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How to plan for taxes in retirement: Using tax efficient strategies

Businesswoman discussing taxes with coworker in office
Luis Alvarez/Getty Images

As you gear up to leave the workforce and rely on your savings and investments for income, knowing how to plan for taxes in retirement becomes a very helpful skill to have.

Working tax efficient strategies into your financial plan can help you boost your long-term financial health. And that starts by understanding the three ways that various accounts are taxed: tax now, tax later and tax never. We'll discuss how diversifying your assets in these three ways can help lighten your tax load once you retire.

The three tax buckets: tax now, tax later & tax never

All investment accounts and financial products fall into one of three categories: "tax now", "tax later" and "tax never." Understanding which bucket your assets fall into is key to setting up a balanced financial strategy that can help you now and in the future.

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Tax now

The "tax now" bucket generally consists of accounts funded with dollars from your paycheck that you've already paid tax on. Accounts included in the "tax now" category include:

  • Checking and savings accounts1
  • Brokerage accounts1
  • Mutual funds1

With "tax now" accounts, you've also already paid taxes on increases to the account's value due to interest, dividends and gains. Account increases might take the form of interest on a banking account or dividends and gains based on stock activity in your brokerage accounts or mutual funds. Even if you hold onto your shares for years, a fund may generate dividends that you pay tax on in the year they're distributed. You may pay interest, dividends and capital gains taxes year after year, but they're still considered "tax now" because you're paying tax on them in the year they occurred.

Taxable accounts like these have certain advantages. There's often no investment or contribution limits, and the money is liquid so it's accessible without financial penalties. This makes them suitable for building a base you can access before and during retirement, for example, if you need a down payment on a house or seed money for a business endeavor.

This bucket will also continue to be what you use as a source of day to day living expenses in retirement. But because of the immediate tax bite, these accounts aren't the only bucket you want to have on hand for retirement savings.

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Tax later

In the "tax later" bucket are accounts you fund with pre-tax dollars. And they grow tax-deferred, which means you pay income tax when you withdraw funds. The most common "tax later" accounts are:

  • 401(k)s 2,3,4
  • 403(b)s 2,3,4
  • Traditional, Simplified Employee Pension Plans (SEP), Savings Incentive Match Plan for Employees (SIMPLE) individual retirement accounts (IRAs) and other pension plan assets 2,3,4
  • Variable and fixed annuities 2,5
  • U.S. Savings Bonds 6

These tax-advantaged accounts are designed for retirement savings, so they're subject to certain access rules and restrictions. You'll want to note that distributions that you take from these before age 591/2 can incur a 10% early withdrawal penalty and trigger income taxes.

If your workplace has a retirement plan, like a 401(k) and 403(b), it's a powerful way to build retirement assets. For one, many employers will provide matching funds, typically a percentage of every dollar you put in up to a certain limit. And with traditional 401(k) plans, the contributions that come out of your paycheck aren't included in your taxable income for the year. That means taxes aren't (yet) eating into the money you're investing.

Keep in mind that 401(k)s, SEP IRAs and SIMPLE IRAs involve required minimum distributions (RMDs) when you reach age 72. This is where the "tax later" part comes in. At that time, you have to take a certain percentage of your account balance or face a penalty, so you can no longer avoid taxation. The factor to consider, though, is that RMDs (which include the original pre-tax income you invested plus any value gained) will be taxed altogether at your income tax rate at the time of withdrawal. This rate may be higher or lower than when you put the money in.

Qualified annuities—which are purchased with pre-tax dollars—act in a similar "tax later" way. While your annuity contract grows on a tax-deferred basis, you pay ordinary income tax on the amount you withdraw. These, too, are subject to RMDs. Nonqualified annuities, which are alternatively purchased with post-tax money, are treated a bit differently. The earnings and interest they accumulate are taxed at your ordinary rate, but the principal amount is tax-free. And unlike qualified annuities, they're not subject to RMD requirements.

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Tax never

The bucket "tax never" includes accounts that are generally funded with after-tax dollars and grow tax-deferred. Crucially, the gains from these may be income-tax-free when distributed. Among the more common examples are these:

  • Roth IRAs 5,7
  • Roth 401(k)s and Roth 403(b)s 5,7
  • Municipal bonds 8
  • Cash value of life insurance 9
  • Health savings accounts (HSAs)

Roth accounts, in particular, offer important potential benefits. For one, they allow younger workers to pay income tax when they're in a different tax bracket than the one they expect to be in during retirement. They also provide tax diversification, giving you access to tax-free income in your later years. Roth IRAs have an additional advantage; they're not subject to RMDs. This can give you more flexibility in withdrawing your money, or you can choose to leave the balance to your beneficiaries.

Retirement accounts aren't the only assets that fit into the "tax never" group. Most (but not all) municipal bonds—those issued by state, county and local governments—are income-tax-free at the federal level. So is the cash value of permanent life insurance. That's why permanent life insurance can be an important part of your tax strategy, especially for individuals who anticipate being in a relatively high tax bracket when they retire.

One potentially tax-free asset that often gets overlooked in terms of retirement is an HSA. These accounts can have a triple-tax advantage because they're funded with pre-tax dollars, grow on a tax-deferred basis, and can be withdrawn tax-free for health-related expenses. And unused funds will roll over to be used in future years.

The caveat is that you can only contribute to an HSA if you have a high-deductible health plan. But if you do, funding them to take care of your future needs—anything from physician and lab bills to eyeglasses and medications—can make a lot of sense.

According to HealthView Services, the average 55-year-old couple will pay a staggering $933,928 in lifetime retirement medical costs. Being able to tap tax-free money for those expenses significantly increases your purchasing power. If you don't have access to an HSA through your health plan, check to see if a flexible spending account (FSA) is an option for you. It works similarly to HSAs except for unused funds will not carry over to the next calendar year.

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Factoring in taxes on Social Security

What bucket do Social Security payments fit into? It depends on the income you have besides Social Security, as well as your tax filing status and the size of your benefit. The IRS uses a measurement called "combined income" (your adjusted gross income plus nontaxable interest plus half of your Social Security benefit) to determine the tax status of your benefits.

As your combined income increases, you may have to pay tax on a portion of your Social Security benefits.

As a hypothetical example, if your combined income is between $25,000 and $34,000 (or $32,000 and $44,000 for joint filers), you'd pay income tax on up to 50% of your benefits. If you make more than $34,000 (or $44,000 if filing jointly), up to 85% of your benefit could be subject to tax. A key element of how to plan for taxes for retirement is reducing your adjusted gross income, thereby increasing the amount of your Social Security benefit that you get to keep.

Why tax diversification matters

It's important to diversify your portfolio by allocating investments across a variety of asset classes. That mix will be determined by your objectives and risk tolerance. But it's also critical to diversify the tax status of your assets, which may increase your after-tax returns.

Investing in Roth accounts, for example, may enable you to pay taxes on income when you're in a lower tax bracket—especially if you're young and haven't yet reached your peak earnings—rather than in retirement. And later in life, having some assets in the "tax never" bucket also enables you to draw from your assets strategically in order to stay in a lower tax rate. The more investment income you rely on, the bigger the potential tax savings.

One hypothetical example is a 70-year-old couple who needs $100,000 of investment income to supplement their Social Security benefits. If they pull the entire $100,000 from a "tax later" account like a traditional 401(k), everything they pull out in excess of $83,550 is taxed at the 22% rate. But if they pull $80,000 from a taxable 401(k) and $20,000 from a Roth IRA, they stay in the 12% tax bracket. They'd keep considerably more of the money they withdraw.

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4 strategies to help reduce your tax liability

The use of prudent retirement tax strategies is one of the best ways to make your assets last when you leave the workforce. Here's how to plan for taxes in retirement and help you potentially keep more of your investment returns:

1. Use "tax later" accounts for retirement funds

It can make sense to use fully taxable stocks and mutual funds for short-term needs. But for your retirement funds, you generally want to max out tax-advantaged accounts like 401(k)s and IRAs rather than relying on "tax now" assets.

2. Take advantage of Roth accounts

Roth 401(k)s and Roth IRAs are particularly beneficial for younger investors or those who believe they may be in a higher tax bracket later in life. If you're not sure where you are relative to your tax bracket in retirement, you may want to mix Roth and traditional accounts. Some employers allow you to split your retirement allocation. If not, you can invest in a 401(k) at work and open a Roth IRA on the side. Note that with Roth 401(k)s, your contributions are "tax never," but your employer's matching contributions are "tax later."

Determine whether a Roth conversion makes sense

Do you believe you haven't hit your full earning potential and you expect to be in a higher tax bracket down the road? You have the potential for a do-over with a Roth conversion. One big caveat: You'll have to pay taxes on the assets in the year you perform the conversion. But if you anticipate being in a higher tax bracket later, diversifying in this way might be a good long-term strategy.

3. Consider permanent life insurance

The cash value of a permanent life insurance contract can be used for retirement as well as other needs, like a loved one's college expenses. The money you withdraw is typically tax-free, which helps keep you in a lower tax bracket in retirement.

4. Invest tax-efficiently

Perhaps you've maxed out your 401(k) and IRA contributions, and the only place left to invest are "tax now" assets like mutual funds. You can still minimize your tax hit by using exchange-traded funds, index mutual funds and tax-managed funds, which can reduce your tax bite today and in future years.

Are you in a high tax bracket? Consider if a municipal bond may be right for you. The interest on most municipal bonds is tax-free at the federal level. In some cases, it's exempt from state taxes as well. However, these usually provide slightly lower yields to account for this advantage. That makes these fixed-income assets advantageous for investors in higher tax brackets but less so for those with a relatively low tax rate.

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Planning with expert guidance

Working tax-efficiency into your financial planning helps you to keep more of the money you earned and invested for retirement. A local Thrivent financial advisor can review your plans and help make sure you're on the right path. Thrivent and its financial advisors do not provide tax or legal advice, but we can partner with you and your tax professional or attorney.

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Any interest, dividends or capital appreciation is subject to taxation when realized.

Gains/income subject to income tax when withdrawn.

Generally funded with pre-tax dollars.

Withdrawals made prior to the age of 59½ may be subject to a 10 percent federal tax penalty.

Distributions prior to age 59½ may incur a 10% premature distribution penalty; all distributions may incur surrender charges.

Generally exempt from state income tax. Special tax benefits may apply.

Funded with after-tax dollars; gains may be tax-free.

Interest is free from federal income tax; may be subject to state income tax, federal alternative minimum tax and capital gains tax.

The primary purpose of life insurance is for the death benefit protection. Withdrawals may be available income-tax-free to the extent of basis. Lifetime distributions of the cash value are subject to possible income taxation and penalties, could reduce the death benefit, and could cause the contract to lapse.

Thrivent financial advisors and professionals have general knowledge of the Social Security tenets. For complete details on your situation, contact the Social Security Administration.
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