Developing a strategy to minimize taxes for the current year is fairly straightforward. Tax planning for next year is a bit more difficult, but planning for the distant future becomes increasingly complex because of the many variables involved. Individuals can, however, choose certain options during their working years to lay the groundwork for minimizing taxes in retirement.
Unless you are a participant in a traditional pension plan, you will likely be able to access many of your retirement assets at age 59 1/2 without penalty. Even though there is not an early withdrawal penalty at that age, the ideal goal is to conserve the funds for as long as possible. When you decide to partially or completely stop working at some point, it will likely become necessary to make withdrawals from one or more types of retirement accounts.
Traditional pensions
An overarching strategy to minimizing tax is to avoid a concentration of taxable withdrawals in any one particular year. If you become the recipient of a traditional pension, the annual payment amounts are likely to remain relatively constant over the years. Even though the taxable income from a pension cannot be changed, it must be factored into your decision of when to receive other retirement distributions.
Individual retirement accounts
After age 59 1/2, financial planning flexibility is enhanced by having IRAs on both a pre-tax and a post-tax basis. If you are eligible to make IRA contributions during your working years, you can split your allowable contributions between a traditional IRA and a Roth IRA. A Roth IRA is post-tax, meaning that taxes are paid on contributions up front. The valuable feature of a Roth IRA is that distributions are tax-free, including the accumulated earnings.
A traditional IRA is pre-tax, so tax is deferred on the contributions. Tax is also postponed on the earnings until distributions are made. Unlike a Roth IRA, the full amount of a distribution from a traditional IRA is generally taxable. Since distributions from a traditional IRA increase your taxable income, you might choose to take them during years in which they have the least effect on increasing your income tax.
401(k) plans
For tax purposes, the typical 401(k) account is treated similarly to a traditional IRA. Contributions are tax-deferred, and distributions are fully taxed when received. An important reminder to 401(k) participants is to understand how to maximize the amount of any matching contribution available from their employer.
Social Security income
Social Security income is potentially taxable. If your other sources of taxable income exceed a certain threshold, a portion of the Social Security income may be taxable. Social Security payments can be delayed for a few years if the delay helps optimize your overall retirement strategy.
For more advice, reach out to retirement planning services like Estate & Financial Strategies, Inc.
