Tax Mistakes To Avoid In Retirement

When planning for retirement, you will want to avoid several common, all-too-easy-to-make mistakes that can lead to unfixable issues. You might not think about forecasting taxes in retirement, but it is a big issue. The good news is that if you keep taxes near the front of your planning, you will be able to avoid many common problems and take advantage of new chances.

Understanding the Way Taxes Change During Retirement

The different types of taxes you pay during retirement is an important thing to think about before you are retired. When you are working, much income might come from your wages, and it may be taxed as regular income. However, once you are retired, you might have several cash flow sources, and each of them might be taxed at different rates. 

For example, if you have retirement account distributions, Social Security, or pensions, you will have an ordinary tax rate. However, you might have to pay capital gains taxes on your non-retirement account investments. On the other hand, Roth IRA account distributions might not get taxed at all.

The way you will pay your tax bill will also change once you have retired. When you are working, the employer will take some of the tax out of each paycheck. However, not all the cash flows during retirement have withholding, so it will be up to you to ensure that you pay enough; otherwise, you might also owe fees on your tax bill.

Try to create a withholding on your income, such as pensions or Social Security. You can have some of the distribution allocated to the taxes in your area to avoid having to make estimated taxes as self-employed people do. Just make sure that you understand that withholdings are also taxable.

Not Creating Tax Diversification

You have likely heard about the idea of diversification, such as when you diversify your funds in investing. Diversification can help you mitigate risk while ensuring the investments are on track to meet or exceed your goals. Tax diversification is equally important. That means you will have assets in various account types. Remember, the IRS does not treat every investment the same, so you will want to categorize your savings into the correct ones.

You don’t have to over-prioritize saving your funds in tax-deferred accounts just because you can access them easily. Instead, think of the way what you do now will affect you in a few more decades. Even if you have several hundred thousand dollars in your IRA, it does not mean you can spend that. Once you have a distribution from the account, you will then have to pay taxes on that amount. You will likely only get to spend a percentage of what the statement tells you. That is why you will want to use the best strategies to save money. 

You should know the strategies your employer offers and ensure that you fund the right programs when necessary. If you are self-employed, you need to think about the other options available to you for saving funds.

Don’t Get Stuck with RMDs

You do not want to have large required minimum distributions (RMDs) when you are using your retirement funds. If you save too much in these tax-deferred accounts, you might not have tax diversification. The RMD is the amount you have to take out from the account every year, which normally happens when you are 72. Each year you will need to take out more from the account. Many people find they spend more early on in retirement, but their spending will taper off at some point. You do not want to pay taxes on funds that you do not need to live your life.

Projecting RMDs used to be difficult, but with online financial planning tools such as WealthTrace and Betterment, this is easier than ever. Using planning tools like this you can accurately project your RMDs and figure out what your taxes will be in the future. You can also project whether or not potential tax-savings strategies like a Roth conversion make sense.

You will want to diversify your taxes and understand how the retirement funds will be taxed. Create a tax diversification process before you are 72. You can also lower your highest taxes, which normally come from RMDs. For instance, you could consider donating some money to charity; the donation will count toward the RMD. 

Closing Thoughts

To avoid these and other issues, you will want to have a great financial plan. Paying too much in taxes does not use your savings in the right way. If you have an advisor, you will want to ensure you address all the specifics of your living situation to create the best tax plan for you.