Mon. Dec 4th, 2023

By: Christina Ioannou and Brad Gotto

These days, thanks to medical and technological advancements, people are seeing an increase in quality of life that will take them well beyond their 60s. A longer life brings great possibilities, but there also are challenges to balance the desire to live a life that is both long and financially secure. Obstacles like increasing health care expenses and maintaining lifestyles and independence will appear as retirees navigate through retirement.

Whether you’re planning to work another decade or wrapping up your career in the near future, anyone looking toward retirement should not overlook the impact taxes can have upon their retirement. Brad Gotto, owner/advisor of Fiat Wealth Management, has found when talking taxes with retirees that many are unprepared for the impact Uncle Sam can have on their wallet as they reach the golden years. He says:

Retirees get to the stage of retirement where complexity goes through the roof. Now it’s not, ‘Here’s your paycheck every month and we’re going to automatically withhold taxes based on your rate of income.’ When you receive a paycheck, they take care of it for you. But when you get to retirement, you have this massive pile of money, and it’s on you to figure out how to pay your tax bill. It’s a daunting thought process.

The good news is a few careful planning strategies can make a big difference in the overall amount of money that stays in retirees’ pockets during their retirement years.

Understand the options.

The first part in planning for taxes in retirement is understanding the account options available and the tax advantages each provides. Here is the breakdown:

  • Roth: Contributions to Roth accounts are made with after-tax dollars. Examples include Roth 401(k)s and IRAs. While the income is taxed immediately, the retiree won’t owe any taxes on the money when withdrawing it in retirement. For a retiree to reap these benefits, they have to wait five years after their first contribution to withdraw their earnings tax-free.
  • Taxable: These traditional accounts are made with after-tax dollars. Investments and withdrawals can be made at any time for any reason with no penalties. Additionally, if the funds grow they are taxed at capital gains rates, which are cheaper in almost all scenarios, and if any losses are taken, there are opportunities to write them off on your taxes.
  • Tax-deferred: These include accounts like traditional IRAs, 401(k)s, and 403(b)s. These allow immediate tax deductions for the year the contribution is made, but future withdrawals will be taxed at the normal income rate. The IRS requires at the age of 72 minimum distributions start being made from these types of accounts.

Many operate under the misconception that deferred means they do not have to pay any taxes, and they are later shocked by the dent it puts in their income. Gotto says that every investment decision is a tax decision. Understanding this is the first step to smart planning for retirement:

There’s only three tax buckets that exist for all people. There’s the pre-tax bucket, which is the 401(k)s, the IRAs, the 403(b)s, the 457s, etc…You choose not to pay the bill today, but instead will pay the bill when the funds are withdrawn. Then you have the after-tax bucket, and this bucket confuses a lot of people. At the end of the day, this is just money that was in your checking account. Then you decide to invest it. You’re hoping, of course, it goes up in value. And if it does go up in value, there’s still a tax bill, right? But it’s a different tax bill. It’s capital gains taxation. It’s what I call a preferential or preferred tax treatment.

That’s what is important to note, Grotto adds. Any money pulled out of that pre-tax bucket is taxed as income, as if a retiree had a job, earned the income, received a paycheck, the government took their share, and the retiree netted what was left.

Then there’s this last tax bucket – that’s the tax-free bucket. After tax money went in, checking account money at some point, you chose to invest it. Gotto says:

Instead of the growth of that money being taxable at this preferential or preferred rate, there just is no tax bill. So, one of the first things I think people need to do is decide out of their pile of money, how much of it is in what bucket? How much of it is in the bucket where they’ve already paid taxes on the money invested, but do they have to worry about possible tax impacts like capital gains? How much is sitting in this after-tax bucket? They should be cognizant of how much to pull out of each bucket and why.

[Related: Getting Ready To Retire? Check These Financial Tasks Off Your List]

Think about the future.

As many retirees are planning for their future, they are concerned with where to put their money: stock, mutual fund, bond, etc. The reality is each of those has a tax impact because whether the money is saved in a retirement account or not, the IRS is still owed money.

Retirees need to plan for their future income and taxes owed on that income. For example, they must consider if their social security will be turned on when taking distributions. For most, but not all, social security is taxable.

Other considerations like pensions, spousal income, dividends from stocks, and other paychecks will have an impact on the amount owed to the IRS. During working years, many have one job, but upon retirement, retirees tend to have multiple streams of income to consider when it comes time for taxation, and all hit differently.

Gotto and his colleagues have found tax planning is very overlooked when it comes to the preparation side of retirement. The decision to put off planning for the future can have dire consequences and lower the quality of living retirees experience later on.

[Related: How Savvy Female Business Owners Can Take Advantage of Tax Planning to Save Thousands Off Their Tax Bill Each Year]

Take out taxes when it’s the cheapest.

Gotto urges retirees to understand what tax codes exist today. For example, the Tax Cuts and Job Act, passed in 2018, basically put taxes on sale for the majority of Americans. It would make sense for Americans to begin paying taxes on their retirement funds at a lower rate, before that sale ends and the tax rate – and bill – goes back up. Gotto says:

If we begin with the end in mind, the big picture, and look at the totality of retirement and figure out how to minimize the IRS in a retiree’s life not just for today, but for five years from now, ten years from now, and twenty years from now, it can make a huge impact on the overall value or how much of their money they actually get to keep. Unless you have a proactive approach to figure out how to control your taxes in retirement, it can get really inefficient really quick and quite frankly, the IRS can be a much bigger part of your life than you want it to be.

[Related: The Heartbreak of Student Loan Debt: How 529 Plans Can Help]

Christina Ioannou is an established professional with experience in advertising, marketing, and arts and design.

Brad Gotto, owner/advisor of Fiat Wealth Management, is part of a team of financial advisors based in the Twin Cities who provide comprehensive financial planning and asset management for their clients. They are independent and, therefore, teach their clients what is in their best interest. Gotto and his team remove the anxiety from their clients’ financial lives. To find out how Gotto and Fiat Wealth can help you, visit Fiat Wealth Management.

By senior