What You Need to Know about Your Income Taxes
When it comes to income taxes and retirement, consider how little the average taxpayer understands about his or her taxes. I had a petroleum engineer from Exxon Mobil stand up in one of my workshops the other night and argue that the "growth" in a Roth IRA would have to be taxable.
How much do you know about your income taxes? Even though you aren't alone, what you don't know can hurt you. It surprises me how little most people know about the income tax code. However, as the IRS is virtually holding a gun to your head, it would be in your best interest to do what you can to protect yourself, especially in retirement.
Consider a quick example: Ted has $250,000 in a Roth, thanks to his clever advisor who helped him to understand conversions. At 6.5 percent, he realizes some $16,250 in real, spendable cash in his pocket. Robert also has $250,000 in an IRA, but sadly, it is a traditional IRA. Robert is in the 25 percent tax bracket, so that means he earns some $4,000 less, due to taxation on his earnings. I'm sure you'll agree that you would rather be Ted than Robert in this example. You can accomplish this by working with a financial advisor who knows some key tax concepts.
In addition to working with your financial advisor, there are some things that you can do yourself to minimize your taxes after you retire:
• Reduce your expenses. If you watch your spending every month, you won't have to tap into your retirement fund. By keeping your expenses low, you will be able to stay under the 15 percent tax bracket and take advantage of many tax breaks.
• Pay off your mortgage. Your mortgage is usually your biggest monthly bill. If you can get rid of that expense, you'll have much more flexibility in retirement. It's more difficult to minimize tax if you need to withdraw a large amount each month to pay the mortgage.
• Social Security benefits. You may not be aware that your Social Security income is taxed based on your combined household income. As your income increases, you will pay more and more tax on your Social Security benefit. Keeping your retirement expenses low will help you minimize tax on your Social Security benefit.
• Roth IRA and Roth 401(k). Your retirement funds in a Roth IRA or Roth 401(k) won't be taxed if your withdrawals are qualified. Check the IRS rule or talk with your tax advisor to make sure. Roth accounts are a great way to diversify your post-retirement income, so we all need to invest in these accounts.
• Traditional IRA and 401(k) distributions. Withdrawals from your traditional IRA (deductible) and 401(k) are fully taxable. These retirement accounts helped lower your tax bill in your working years, but they will increase your tax liability once you start taking distributions.
• Diversify your after-retirement income. It's important to diversify your after-retirement income-Social Security, pensions, rentals, taxable brokerage accounts, tax-free Roth accounts, saving accounts, bonds and more. These income sources can be fully taxed, taxed at the long-term capital gains rate, partially taxed (Social Security benefit) or not taxed at all. Keeping your taxable income under the 15-percent tax bracket will help you minimize your future taxes. If you can, start saving and investing in all these accounts while you are still working to give you more options in your retirement years.
Be sure to talk to your financial advisor now about your taxes to make sure you don't pay Uncle Sam more than you have to when you are retired.