Retirement and Taxes: "To" and "Through" Planning

If you picture retirement planning and taxes as a Venn Diagram, there is lots of overlap between these two areas of personal finance. This is true both during one’s working years (when taxpayers are saving for retirement) and later, when people are older and withdrawing taxable income from tax-deferred accounts.

This post describes highlights from a recent webinar about retirement planning and taxes in both "to retirement" years (working and saving) and "through retirement" years (later life asset withdrawals). 

At any stage of retirement planning, taxpayers' taxable income determines their tax rate. It is calculated by subtracting adjustments and deductions (standard deduction or itemized deductions) from adjusted gross income and applying tax credits, if any. There are seven tax rates in effect through 2025: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. 

 

“To Retirement” Planning

 

¨    Tax-Advantaged Investing- Tax- deferred income is where taxpayers defer paying taxes until a future time. Examples include a 401(k) or 403(b) plan and traditional IRA. Tax-exempt income is income that is free from federal income tax. Examples include earnings on municipal bonds and Roth IRAs.

 

¨    Retirement Account Considerations- Four key questions to ask before deciding where to save for retirement are: 1. Does your employer offer matching retirement contributions?, 2. What tax bracket are you in now? 3. What tax bracket do you expect to be when you retire, and 4. How many years do you have before retirement?

 

¨    Workplace Retirement Plans- The four types of tax-deferred, salary-reduction, defined contribution plans available through employers are 401(k) (for-profit corporation employees), 403(b (school and non-profit employees), 457 (state/local government employees), and Thrift Savings Plan (federal government employees and service members).

 

¨    Contribution Limits- The maximum contribution for Roth and traditional individual retirement accounts (IRAs) in 2022 is $6,000 (under age 50) and $7,000 (age 50+). Contributions can be made until the tax filing deadline in April 2023. The 2022 limits for the plans noted above are $20,500 (under age 50) and $27,000 (age 50+).

 

“Through Retirement” Planning

 

¨    Taxable Income Sources- Common types of taxable income in later life include pensions, distributions from workplace retirement accounts, and Social Security. For Social Security, a portion (up to 85%) of benefits may be taxable depending upon “combined income” (adjusted gross income + nontaxable interest + ½ of Social Security benefits) for their tax filing status. Some older adults have a higher tax bracket than when they were working, which can trigger IRMAA Medicare premium surcharges and/or the net investment income tax.

 

¨    Pensions and Annuities- A portion of the money that people receive in pension payments is not taxable because it is considered their basis (i.e., a return of their own money). Older taxpayers who receive annuity payments pay income tax on the gain (earnings) on after-tax dollars used to fund their account.

 

¨    Required Minimum Distributions (RMDs)- RMDs must begin at age 72 for traditional IRAs, employer retirement accounts, and SEPs (for self-employed workers). These distributions are taxed at ordinary income tax rates. Thanks to RMDs, pensions, and other income sources, some older adults with multiple income streams are surprised to see themselves in a higher tax bracket in retirement than when they were working. One strategy to mitigate the tax impact of RMDS is to gradually transfer (and pay tax on) money from a traditional IRA to a Roth IRA before RMDs begin (i.e., a Roth IRA conversion).

Finally, a definition of terms. There is a big difference between “tax planning” and “tax preparation.” The former is focused on proactively using legal strategies to reduce income taxes to the lowest amount possible. The latter is focused on preparing a tax return and filing it with the IRS. 

For people who are unfamiliar with income tax rules and forms, money spent on either or both services could be money well spent and save money in the long run.

This post provides general personal finance or consumer decision-making information and does not address all the variables that apply to an individual’s unique situation. It does not endorse specific products or services and should not be construed as legal or financial advice. If professional assistance is required, the services of a competent professional should be sought.