If you’re nearing retirement, you’re probably looking forward to relaxing, traveling, or even starting up a side hustle. What you may not be looking forward to—or even anticipating—is the new set of financial challenges that come with retirement. Taxes are one of the biggest challenges for retirees and it’s important you know how to plan for them so you’re not caught off guard.
Here are some tips to help you plan for taxes in retirement so you can navigate the transition smoothly and enjoy your well-deserved time.
1. Understand How Taxes Work in Retirement
When it comes to taxes in retirement, you need to know how your income will be taxed. Your income will likely come from a variety of sources including your Social Security, a pension, IRA withdrawals, 401(k)s, or personal savings. Taxes will vary depending on the source of the income.
For example, up to 85% of your Social Security benefits can be taxed. The level depends on your overall income. When it comes to pensions and retirement accounts, you can expect the withdrawals to be taxed as ordinary income as contributions were made with pre-tax dollars. Planning to use a Roth account? Qualified withdrawals from these are not taxed as they are funded with after-tax contributions.
2. Create a Retirement Income Strategy
Now that you know how your income is taxed, you can develop a strategy for how to withdraw funds. Here are some good strategies to consider:
- Diversify Your Retirement Accounts: If possible, build a mix of tax-deferred (traditional 401(k), IRA), tax-free (Roth IRA), and taxable (brokerage accounts) accounts. This will give you more flexibility when it comes to withdrawals and allow you to better manage your tax liability.
- Withdrawal Order: The order in which you withdraw money can make a big difference. For example, consider withdrawing funds first from taxable accounts, then tax-deferred accounts, and saving Roth IRAs for later years. This strategy can help minimize the taxes you owe in the early years of retirement and allow your tax-free Roth funds to grow longer.
- Required Minimum Distributions (RMDs): Once you turn 73 (starting in 2024), you’ll be required to begin taking RMDs from your traditional retirement accounts, including IRAs and 401(k)s. These withdrawals are taxed as ordinary income, so it’s important to account for them in your tax planning. Be sure to plan ahead to avoid a large tax bill when RMDs start.
3. Consider the Impact of State Taxes
Federal taxes are not the only ones you need to consider in retirement. State income taxes may also affect your income. In Nebraska, Social Security income is no longer taxed on a state level. However, pensions and 401(k) and IRA distributions are taxed and the amount you will pay will depend on your income level.
4. Plan for Healthcare Costs
Healthcare is one of the most significant expenses in retirement, and it also has tax implications. The cost of premiums, copays, and prescription drugs may not be deductible unless they exceed a certain percentage of your income. Additionally, some healthcare-related costs (such as long-term care) may be deductible, depending on your situation.
Be sure to consider the tax implications of healthcare costs and explore options like Health Savings Accounts (HSAs) if you’re still working, as they offer triple tax advantages (tax-free contributions, growth, and withdrawals for medical expenses).
5. Work with a Tax Professional
Tax planning can be complex, especially in retirement when your income may come from multiple sources. Working with a tax professional such as those at Hayes & Associates who specialize in retirement planning can help you navigate the tax landscape and identify strategies to reduce your tax liability. A professional can also help you stay compliant with tax laws, make informed decisions about when to take withdrawals and optimize your tax situation in retirement.
Confused about how your retirement income will be taxed or want to work with a professional to make sure your strategy is solid? Reach out to the helpful team at Hayes & Associates. We’d be happy to help!
