Four Ways You Can Avoid Retirement Tax Surprises

According to Nationwide Retirement Institute, nearly half of retirees wish they had been better prepared for the taxes they would pay in their retirement years. In fact, a full 25 percent reported paying thousands more than expected. These surprise expenses can be frustrating at best and downright painful at worst, and they’re getting more and more common as retirees rely on tax-deferred options like 401(k) accounts.

In recent years, workplace pensions have been largely replaced by individual savings plans, often with employer matches. These accounts allow workers to take control of their retirement savings, but they come with rules: once you turn 70 ½ years old, you are forced to take required minimum distributions (RMDs) annually. If you fail to comply, you’ll face a tax penalty of 50 percent – even if your IRA is six figures or more. With a risk of hefty penalties and annual withdrawals that are larger than many retirees expect, it pays to do some advanced planning. Below are four ways to do just that.

Diversify Your Portfolio

You’ve undoubtedly heard this general advice before, but let’s get specific: you want to divide your savings into three different categories. First, invest in tax-deferred accounts like the 401(k) listed above or a traditional IRA. These funds will not be taxed until you withdraw them. Second, take advantage of after-tax accounts like a Roth IRA. Since this money is taxed already, you can withdraw it tax-free in retirement. Third, utilize taxable investments such as savings accounts. With these, you’ll pay taxes on interest and dividends. Maintaining a good mix of all three investment types will allow you to have more control and options when it comes time to withdraw funds in retirement. For example, if you decide you’d like to retire early but all your savings is tied up in a traditional IRA, you’ll be unable to withdraw those funds without a penalty until you reach age 59 ½.

Don’t Overlook the Roth

More employers are beginning to offer Roth IRAs, but you can also open an individual account if your employer doesn’t. This option allows you to invest as much as $5,500 annually, or $6,500 annually if you’re over age 50. There are income limitations to be aware of, though – if you earn more than $120,000 as a single filer or $189,000 filing jointly, you do not qualify for a Roth IRA. If a Roth account is a viable option for you and you’ve maxed out your 401(k) contributions, it may be smart to roll additional savings into this convenient after-tax account to avoid paying a larger tax bill in retirement.

Contribute to a Health Savings Account (HSA)

If you’re looking to really maximize your savings, Health Savings Accounts have a lot to offer. With an HSA, you essentially get a triple-tax advantage: you can choose to contribute either pre-tax or tax-deductible, there is no withdrawal penalty if you use the money for medical bills and they grow tax-free. Let’s face it – most of us will face an expensive health care scenario at some point. In fact, the average retired couple can expect to pay upwards of $280,000 in health-related expenses, according to Fidelity. So, stashing money in an HSA makes good financial sense. To truly get the most benefit, try to max out your contributions and avoid using the money for minor medical costs.

Develop a Retirement Budget Plan

If you take the above advice and maintain three different types of assets to utilize once you retire, it can begin to get complicated tax-wise. You’ll need to understand which types of withdrawals will incur the highest taxes, which may bump you up into a new tax bracket, which might have the greatest effect on your Social Security benefits, and so on. Depending on your situation, it may make sense to utilize Qualified Charitable Distributions to lower your income or to postpone taking RMDs until it’s required by law. Running through all the scenarios can make your head spin, especially if you aren’t certain you understand the tax implications of each one. At this juncture, utilizing the services of a qualified financial advisor can ensure your day-to-day living expenses will be covered and that you won’t face any unfortunate tax surprises in retirement.

If you’d like professional assistance in looking over your portfolio in this way, let’s start a conversation today and work toward a plan that keeps your hard-earned money working for you long into the future.