Reducing Your Tax Burden in Retirement

“The only difference between death and taxes is that death doesn't get worse every time Congress meets.” - Will Rogers

Building a portfolio that minimizes taxes in retirement years is of great importance. For many, taxes end up eating away at retirement savings so that they cannot reap the most benefit from their hard-earned money.

A few years ago, I had the privilege of traveling to attend a conference in Curacao, in the Southern Caribbean. At the conference, there was a lot of discussion about tax information reciprocity between countries. Maybe you don't know why this is of great importance to everyone. (For related reading, see: Retirement Taxes: 5 Ways to Save Money.)

In the past it was possible for wealthy individuals to move money and investments offshore to avoid paying taxes. I’m sure you’ve heard of this happening before. In order to stop this practice, in 2010 the U.S. Congress passed the Foreign Account Tax Compliance Act (FATCA), a federal law requiring United States persons to declare, for the purposes of tax assessment, any financial holdings outside the U.S. There is now growing international cooperation to ensure that this law is enforced.

This is a good thing because it's unfair when privileged individuals can evade paying their share of tax by removing a significant portion of the country’s wealth from our economy. It ultimately means higher taxes for the rest of us.

Tax Diversification

There's another enemy that causes Americans to pay more than their fair share of taxes, and it is far more common. There’s no law that can be passed to stop the enemy of ignorance.

I don’t believe that anyone should be able to get away with tax evasion. On the other hand, I also hate to see people, who have worked hard all their lives, having their retirement savings depleted because they end up paying more taxes than they need to. Yet, this happens all the time when people don’t understand the provisions that are available to them within the law to reduce taxes in retirement.

As a financial planner, I enjoy providing people with the knowledge they need to plan wisely so that they protect their hard-earned nest egg for those years when they’re going to need it. One of the great tools at our disposal is a strategy of tax diversification. (For more, see: How Yearly Taxes on 401(k) Accounts Work.)

Retirement Savings Categories

In order to understand how tax diversification works, it’s helpful to think of your retirement savings in three different categories:

1. Tax Deferred: Includes things like traditional 401(k) and IRA accounts. Contributions that you make to these are excluded from your current income, so you don’t pay tax on this money until you make a withdrawal. However, at age 70½, annual withdrawals are required and taxes are due each time.

2. After Tax: Roth accounts. Contributions are made to these with after-tax dollars. When you withdraw money later in retirement, no tax is due. These accounts also give you great flexibility because you don’t have to make withdrawals on any schedule. This means that you can take money out at a time when you need it without tax consequences, or choose to leave it for later in retirement.

3. Taxable: All regular savings and investment accounts that have no tax advantages for contributing, and require you to pay capital gains tax each year. The importance of these accounts, however, is that they don’t attract penalties for withdrawals before a certain age. So these give you a lot of flexibility for spending or emergencies.

Reducing Your Tax Burden

By wisely distributing some of your savings into each of these three categories, you can reduce the amount of taxes in retirement while still maintaining some flexibility to allow for unexpected life events. The real skill is, obviously, in getting the mix just right. To do this, you need to have a plan that details the order in which you will save money into each category now, and the order in which you will withdraw money from each category in the future.

It would be nice if we could advise a “one-size-fits-all” strategy for everyone to follow, but there are always variables to be considered. For example, some people still have traditional pensions, which require you to pay taxes in retirement. Your withdrawal strategy will have to factor that in. Social Security benefits are another potentially taxable income that can vary.

It’s important that you get sound advice and think about your tax diversification strategy sooner rather than later. By addressing it now, you’ll have more options for managing your money when you’re no longer earning a salary. (For related reading, see: 5 Tax(ing) Retirement Mistakes.)