Many people are not saving enough for retirement. And those who are saving may underestimate how much money it could take to live comfortably. Understanding how taxes can affect your retirement is an important step in planning your future and keeping more money in your pocket instead of the government’s. After all, taxes are the largest never-ending expense for most people.
Coming up with a withdrawal strategy is another important part of retirement planning. How you decide to withdraw funds depends on your personal goals and financial situation, but a commonly recommended method is to liquidate funds from your least tax efficient accounts first.
This approach may help you minimize capital gains and maximize tax-deferred growth by preserving your tax-advantaged accounts for as long as possible. Here’s an example of the order in which you could choose to withdraw funds in retirement1 :
1. Taxable accounts such as investment portfolios.
2. Tax-deferred accounts such as traditional IRAs, 401(k)s and SIMPLE IRAs.
3. Tax-exempt accounts such as Roth IRAs.
Tax Differences Between Traditional And Roth IRAs
People are often confused about whether to save in a traditional or Roth IRA. In essence, their differences in taxation can affect how much in taxes you pay in retirement.
A simplest way to decide between the two is to consider which is greater: your current tax rate or your anticipated tax rate in retirement. If you anticipate having a lower tax rate when you retire, as most people do, a traditional IRA could be preferable. Account holders of traditional IRAs can contribute income tax-free in exchange for paying any taxes due down the road upon withdrawal.
If you anticipate a higher tax rate in retirement, or want to have maximum cash flow later on, a Roth IRA might suit you better. Roth IRAs are funded with after tax money, thereby making the withdrawals tax-free during eligible years.
Like in investing, it’s a good idea to diversify your retirement contributions in various plans. For example, you may choose to max out your pre-tax 401(k) first before contributing to an after-tax Roth IRA. Or, you may choose to contribute to your 401(k) up to the company match, then max out our Roth IRA, and then contribute to your Motif Investing portfolio for liquidity purposes. Given there’s the 59.5 age limit before you can withdraw from tax-advantaged accounts penalty free, it’s important to carefully assess your liquidity needs before deciding how much to contribute.
Note: for 2015, the maximum contribution to all of your traditional and Roth accounts cannot exceed $5,500 for those aged 49 and under or $6,500 for people 50 and over.2
Warning: Your Social Security Benefits Could Be Taxable!
The act of retiring doesn’t necessarily shield you from having to pay taxes. Even if you’re no longer working, you may still receive income such as dividends and interest payments that are subject to federal or state taxes. The same applies with Social Security benefits.
It’s important to understand that where you live and how much total income you bring in each year can have a direct impact on how much of your Social Security benefits you get to keep for yourself.
The IRS provides some general guidance on federal taxation of Social Security benefits as follows3:
1. Calculate the sum of half of your Social Security benefits and all of your other income including tax-exempt interest.
2. If your total from step 1 is greater than one of the base amounts below (based on your tax filing status), some of your benefits could be taxable.
– $25,000: for single, head of household, qualifying widow or widower with a dependent child or married individuals filing separately who did not live with their spouse at any time during the year
– $32,000: for married couples filing jointly
– $0: for married persons filing separately who lived together at any time during the year
Most states do not tax Social Security benefits, but it is helpful to know there are 13 that do: Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont and West Virginia.4
If you are worried about not having the discipline to set enough money aside from your Social Security benefits to pay for taxes, you may want to consider electing to have a percentage of your benefits checks withheld up front.
Relocating Could Save You On Taxes
There are a lot of differences between states on income, property, inheritance, estate, sales and Social Security taxes. Where you live, leading up to and during your retirement, can greatly impact how much money you have at your disposal when you’re no longer working.
If you currently live in California, Connecticut, Delaware, Minnesota, Montana, Nebraska, New Jersey, New York, Oregon or Rhode Island, you may want to rethink your future living situation. These 10 states have the worst tax burdens.5 Relocating to a more tax-friendly state could be something to consider if you do not have strong ties to your current location.
Wondering where you could go? There’s a reason why Florida is so popular for retirees – it’s one of the top 10 most tax-friendly states. In addition to no state income tax, Florida does not have any inheritance or estate taxes. Social security benefits and retirement income are also tax-free in the Sunshine State. Floridians can also get up to a $50,000 homestead exemption on their permanent residence. Some seniors 65 and older may qualify for up to an additional $50,000 exemption if they’ve lived in the state for 25 or more years, have a household income below $28,228 (for 2015), and a residence worth less than $250,000. 6
Here is a list of the top 10 most tax-friendly states:
– South Dakota
Perhaps a visit to one of these states for your next vacation could be a fun way to familiarize yourself with the local property markets and get a sense for what it might be like to establish roots there.
Start Saving And Investing For Your Retirement Today
Taxes are unavoidable, but you can take various steps to mitigate the expense. The sooner you start saving for retirement and putting your cash to work, the greater your chances for a better financial future.
Motif Investing offers Traditional IRA, Roth IRA and Rollover IRA retirement accounts with no fees. Ready to get started? Click here to apply now.
Motif Investing does not provide tax, legal, or estate planning information. Please see your tax and legal advisors to determine how this information may apply to your own situation.
1 Campbell, Kelly, “Ensure Your Retirement Income Isn’t Taxed To Death,” US News, March 6, 2014.
2 IRS, “Retirement Topics – IRA Contribution Limits,” Internal Revenue Service, January 22, 2015.
3 IRS, “Are Your Social Security Benefits Taxable?” Internal Revenue Service, June 5, 2015.
4 Kiplinger, “State-by-State Guide To Taxes On Retirees,” Kiplinger, October 2015.
5 Kiplinger, “State-by-State Guide To Taxes On Retirees,” Kiplinger, October 2015.