The Hidden Snag in Retirement Planning: Understanding Tax Implications and Strategies
Matthew Allgood- August 2023- Article 2
Post Date: 8/01/2023
The Hidden Snag in Retirement Planning: Understanding Tax Implications and Strategies
As a seasoned financial advisor and someone who's personally navigated the complexities of financial planning, I’ve come to understand that tax considerations play a critical role in designing a resilient retirement plan. Having seen the dramatic impacts that taxes can have on one's retirement savings, I've made it my mission to help others understand this often overlooked aspect of financial planning. This article aims to shed light on how taxes can unintentionally undermine your retirement plans and the strategies you can employ to mitigate such risks.
Section 1: Taxes on Retirement Account Withdrawals
First and foremost, it’s crucial to remember that tax-advantaged retirement accounts such as 401(k)s and traditional IRAs are not entirely tax-free. The word "advantaged" signifies that these accounts offer tax benefits - the contributions you make to these accounts are often tax-deductible, which means they reduce your taxable income for the year you contribute. However, the catch comes when you start to withdraw from these accounts in retirement. The withdrawals are considered as ordinary income and are absolutely subject to income taxes both federally and in most states that tax income as well.
If you've been successful in growing your retirement account, you may actually find yourself “graduating” into a higher tax bracket when you retire than you were in while you were working. Consequently, you might end up paying more in taxes than you initially anticipated. To avoid this, one strategy to consider is contributing some or all your retirement savings to a Roth IRA or Roth 401(k), where you pay the taxes upfront, and the withdrawals in retirement are typically income tax-free. Or, you may consider doing a Roth IRA conversion, or even a series of them, between the time you stop drawing a paycheck and the time when your Required Minimum Distributions (RMDs) kick in.
Section 2: Taxes on Social Security Benefits
Another area that often surprises retirees is the taxation of Social Security benefits. Many people assume these benefits are entirely tax-free, but that’s not always the case. Depending on your income in retirement, you might have to pay taxes on up to 85% of your Social Security benefits.
The key to minimizing taxes on your Social Security benefits is careful income planning. By managing your other sources of retirement income, you can potentially decrease the amount of your Social Security benefits subject to taxation.
Section 3: Taxes on Investment Income
The third major tax consideration in retirement is the tax on investment income. While you may have planned for capital gains taxes when selling investments in your taxable accounts, it's essential to be aware of the tax implications of dividend and interest income as well.
Taxable investment income can potentially push you into a higher tax bracket or increase the amount of your Social Security benefits subject to taxes. Therefore, it’s important to manage your investments strategically. For instance, holding investments that produce qualified dividends could help, as these dividends are usually taxed at a lower rate. Also, concentrating your interest bearing bonds in tax-qualified accounts where they will not get taxed right away as income can be helpful as well.
Section 4: Medicare Premiums
In Romeo & Juliet, Shakespeare penned the line “A rose by any other name would smell as sweet.” And any time the government asks you for money, the resultant payment could still fairly be called a “tax.” The government likes to call the money you pay into their Medicare Health Insurance Program “premiums,” because the dollars are pooled with other people’s money to pay for healthcare, much like private insurance policy premiums. But unlike private insurance healthcare premiums, which are based upon the age and health of the insured, Medicare “premiums” are set based upon income ranges. The more income you earn, the higher your monthly premiums will be. Most people do not get out of the lowest premium “bracket,” but many retirees with higher incomes can be surprised when they are introduced to a Medicare “surcharge” provision called “IRMAA,” which stands for “Income-Related Monthly Adjustment Amount” (see how that sounds more like a “tax” than a “premium”?).
IRMAA surcharges are determined by a Medicare beneficiary’s modified adjusted gross income (MAGI)— the total of your gross income and tax-exempt interest minus things like retirement account contributions and alimony payments.
For 2023, IRMAA kicks in if your 2021 MAGI was over $97,000; for married couples filing joint tax returns, above $194,000. If you were paying close attention as you read that last sentence, you might notice the surcharge for a given year is determined by income from two years before. And that two-year lag is one of the aspects of that provision that allows it to “sneak up” on retirees. For many, it’s a new tax concern they haven’t even heard of, let alone had experience with … and by the time they do experience it, they’re likely to be dealing with it for at least couple of years unless the income that triggered it was a one-time event.
The size of the surcharge is based on a sliding scale and increases with each of five IRMAA-related income brackets. Those brackets top out for people with incomes of $500,000 or more ($750,000 or higher for couples).
IRMAA thresholds change each year, partly due to inflation, and there are opportunities to appeal them under certain circumstances if you’re able to appeal within 60 days of receiving your notice. But those circumstances are limited, and careful management of your income levels in retirement is a better way to help you land in a lower “surcharge bracket.”
Section 5: Proactive Tax Planning: The Key to a Secure Retirement
Understanding the tax implications of your retirement income is only the first step. It's equally important to engage in proactive tax planning. This involves a continuous assessment of your tax situation and adjusting your strategies accordingly.
Given the complexities of tax laws and financial planning, seeking professional advice can be invaluable. A trusted financial advisor can help you navigate the maze of tax rules and regulations and align your retirement strategies with the most current tax laws.
While it may seem like an uphill battle, understanding the tax implications on your retirement plan is key to securing a financially stable future. It's about anticipating the challenges and developing strategies that can minimize your tax liabilities while maximizing your retirement income. As the Principal and CFP® at Allgood Financial, my goal is to help you build a solid financial structure that will stand the test of time. With careful planning and expert guidance, you can create a tax-efficient retirement plan that brings you closer to achieving your dreams and financial goals.
