiving your Social Security benefits. Once a taxpayer makes a nominal amount of income, these benefits may be taxed. Therefore, deferring your payments means you can avoid paying taxes on the benefits until further into your retirement, which could be beneficial if you expect your income (and your tax rate) to drop as you age. If you push the date you start receiving payments beyond full retirement age as defined by the Social Security Administration, an even bigger benefit is that you may get a larger monthly payment.
What you can do today
Tax laws change over time. For example, just because long-term capital gains are currently taxed at lower rates than ordinary income, there’s no guarantee that will still be the case in the future when you retire.
Everyone’s tax situation is unique. The impact of taxes is dependent on many things specific to your income and the structure of your investments. It may not be accurate to assume that your tax rate or the amount of tax you will pay in retirement will be lower than during your working years.
For these reasons, it is important to work with your financial and tax advisors on a regular basis to understand the tax implications of your investments and to plan accordingly to help structure your retirement income plan for the best possible outcome for you.
Wells Fargo & Company and its affiliates do not provide tax or legal advice. This communication cannot be relied upon to avoid tax penalties. Please consult your tax and legal advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your tax return is filed.
Wells Fargo Wealth & Investment Management (WIM) is a division within Wells Fargo & Company. WIM provides financial products and services through various bank and brokerage affiliates of Wells Fargo & Company.