Rethinking Retirement: A Smarter Approach to Tax Planning
When it comes to retirement, many of us assume that deferring taxes is the best strategy. But what if we’re wrong? According to Mark Miller of Morningstar, focusing on minimizing overall taxes during retirement might be a better approach. This means tapping into tax-deferred accounts first, rather than last.
The Tax Trap of Social Security
One major consideration is the impact of Social Security benefits on your tax liability. If you’re collecting benefits while making withdrawals from tax-deferred accounts, you’ll likely pay taxes on those benefits. Single filers earning between $25,000 and $34,000 in “combined income” will pay taxes on 50% of their benefits, while those earning over $34,000 will pay taxes on up to 85%. The limits for joint filers are $32,000 and $44,000.
The “Tax Torpedo” Effect
The problem is that Social Security benefits are indexed to wage growth and inflation, while the income threshold levels used to determine taxable benefits are fixed by law and not indexed. This means more people are being affected by the “tax torpedo” – the combined effect of earned income and Social Security on tax liability.
A Better Way: Roth Assets and Tax-Efficient Drawdowns
So, what can you do? One strategy is to draw down tax-deferred accounts before claiming Social Security, and to convert some of those assets to Roth IRAs. This will give you tax-free income that won’t add to your combined income. Alternatively, you could rely on cash from taxable accounts to meet living expenses early in retirement, allowing you to delay Social Security benefits.
Getting Professional Help
Figuring out the best approach for your individual situation can be complex. A financial advisor can help you weigh your options and create a tax-efficient retirement income strategy. You can also use online tools and services to calculate Social Security and drawdown sequencing.
The Bottom Line
Tapping your tax-deferred assets first can help lower your total tax burden in retirement. By deferring Social Security and maximizing your future benefit, you can create a more sustainable income stream. And with Roth conversions, you can generate tax-free income that won’t add to your combined income.
Tax Planning Tips
- Consult with a financial advisor to plan for retirement taxes and draw down your assets in a tax-efficient manner.
- Consider moving to a more tax-friendly state in retirement.
- Keep an emergency fund on hand to cover unexpected expenses.
- Compare savings accounts to find the best option for your needs.
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