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. In fact, the
Working tax efficient strategies into your financial plan can help 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. Diversifying your assets in these three ways can help lighten your tax load once you retire.
The 3 tax buckets Why tax diversification matters Planning for Social Security taxes 4 strategies to help you be tax-efficient in retirement
The 3 tax buckets: tax now, tax later & 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. All investment accounts and financial products fall into one of three categories:
1. 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:
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
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 also will 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.
2. 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)s2,3,4 403(b)s2,3,4 457(b)s2,3,4 Traditional IRAs Simplified Employee Pension Plans (SEP) IRAs2,3,4 Savings Incentive Match Plan for Employees (SIMPLE) IRAs2,3,4 Pension plan assets2,3,4 Variable annuities2,5 Fixed annuities2,5 U.S. Savings Bonds6
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 59½ 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
Keep in mind that 401(k)s, traditional IRAs, SEP IRAs and SIMPLE IRAs involve
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.
3. 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.4 Among the more common examples are these:
Roth IRAs5,7 Roth 401(k)s5,7 Roth 403(b)s5,7 Roth 457(b)s5,7 Municipal bonds8 Cash value of life insurance9 Health savings accounts (HSAs) Flexible spending accounts (FSAs)
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. They also have an additional advantage; they're not subject to RMDs (including Roth 401(k)s, Roth 403(b)s and Roth 457(b)s starting in 2024). 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
Assets that often get overlooked in terms of tax-efficiency are health savings accounts (HSAs) or flexible spending accounts (FSAs). 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.
Why tax diversification matters in retirement
It's important to
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.
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.
Although it's possible that you won't owe any taxes on your benefits, some Social Security recipients may owe taxes on up to 85% of their Social Security income based on your combined income.
Common questions about taxes after retirement
4 strategies to help reduce your tax liability in retirement
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-later 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."
Should you do a Roth conversion?
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
One big caveat: You'll have to
3. Consider permanent life insurance
The cash value of a
4. Invest tax-efficiently
Are you in a high tax bracket? Consider if a
Planning with expert guidance
Working tax-efficiency into your financial plan can help you keep more of the money you earned and invested for retirement. A local