Why Professional Tax Planning Should Be Part of Your Retirement Plan

Jar with coins and bills marked RetirementWhen most people think of retirement planning, they think of setting a wealth goal and saving up until they reach it. Perhaps thoughts about supplementing that saved money with other income will come to mind as well. But far too few people realize how professional tax planning now can benefit them in their retirement, and therefore don’t make it a part of their retirement planning. Keep reading to learn why you should seek professional tax planning as part of your retirement planning efforts.

Understanding How Retirement Income Is Taxed

First, it’s important to understand exactly how your various sources of retirement income will be taxed—because, yes, at least some of it will be. Those taxes can take a significant chunk out of your planned income, which impacts the amount you need to save before you’re ready to retire. If you don’t account for those future taxes, you may not save enough and end up running out of money during your retirement.

Social Security income is one good example. Most people believe that SSI is a tax-free source of income in retirement, but that’s only true if your total income is below $25,000 for individual filers or below $32,000 for joint filers. (Note that these are the current thresholds, and those numbers will likely change over the years.) If you make between $25,000 and $34,000 individually, or between $32,000 and $44,000 as a couple, up to 50% of your benefits may be taxable. And if you make more than that, up to 85% of your SSI can be taxed.

Different retirement accounts are also taxed differently. For example, a traditional IRA is considered a tax deductible contribution when you’re saving for retirement; but when you withdraw, that amount is considered taxable income. Roth IRAs, however, are the opposite; you’re taxed on the income prior to your contribution, and not taxed on any amount you withdraw.

Knowing how and when your various retirement income sources are taxed can help you to better plan and save now, as well as create a more effective income strategy for the future.

Knowing When to Take Social Security

Many people think they should take their Social Security income as soon as they retire, but that’s not always the most effective choice. As we mentioned, having a higher income means higher taxes on your SSI. So, if you have other income sources immediately after retiring and you still take your SSI benefits immediately, you could end up losing some of your retirement funds to taxes. If you wait until your SSI is your sole source of income or your other income sources are reduced, you’ll likely pay less in taxes.

Saving for Retirement More Effectively

Saving for your retirement isn’t just about getting the right amount of money saved up; it’s also about getting that money in the right places for the most benefit. Taxes are a serious consideration in deciding where to put your money. While there’s no sole answer that will fit everyone’s circumstances, here’s a good general order in which to invest in the most common retirement accounts:

  1. If you have an employer-sponsored 401(k) plan that offers contribution matching, you should absolutely max out the amount that they’ll match first. This is doubling your retirement savings automatically, and no other retirement account will offer you that kind of immediate return on your investment.
  2. Generally speaking, it’s a good idea to diversify your retirement funds to have both taxed and untaxed sources of income. 401(k) contributions are a pre-tax contribution. This means that you’ll be taxed on any money you withdraw from this account in your retirement. So, your next step should be to max out your contribution to your Roth IRA.
  3. From there, things begin to change based on your unique circumstances. In some cases, going back to contributing to your 401(k) is the best step. For others, maxing out a traditional IRA could be a better option.

The only way to know which retirement account contributions will be most effective from a tax standpoint is to consult with a tax professional. We can often work in conjunction with the advice you receive from your financial planner or advisor, providing a more unique perspective as to how your current investment decisions impact your taxes both today and in retirement.

If you would like to talk more about how to incorporate professional tax planning into your retirement plan, contact Demian & Company, CPAs, today.