Who Benefits Most From Tax Planning?
The opportunity to pay less in taxes is greatest for:
Those who have savings in both tax-deferred retirement accounts, such as 401(k) plans or individual retirement accounts (IRAs), and after-tax savings, such as a brokerage account. Those who have years where their income might be less, such as when one spouse retires mid-year, when spouses retire during different years when either spouse goes through a period of unemployment, or when income fluctuates due to a commission-based job. Those who have years where their itemized deductions can change, such as by taking on a new mortgage, paying off a mortgage, experiencing a year with increased medical expenses or charitable deductions, or acquiring a new dependent.
How Retirement Taxes Are Calculated
During your retirement planning, it’s important to consider the way in which your Social Security benefits will be taxed. Careful tax planning prior to retirement can give you, as a retiree, an opportunity to reduce the amount of your Social Security benefits that will be taxed. According to the Internal Revenue Service (IRS), you may need to pay income taxes on a portion of your Social Security benefits. The taxable amount depends on your tax filing status and your total income, including income from other sources such as pensions, dividends, and capital gains. You must add half of your Social Security income to the total of your other income to determine if you’re over the threshold outlined below based on your tax filing status.
Up to 50% of Your Benefits Might Be Taxable
If your tax-filing status was single, head of household, or a qualifying widow(er) and you had income—including half your benefits—between $25,000 and $34,000, up to 50% of your benefits might be taxable as of the 2021 tax year (the return filed in 2022). This rule also applies to some married taxpayers who file separate returns if they did not live with their spouse at any time during the tax year. Married taxpayers who file joint returns might be taxed on 50% of their benefits if their total income is between $32,000 and $44,000.
Up to 85% of Your Benefits Might Be Taxable
If your tax-filing status was single, head of household, or a qualifying widow(er), and your total income was more than $34,000, up to 85% of your benefits might be taxable as of the 2021 tax year (the return filed in 2022). Married taxpayers who file joint returns with income totaling more than $44,000 might be taxed on 85% of their benefits.
Tax Planning Saves Money
Two types of tax planning can help you reduce retirement taxes and increase your after-tax retirement income:
Long-range tax planning provides general guidance as to how much you should withdraw from which accounts from year to year and how to coordinate your sources of income with your Social Security benefits to deliver more after-tax income.Annual tax planning addresses how tax rates and deductions can change each year. Annual tax planning done in the fall can uncover opportunities that wouldn’t be discovered with long-range tax planning alone.
Long-Range Tax Bracket Planning
Long-range tax planning looks at your projected tax rates and sources of income. It shows how you might rearrange your sources of income to deliver more after-tax income. This type of planning requires software or a spreadsheet that contains detailed tax calculations to show you the amount of after-tax income you can have by taking one course of action versus another. Long-range tax planning helps reduce your retirement taxes in two ways:
You can design a general strategy about when to withdraw money from which types of accounts to keep you in the lowest tax bracket possible.It can show you how to allocate investments across your tax-deferred vs. after-tax accounts to reduce your tax burden over your retirement years.
Annual Tax Bracket Planning
Annual tax planning can help you uncover opportunities to:
Withdraw money from an IRA or convert Traditional IRA funds to a Roth IRA, and pay little to no tax in years when your deductions are high and your other sources of income are low. Realize capital losses to offset capital gains or create a capital loss carryover. Use years with high itemized deductions to your advantage. Fund the type of account—Roth IRA, Traditional IRA, or 401(k)—that will provide the most long-term tax benefit to you based on your tax situation in that year.
Get Help With Retirement Tax Planning
It’s difficult to do smart tax planning without professional assistance. Remember when you seek help that many people who call themselves financial advisors work for big investment firms or banks that prohibit them from offering tax advice. Find either a certified public accountant (CPA) or tax professional who has their PFS designation and does the type of long-range tax planning you’re looking for or a retirement planner who practices independently. They should have a background in taxation and a process in place to identify tax-planning opportunities. “PFS” designates a credentialed personal financial planner or personal financial specialist. From there, you can evaluate what is taxable, nontaxable, and your tax deductions. Next, project the most tax-efficient account for your money, when to take distributions, and how much to withdraw. Consult a tax professional to help you.
