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It’s Not What You Make, It’s What You Keep – The Strategic Importance of Tax Planning for Retirement

Tips on creating a tax-efficient paycheck in retirement from adviser Dennis Notchick.

By Dennis Notchick

It’s not what you make, it’s what you keep! This saying has a lot of meaning for many people, but for those planning for retirement, it has extra meaning. Why is this? Well, once you retire you no longer collect a monthly paycheck, yet all the while you are under attack from the constant threat of the cost of living rising everyday as well as taxes. A retiree must recreate that income efficiently – Social Security will provide some replacement, but most retirees will rely on their savings and investments throughout retirement.

So what if the amount you were keeping every month could be improved? How many people reading this think they are paying too much in taxes? The bad news is that you may be paying too much in taxes now or set to in the future; the good news is that there could be tax planning strategies to help you keep more. Here are a few examples that may help you insulate yourself from taxes in retirement.

Roth IRAs are Powerful Tax Havens – Use Them

If you do not have a Roth IRA make a note to yourself to start one. The Roth IRA is unique because the money that goes into it has already been taxed, therefore qualified withdrawals are tax-free for both contributions and earnings. (A distribution from a Roth IRA is qualified provided the 5-year aging requirement has been satisfied and one of the following conditions is met: age 59½, disability, qualified first-time home purchase, or death.) This means that all of your investment gains, compounded for years, will not be taxed. This compounding effect is very powerful as long as you have the time to do so, the longer the better. I’ve seen some people start Roth IRAs as young as age 18, however the Roth IRA was introduced in 1997, so many people did not have the opportunity to do so.

But what if all of your retirement is in a 401(k) or IRA? This is where the Roth conversion, when properly planned, can help those approaching retirement as well as those who are already in retirement start creating a safe haven for taxes. A Roth conversion is when you move money from a pre-taxed account, like a 401(k) or IRA, into your Roth IRA. This conversion is considered a taxable event, you will pay taxes on the amount converted now, but qualified withdrawals are tax free for both conversion amounts and earnings. This is extremely important – keep reading to see why.

The Power of Compounding

To give you an example of how powerful this tax-free compounding is, here is an example. Let us say someone started a retirement account and invested $5,000 in the beginning of every year for 30 years. Over that 30-year period, this person has invested $150,000. Using a 7% annual rate of return and allowing the investment to compound, this will now equal $505,365 in 30 years’ time. The obvious question becomes, would someone rather pay taxes on their contributions of $150,000 or pay taxes on the entire account which has now grown to $505,365? I think most would rather pay on the smaller amount. However mistakes can be made by not anticipating the tax picture in the future and not taking advantage of the time allowing you to contribute or convert to a Roth. Will you have a tax bomb in the future?

How Much Will the IRS Make You Withdraw from Your 401(k) or IRA?

If you have a 401(k) or IRA account, you may want to look ahead and estimate what your required minimum distribution will be in the future. The required minimum distribution, or RMD, is what the IRS mandates you start removing from the pre-tax retirement accounts every year until you die. If you don’t, there is a 50% penalty on the amount required, even if you do not need the money. The RMD starts around 3.9% at age 72 and goes up each year from there. Here is the IRS Table for the calculation. This is considered taxable income along with all other income – including Social Security, dividend income, pensions, etc. This mandated income can wreak havoc on your tax bill. Why not start chipping away at that ahead of time with Roth conversions? The idea is to lower your taxable income in the future.

Vaccinate Your Accounts from Higher Taxes in the Future

Currently we are in one of the most favorable tax environments, according to the Tax Policy Center. However, this won’t last forever as these rates are set to expire at the end of 2025. There is a very strong possibility that tax rates will rise in the coming years to help pay for the trillions of dollars in fiscal spending and deficits (not to mention the ballooning national debt). As nations race to develop a vaccine for COVID-19, a Roth IRA could help you vaccinate yourself from higher tax rates in the future.

Are You Paying Too Much Tax on Your Dividends?

In this low interest rate environment, many investors are tempted to only look at the yield of a security for income purposes. What they may fail to understand is how that dividend is taxed; not all dividends are taxed equally. Some dividends are qualified, while some dividends are not qualified. The non-qualified dividends you receive will be taxed at ordinary income tax rates which are as high as 37%, not to mention any potential state income tax on top of that. To make things simple, if you have an investment yielding 5% and are in the 37% bracket, the after-tax yield is actually 3.15%! On the other hand, if the dividend was considered qualified, it would be taxed at 20%, 15%, or 0% depending on your other income. Wouldn’t it be nice to keep the full 5%? If you do not know how your income is being taxed and you are paying too much in taxes, this will affect how much of your income you actually keep.

These are just two examples of planning for taxes in retirement and how to strategically lower your tax bill. If you have not created a tax plan for retirement, it makes sense now more than ever to construct a plan to lower taxes and immunize yourself against higher rates in the future. Find a Certified Financial Planner to help you.

About the author: By Dennis Notchick, CFP®

Dennis Notchick, a certified financial planner for Stratos Wealth Advisors, has been serving high net-worth families and business owners since 2008. A certified financial planner since 2010, Notchick has worked with many well-respected firms on Wall Street and provides consulting on retirement planning, investment management, and holistic financial planning. He’s been published or mentioned in numerous online financial publications, including The Wall Street Journal, CNBC, Forbes, Marketwatch and TheStreet.

Investment advice offered through Stratos Wealth Advisors, LLC, a Registered Investment Advisor. Financial services offered through Stratos Wealth Advisors LLC (“Stratos”), a Registered Investment Advisory Firm. The presentation of these topics is for general information only and are not intended to provide specific advice or recommendations for any individual. The information also does not intend to make an offer or solicitation for the sale or purchase of any product or security. Investments involve risk and unless otherwise stated, are not guaranteed. Stratos Wealth Advisors LLC does not provide tax advice. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed here.