Outside the Box: Gearing up for retirement? Make sure you understand your tax obligations

Benjamin Franklin taught us that only a couple of things are certain in this world, and taxes are among them. His words still ring true today, as taxes are a part of the American work experience — and postwork experience. Even in retirement, you must be mindful of how your income strategy affects your tax obligations and how that can impact your overall financial picture in your golden years.

There are several factors at play when we talk about taxes in retirement, including age, tax-deferred and other retirement accounts, additional investments and Social Security. Understanding how to navigate these interconnected factors, and how to use specific tax strategies, can help you build a comfortable retirement.

Types of retirement and how they’re taxed

Distributions from a tax-deferred account, like an IRA, 401(k) or pension, are generally taxed at your ordinary income-tax rate in retirement. In contrast, Roth IRAs and Roth 401(k)s are eligible for income-tax-free distributions once the account holder is aged 59½ or older and as long as the account has been open for at least five years.

And then there are investment earnings. Your tax rate on the profit from selling investments depends both on your income and how long you’ve owned the investment. Short-term capital gains, those on investments held for one year or less, are currently taxed as ordinary income, while long-term capital gains, those on investments held for more than one year, are generally taxed at a more favorable rate.

Lastly, there is Social Security to consider. Social Security benefits may or may not be taxed, depending on what the IRS calls “provisional income.” Provisional income includes gross income, tax-free interest and one half of your Social Security benefits. If your provisional income total is above a certain amount, then at least a portion of your Social Security benefits will be taxed.

Some important numbers

There are a couple of “magic numbers” to remember when it comes to retirement. These include age 59½, when you can start taking penalty-free withdrawals from your retirement accounts, and 65, when you become eligible for Medicare, and when many people plan to retire.

But one of the most important numbers, especially from a tax perspective, is 70½. This is the age at which retirees must begin taking annual withdrawals from their retirement accounts, known as required minimum distributions (RMDs), and must pay the taxes that accompany them.

After you retire, the amount you must withdraw for the RMD is typically determined by your age and the account’s value. Failure to withdraw the full required amount results in a penalty of 50% of the difference between the distribution amount you did take and the one you should have taken, so it’s important to be informed.

As a retiree, you actually have until April 1 of the year after you turn 70½ to take your first distribution, but 70½ is the trigger, so waiting means you’ll have to take two distributions in the first full year, which could move you into a higher tax bracket.

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Strategies to manage taxes in retirement

One way to potentially lower taxes in retirement is to start taking distributions from tax-deferred accounts before it’s required. Again, once you reach age 59½, you can withdraw funds from those accounts without paying the 10% early-withdrawal penalty. The withdrawals are still taxed as ordinary income, but over time they reduce the size of tax-deferred accounts, and thus the size of your RMDs. Another reason to access those funds before 70½ is that it could help you delay taking your Social Security benefit, which increases in size the later you take it, up to age 70.

That said, it’s important to look at your tax situation at age 59½ before taking early withdrawals. For the many Americans who will still be working at that age, withdrawing too much could push them into a higher tax bracket. Taking Social Security benefits could also push you into a higher tax bracket, but keeping RMDs low means less income would be subject to the higher tax rate.

One of the most popular and appealing strategies for reducing the potential tax consequences of RMDs is converting a traditional IRA or 401(k) plan into a Roth IRA before the age of 70½. Roth IRAs are funded with after-tax dollars and thus are exempt from RMDs during the owner’s lifetime — and when the funds are withdrawn, both the principal and earnings are tax-free. It’s worth noting that the act of converting to a Roth IRA is a taxable event and the five-year rule still applies.

A Roth conversion may make sense when you’re certain you’ll be in a higher bracket when you eventually withdraw the money, which is often the case once RMDs and Social Security are factored in. It may also be a good option when you don’t need the money, aren’t concerned about paying income taxes and would like to leave an income-tax-free Roth IRA to your heirs.

Lastly, if you make a full or partial conversion to a Roth IRA, you may be able to reduce the resulting tax burden via charitable giving during the same year as the conversion — though the donation can’t be funded from your retirement accounts.

There’s a lot to consider as you plan for how to manage your tax obligation in retirement. Consulting with a financial professional, and particularly a tax adviser, can help ensure your choices are most advantageous for your situation.

Catherine Golladay is senior vice president for 401(k) participant services and administration with Schwab Retirement Plan Services.

The information contained herein is proprietary to Schwab Retirement Plan Services Inc. (SRPS) and is for informational purposes only. None of the information constitutes a recommendation by SRPS. The information is not intended to provide tax, legal, or investment advice; please consult with your accountant or investment adviser for how this applies to your specific situation. SRPS does not guarantee the suitability or potential value of any particular investment or information source. Certain information provided herein may be subject to change. None of the information contained herein may be copied, assigned, transferred, disclosed, or utilized without the express written approval of SRPS and its affiliates. 0618-8UPD.

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