While we are all aware that we must continue paying income taxes when we retire, some people fail to fully calculate those pesky little (or big) expenses into their budgets. Especially without a trusted wealth planner or savvy CPA on hand for stellar advice. And, if you haven’t considered inflation or how costly things may be when you retire—well, you may find yourself in a bit of a financial distress during a time when you should be relaxed and somewhat worry free.
So, let’s talk income taxes first.
You should identify your fixed income (including Social Security, investment income, etc.) and estimate your living expenses in retirement. You can project what the wealth will (hopefully) be in your retirement plan when you retire and come up with the annual income you’ll need.
In your retirement planning stages (before you retire) you should take inventory of all your assets—IRAs, pension plan, 401(k), etc., as well as your other non-retirement assets such as stock, mutual funds, bonds, or real estate portfolios. Then, calculate how much income is currently produced from all the assets. If your total projected retirement expenses exceed your total projected retirement income at retirement, you need to beef up your savings strategy.
While some experts recommend the 4 percent withdrawal rule, that may not apply to you. In fact, determining your withdrawal rate in retirement can be a bit tricky. It depends on your situation and factors beyond your control. This rule is not as simple as it seems, because it doesn’t account for real life factors that may come into play such as market volatility and other impactful issues like rising health care costs. If you withdraw too much from your savings, you may find yourself in a position where you outlive your funds.
With that in mind, other experts recommend a 3 percent withdrawal rate when you first retire, which may help hedge potential losses your portfolio may suffer should the markets decline. Conversely, if the markets and your investments perform well—you could find yourself with more than enough income to maintain the retirement you desire. The point is, determining the percentage at which you should withdraw your earnings yearly upon retirement is critical, and should be considered with great care.
These are the basics—kind of a retirement and financial management 101 review. It is vitally important to make sure you spend less than your income to make your funds last as long as you need them. For instance, unpredictable health factors such as long-term care, should be considered early so as not to deplete your savings if the expense arises as a surprise.
Where taxes come in can get a bit tricky depending on your retirement plan, the assets you have, as well as what deductions are available at that time.
For example, 401(k) and traditional IRA contributions are made on a pre-tax basis. You’re able to deduct those contributions on your income taxes in the years you make them. However, when you take distributions in retirement, you’ll pay ordinary income tax on the withdrawal of the contributions since you didn’t pay tax on it before you made the contribution. You’ll also take a tax hit on distributions of the earnings the account made. This tax liability can add to your yearly expenses and if not considered—can be a bit of a shock. Especially if you have a large amount in your retirement plan, if there are less deductions available, and if tax rates are higher in the future than they are now.
If you qualify, a Roth IRA is a fantastic plan to circumvent future tax liability. All contributions are made after tax. All distributions of those contributions are tax-free. So are the earnings the account makes. The only catch to avoid taxation on the earnings is to wait until you are over 59 ½ years old and meet the Roth five-year rule before you start taking distributions on the earnings.
Now, what about inflation?
You know this rises every year. In fact, every month inflation fluctuates depending on the economic state of the nation (and the globe!). It’s a pretty undependable number, inflation. And, while it’s never skyrocketed in daily stock market terms—any jump can affect retirees on a fixed income. While the year-to-year inflation rates may be manageable, decades of living longer in retirement (which is the current trend) could affect your financial bottom line.
It is hard to plan every detail for every potential obstacle. Mishaps and miscalculations are bound to occur. But, when it comes to taxes and inflation, you need make the best effort nail these numbers down, so you can afford to ante up when the time comes. Make sure to really look at overall picture before you jump into retirement.
With a little forethought and planning, you can easily take a look at the big picture you envision your golden years to be—and make moves now to help paint yourself happily into that scenery when you retire.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.