Most people are shocked to learn that the biggest expense in retirement, that long-sought oasis after a lifetime of hard work, won’t be a mortgage, healthcare, or green fees at the local golf course. It will be taxes! The unfortunate reality is that even the most meticulous, careful, and perfectly timed investments and investment strategies can crumble before the harsh winds of taxes. Here are five retirement tax traps that could save you thousands!
Retirement Tax Trap #1: 85% Social Security Tax?
Social Security is a pillar of America’s retirement, representing a third of all retirement income, according to the Social Security Administration.
What you may not know is that, depending on how much other income you receive, your Social Security benefits could be taxed by as much as 85 percent! The Catch-22 of retirement planning (and income in general) is that the more you earn the more Uncle Sam takes. So while those whose sole income is Social Security likely won’t be taxed at all, those with multiple sources of income will not only see less of their Social Security benefits but higher tax rates on all retirement income.
There are some ways to mitigate this, such as postponing retirement until you’ve paid off your mortgage(s) and vehicles. This cuts your monthly expenses during retirement and lowers the need to tap other sources of income in order to maintain a comfortable lifestyle. Another option is to invest in and pull from Roth IRA accounts, which are taxed at the time of investment and thus tax-free when cashed out. Income from Roth IRAs doesn’t contribute to your total income and as such doesn’t negatively affect the tax rate on your Social Security benefits (though there is another catch; see #2 below).
The point is, there’s a difference between claiming Social Security benefits and maximizing Social Security benefits. That difference could cost you thousands.
Retirement Tax Trap #2: The Cost of Cashing Out Your IRA or 401(k)
If you hate paying taxes now, just wait. The Government isn’t keen on letting citizens transfer money untaxed (aka “inheritances”), so it has empowered the IRS to use what are called Required Minimum Distributions (RMDs) to force you to withdraw money from IRA and 401(k) accounts. The good news is RMDs don’t take effect until you’re 70 ½ years old. The bad news is that you can be forced to withdraw money you don’t want or need, which can increase your tax liability. The worst news (sorry) is your liability can get worse every year if you don’t plan ahead.
Retirement Tax Trap #3: Under-utilizing Roth IRA & Life Insurance
Nobody can predict tomorrow’s tax rates, which is why investment diversification is important. With a Roth IRA, taxes are paid up front, upon investment; with a 401(k), taxes are deferred (paid when you cash out). This makes the investment game unpredictable. If taxes are higher when you cash out than when you invested, you’re losing gains with a 401(k) but maximizing returns with a Roth IRA. On the other hand, if taxes are lower than when you invested compared to when you cashed it out, you’d be better off with a 401(k).
There is no political or economic crystal ball, which is why investment gurus chant “Diversify! Diversify! Diversify!” to young investigators. Not to be confused with “tax diversification” (see #5 below), “investment diversification” ensures that you won’t have all of your retirement eggs in one tax basket. Just like a Roth IRA, life insurance policies are a tax-free option for supplementing retirement income.
Tax efficient strategies are an essential part of financial planning, so it’s important that people include life insurance solutions in the overall conversation. A permanent life insurance policy provides three distinct tax advantages – tax-deferred cash value accumulation potential, income-tax-free loans and withdrawals and, of course, the income-tax-free death benefit. Any or all of these can be a real benefit when considering future financial needs.
Retirement Tax Trap #4: You Forgot the Estate Plan
Too many people underestimate the value of an estate plan. Without one, everything you own (not only the house but also cars, investments, et cetera), could be tied up in probate court for years, costing your family thousands in probate fees, legal fees, and even double-taxation by Uncle Sam—all of which is 100% avoidable if you plan now!
Retirement Tax Trap #5: The Tax Diversification Factor
Another underappreciated retirement strategy and unnecessarily costly tax trap is tax diversification. Though different than income diversification, tax diversification is similar in that you want to avoid retirement vehicles that will all be taxed at the same rate. Ideally, you’ll have varying tax rates for dividends, capital gains, and interest on brokerage and checking/savings accounts compared to 401(k), Roth IRAs, real estate, and bonds.
While it sometimes seems like your retirement income will be guided by the political winds in Washington, that’s just not the case. With knowledge comes freedom, and with a custom-tailored retirement strategy, you can head into retirement with confidence.
We’re here to help you protect your hard-earned money and secure the retirement lifestyle you’ve worked so hard to create. Contact us today to start getting the answers to your retirement questions.