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Created: April 2, 2023
Modified: March 31, 2023

Taxes in Retirement

Today we’re talking about a very important subject: taxes in retirement. Can we reduce taxes? Taxes are often the greatest issue people face when planning for retirement and I want to start off by first asking you this question: do you think taxes are going to go up in the future?

Are Taxes Going Up?

If you’ve been following the news, you know that we have real issues in this country when it comes to retirement security. Back when Social Security was created, the average life expectancy was around 65-66 years old. Think about that. You would get your Social Security check at age 65, get paid out for a year or two, and then you’d die. It was much easier to fund a system that only had to pay two years of retirement benefits. Today, the average life expectancy it’s well into the 80s and it won’t be too long from now where that life expectancy creeps into the 90s.

When it comes to social security, pensions and deferred compensation plans, those retirement benefits have to be paid out over a much longer period of time – anywhere from 15 to 30 years. You need to put a lot more money aside to pay a benefit out for 30 years than you do to pay out for 2 years and that’s the real problem with things like Social Security and pensions. It is not that these ideas were ill-conceived or were neglected of funding, but rather funded with a much shorter life expectancy in mind. In order to keep this promise moving forward, taxes may have to be increased or modified accordingly to come up with the necessary funding.

Our government has made a number of promises to the public, such as Medicare disability payments for those with disabilities, and Social Security Disability benefits. Particularly due to the fact that over 65 year-olds make up a large proportion of voters, it is unlikely that these promises will be retracted or modified in any way. And so there is going to be an issue with keeping those promises and the money can only come from a few places. It’s probably going to come from taxes.

I am bringing this up as a reminder that taxes can be a difficult element of retirement and unfortunately, many people coming to our office for planning are already fixated on the rate of return from their investments. They ask questions like: “how can I make more money? How do I protect my finances when the market is down?” This tends to be an immediate focus with little regard for any other aspects of retirement. Investments are important, but many times we can reduce taxes which is the same as getting a higher level of return. It’s important as we plan for retirement, to be aware that taxes will probably go up.

What are some things that we should be thinking about when it comes to planning for taxes in retirement?

Imagine that you’re currently paying 20% of your income as taxes. You earn a gross monthly income of $10,000, meaning after taxes you are able to keep $8,000 each month. Now if those taxes suddenly increase from 20%, say to 25%, then instead of keeping $8,000 per month post-taxes, now you can only take home $7,500 – and even less if the tax rate increases again! At the same time, inflation’s kicking in, so our cost of living is going up while our spendable income is going down. This is so critical and I can’t emphasize enough the importance of planning for taxes going up in retirement.

Reducing Taxes in Retirement

When it comes to minimizing taxes in retirement, there are a number of strategies worth considering. When you retire, Social Security kicks in as a source of income and that will be taxed a certain way. Medicare premiums are determined by the amount of disposable income available to you at retirement. You’ll probably have a number of different accounts you could draw from in retirement, such as 401(k), or savings in the bank. Even though many people look at Social Security as payments over time rather than an account per se, I would still consider it one big savings account for the future. One of the keys to reducing taxes on your retirement income is the order in which you draw from these accounts.

For instance, you may opt to take Social Security early in order to refrain from dipping into your 401(k) or retirement accounts. Now that’s not necessarily right or wrong for everybody, it depends on your situation, but that’s just an example of some of the choices that you have to make to make sure again you’re reducing those taxes in retirement.

When you enter retirement, there are other taxes that come into play. Property taxes become a key concern when deciding where to live in your later years. Places such as New York City require an additional city income tax that’s over and above the state income tax that New York has – something to consider before choosing where to retire!

What about relocating to a more tax-friendly state like Florida, Texas, or the Carolinas? This can be a tricky tradeoff. Moving away from children and grandchildren in order to save money on taxes – does that make sense? It is so important to think about these matters and have these conversations so that we can better understand our options.

How do we reduce taxes in retirement?

The key is establishing a solid financial plan that focuses on two things:

  1. Where is your income is going to come from?
  2. Can you manipulate the order in which you draw from those accounts to reduce your taxes?

Required Minimum Distributions

Retirement plans are a great way to invest for the future and save on taxes. However, there comes a time in retirement where if you live long enough, the government will require us to make withdrawals from our retirement accounts. When investing in these types of plans while working, many times you receive tax deductions which also allows your money to grow without being taxed until withdrawal. While this seems like free money, it’s important to remember that nothing is truly free! When it comes to retirement plans, any money that is withdrawn must now be taxed. Let’s say for instance you invested $1 when you were 30 years old; if by the time you reach 73, that dollar has grown to be worth $3, then all three will be subject to taxation upon being removed in your retirement period. It is an unavoidable process everyone must go through. You will be forced to withdraw from these accounts, and for most of us it will be at age 73.

If you’re fortunate enough to have saved a substantial amount of money by the time you reach age 73, one major mistake people make is assuming that their savings should be used up before touching anything in their retirement accounts. However, this may not be the best plan for you! When you hit age 73, the government will require you to start withdrawing funds from your retirement accounts and that withdrawal amount percentage will increase annually. That money is going to be forced out. Let’s go back to my previous example and say you’re living on $10,000 a month. If all of a sudden at age 73 they force $60,000 over and above your needed income out of your retirement plan, $65,000 the following year, and then $70,000 after that, you are going to have to pay taxes on all of this income. This is one of the biggest taxes to anticipate is losing control of the way we take our money out in retirement.

For some, it may be best to withdraw from your retirement plan before touching brokerage accounts or your savings. For others, it may make more sense to do something we call a Roth conversion where in return for paying taxes on the money today, all the growth is tax free in the future, including leaving money behind. With so many options available, focusing on and anticipating the taxes that you’ll need to pay in retirement can enable you to make more informed decisions. All too often people overlook this crucial component which leads to a lack of choices further down the line when it’s too late. Don’t let yourself become one of them; plan ahead and consider tax implications now!

Taxes on Social Security

Taxation on Social Security is a controversial issue, and while you may disagree with it, the reality is that taxes exist at present. Whether you contributed to taxes when your income was previously taxed or not, this doesn’t change anything – taxation still applies to your Social Security benefits.

Currently, Social Security is taxed based on your other sources of income. If you don’t have any earnings in addition to Social Security, then you’re probably not paying any taxes on your Social Security. If you have other income, there is a specific formula to calculate your taxes on Social Security. 50% of it might be taxable, and for those who may fall into the higher-income bracket, as much as 85% could be subject to taxation – just remember that this doesn’t mean 85% of your check goes towards taxes automatically; merely that an equal amount gets added onto your total annual income when calculating how much tax you owe.

Why is this important? Take into consideration my example. If I have a low income, then Social Security will not be taxed. Conversely, if I generate large amounts of income in one year and less the next year, it can help me avoid paying taxes on Social Security each time. For instance, let’s say that during Year One of this strategy I have substantial earnings – enough to where Social Security will get taxed at its maximum rate; however, in Year Two I reduce my taxable income so that no tax needs to be paid on SS benefits. This approach enables me to obtain the best possible outcome with regards to taxation on these funds!

How would I be able to do this? Well what if I took two years of income out in Year One for instance, got whacked with SS taxes, but in Year Two I don’t have to take any income out of my retirement plans because I already satisfied that two-year need. Instead of planning year-by-year, why not plan two years in advance? It may sound confusing, but the main takeaway here is that by properly managing your income you can significantly reduce taxes on sources like Social Security.

Pensions come in a variety of forms and are subject to different taxes depending on the type. For instance, government pensions, railroad pensions, post office pensions or teacher’s pension can all be taxed differently. For those of you who are educators, the Social Security is not something that will apply to you. Nonetheless, would it be possible to find ways to reduce taxes on your pension income? A few strategies exist that can help make a meaningful difference in how much tax you pay on this type of retirement income.

Taxes on Inheritance

Last but not least let’s talk about inheritance. As I record this, I am 60 years old and my kids are 32, 27, 25 and 23. If I manage to reach life expectancy at 85 years old, then when I pass away my eldest, Brandon, will be 57 – just entering his peak earning years between the ages of 55-65. If I leave him money when I die and he’s in his peak earning years, that money will be taxed at his rate, not mine. We could lose up 50-70% of that money in taxes and if it’s in a retirement account, he will be forced to make withdrawals very quickly.

It’s important to talk about these issues and have a plan in place. How do you want to leave money to your kids, your grand kids, or to charity if you don’t need all the money that you’ve saved? We’ve heard people say that their children can take responsibility for paying taxes on the money they inherit, but what if there were no costs associated with giving them more control over those very same taxes?

You may come to the conclusion that there’s no need to save any more money. Your current lifestyle should sustain you for life, even if you were to ramp up your lifestyle in the future; your savings are so great they would never be depleted completely. If hypothetically speaking, you were to leave one million dollars to your children, what would be the most beneficial way of doing so? It likely involves some tax planning now in order for them have more control and save those hefty taxes. You may think that paying taxes yourself is a waste, but it could mean your loved ones are left with an even larger sum, or perhaps a larger donation to charity. Whatever decision you make today can result in fruitful consequences later on.

As we’ve discussed, when it comes to taxes in retirement, there are several matters that must be considered. Most people are so focused on obtaining a higher return on their investments that they overlook one of the most significant opportunities for savings – minimizing taxation! In many cases, reducing your tax liability is significantly easier than improving upon financial returns. This can present an immense advantage and opportunity to save money during this critical life stage. Here at Johnson Brunetti, our goal is to ensure that you are as knowledgeable as possible. Through this YouTube channel, we aim to equip you with the know-how and resources so that whether you communicate with us or other financial advisors and tax professionals,you have all of the ammunition necessary to make informed decisions about your situation.

Information presented in our podcasts is considered current as of the created date. Over time, some information presented may become stale. We recommend you consult with your Financial Professional before making any changes based on information contained here.

Johnson Brunetti is a marketing name for the businesses of JB Capital and JN Financial.

Investment Advisory Services offered through JB Capital, LLC. Insurance Products offered through JN Financial, LLC.

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