The importance of saving your income and making a financial plan for a comfortable retirement is not lost on most folks. However, only deciding the amount to save and where to invest it is not enough to ensure to build a large enough corpus for retirement. Being aware of different taxes that can be levied on your retirement savings is essential to employ tax-saving strategies to protect your income.
The different factors that determine how much taxes will be levied on your income are sources of retirement income, total annual income earned per year, and your filing status. Your social security benefits may also be taxable. If your retirement income solely depends on social security benefits, it will not be taxed. However, generally, people do have other sources of income to make up their retirement fund since social security benefits on its own is a relatively small amount. It has been observed that more than half of the beneficiaries of social security end up paying taxes on the same. To better understand different tax-saving strategies and how you can maximize your social security benefits to make the most of them, reach out to a professional financial advisor who can advise you on the same.
Tax on Social Security Benefits
The amount of tax on your social security benefit will be derived from your combined income (a sum of 50% of your total annual social security benefit), your average gross income (income minus deductions/exclusions), and the part of your income that is exempt from tax.
- If your combined sum is between $25,000 to $34,000, then 50% of your social security will be taxed.
- If the sum is below $25000, then no taxes are to be paid.
- If the sum is above $34,000, then 85% of your social security is taxable.
For married couples:
- If your joint income is between $32,000 and $44,000, then social security is subject to 50% tax.
- For those having an income above $44,000, they will be subject to 85% taxable social security benefit
- If the sum is below $32,000, it will attract no tax.
If you are married but live separately, any sum will lead to an 85% tax on social security.
What are the different tax-saving withdrawal strategies for retirement?
To ensure you end up with a significant retirement fund for a comfortable retirement, you can consider adopting the following retirement withdrawal strategies:
1. Convert your traditional 401(k) account to a Roth account
You can reduce your tax burden during retirement by converting your traditional 401(k) account to a Roth 401(k) account or a Roth IRA (Individual Retirement Account). The Roth accounts do not attract taxes during withdrawals, given that the accounts adhere to the rules of a qualified distribution plan. A Roth 401(k) account is an employee-sponsored account. The withdrawals from this account and the Roth IRA account consist of after-tax money, and hence no taxes are levied on them. Roth 401(k) has an advantage compared to Roth IRAs as it does not have an income limit, thus making it ideal for people who earn a high income.
2. Be aware of tax diversification
It is important that you understand about different methods of taxation. Both diversifying your portfolio with various asset classes as well as different types of tax vehicles is advised. Accounts are taxed in different ways. There are tax-deferred vehicles that allow taxpayers to postpone their tax payments, allowing them to take advantage of tax-deferred compounded growth. You can also pay pre-tax money to lower the present tax burden and retain most of your income earned. Tax-free vehicles are funded by the taxes that you contribute to your investment. These investments then benefit from tax-free compounded growth later. You are also able to get tax-free withdrawals during retirement. Taxable accounts consist of brokerage accounts. Any assets held less than a year will be taxed. Capital gains taxes are also levied if any investments are sold. Income from dividends and mutual funds is taxed, whereas municipal bonds are exempt from tax.
3. Know where to allocate your assets
Different types of assets attract different tax treatments. Some investments are more tax-efficient than others. Understanding asset allocation is one of the best strategies to help minimize tax burden while also gaining optimal returns.
According to this strategy, tax-efficient assets such as ETFs, index funds, municipal bonds, and buy and hold stocks should come under taxable accounts. In the same way, tax-inefficient assets like REITs, fixed income, liquid assets, and similar actively managed funds should be located in tax-free or tax-deferred accounts to lower the amount of gains lost to taxes. After fully utilizing your retirement plans, you can consider opting for low-cost investment-only variable annuities (IOVAs) to obtain more tax deferral.
4. Withdraw your RMDs (Required Minimum Distributions) at stipulated time intervals
Every taxpayer who holds a 401(k) account or traditional IRA must take required minimum distributions (RMDs) after reaching 72 years of age. If you are still working at the age of 70 and a half and have a 401(k) account with your current employer, the RMD rule is not applicable for you. However, you must form a plan to manage your RMDs as they can cause inconvenience during periods of market uncertainties and a higher tax bracket. You can take the guidance of your financial advisor to help you with the task of looking after RMDs, which can, in turn, save you from tax penalties and preserve your wealth.
5. Pay attention to the tax bracket you fall in
Making sure not to cross the upper limit of the tax bracket is essential to avoid increasing higher taxes. Make sure you know different tax brackets, and the percentage of taxes levied on each bracket. Plan your 401(k) withdrawals accordingly to limit paying taxes. For 2021, you would incur a 12% tax on income below $81,050. For 2022, the upper tax limit has been increased to $83,550. One way to limit withdrawals from 401(k) accounts is to make combined withdrawals from both 401(k) and Roth accounts.
6. Consider deferring your Social Security benefits
It is advisable to delay taking social security benefits for as long as possible. The later you start taking social security benefits, the higher your payout. If the retirees can afford to postpone the benefits until the age of 70, they can raise the payment they receive by almost one-third. It is a good way to remain in the lower tax bracket and reduce taxable income.
7. Rollover your old 401(k)s to your current 401(k) account
Ensure that you roll over your 401(k) accounts that you might have with your previous employers into your current 401(k) account to avoid incurring RMD requirements on the former. You will be able to defer taxable income till retirement, after which the distributions could be at a lower tax bracket.
8. Ensure that your capital gains taxes are at a minimum
Make an effort to take withdrawals only up to the level of your earned income from your 401(k) account. This will result in a 0% tax on your long-term capital gains. For 2022, individuals who have earned a taxable income less than or equal to $41,675 and married couples who file joint tax returns with income under $83,350 are included in the 0% capital gains tax bracket. If they exceed the above-mentioned thresholds, they will incur a capital gains tax of 15%.
Systematically planning for taxes is vital to lower your tax burdens and have a higher sum saved for retirement. Converting your 401(k) accounts, diversifying assets for tax diversification, and reviewing your retirement accounts to avoid incurring unnecessary taxes on some assets are some of the methods that one should adopt to save taxes. Sitting down with your financial advisor and making retirement tax plans after considering factors like your current income, your present tax bracket and one you foresee yourself in at the time of retirement, retirement corpus are equally significant when it comes to saving sufficient funds for retirement.
If you’re unsure of the most suitable retirement strategies to manage and grow your finances, use Paladin Registry’s free advisor match tool and get matched with experienced and certified financial advisors who may be able to guide you effectively as per your unique financial requirements. Answer a few simple questions about yourself, and the free match tool will connect you to 1-3 advisors suited to meet your financial needs and goals.
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