Four Ways to Avoid the Tax Torpedo in Retirement

The Tax Torpedo and 4 Ways to Avoid It

The tax torpedo is something that affects millions of retirees – many of which aren’t aware it was coming. It could decrease your retirement funds exponentially, leaving you with much less than you planned during your golden years.

You pay taxes all your life – even during retirement. Even though you’re not actively earning money in retirement, you’re using funds that you earned at some point. If those earnings haven’t been taxed yet (traditional IRA and Social Security income), then you’re on the hook for the taxes during a vulnerable time in your life – retirement.

Understanding Taxes Before and During Retirement

Taxes before retirement are easy to understand. You know your tax rate and most of your taxes come from your paycheck. If you’re self-employed, your tax advisor helps you minimize your tax liability by taking advantage of the various write-offs available to you. Chances are you pay taxes with each paycheck, quarterly, or annually (not recommended). But you pay the taxes when they’re due – you don’t defer them during your working years.

During retirement, it’s a whole new ballgame. Suddenly you’re receiving income from multiple sources, not just one, and may are tax-deferred accounts. Each one typically has different tax consequences too, which complicates matters even more.

What is the Tax Torpedo?

This is when the tax torpedo occurs. If your marginal tax rate exceeds your statutory tax rate, you’re on the hook for a much higher tax liability. This decreases your retirement funds balance and your ability to live the lifestyle you planned during retirement.

Many retirees find themselves in the absolute highest tax bracket during their golden years when they anticipated owing little to no taxes during this time. It’s a tailspin that you don’t want to find yourself in during retirement.

Fortunately, you can prevent the tax torpedo with proper planning. Planning tax efficiency during retirement should be a part of your plan so that you cover all your bases – looking at all aspects of your retirement income and how it will affect your tax liabilities.

How to Avoid a Tax Torpedo

There are four ways to avoid a tax torpedo. The methods that affect you depend on the accounts you have and your tax rate.

1. Take withdrawals from tax-deferred accounts first

It’s tempting to wait until you need the funds from the pre-tax retirement funds to delay paying taxes, but this could hurt you in the end. If you wait until you’re 72, you’ll be subject to Required Minimum Distributions. If you also wait to take Social Security until later in life, you’ll get hit twice as hard with tax obligations, decreasing the money you receive.

Withdrawing funds earlier allows you to control when you withdraw funds based on your tax rate at the time. If you time it when you’re in the lowest tax bracket possible for your situation, you’ll put more money in your pocket. Most importantly, you avoid RMDs and being ‘forced’ to withdraw from your retirement fund.

2. Consider Roth IRA contributions versus traditional IRA contributions

Contributing some retirement funds to a Roth IRA sidelines the tax issues traditional IRAs cause. While there should be a combination of Roth and traditional IRA contributions, there are plenty of arguments to convince you to contribute to a Roth IRA including:

• • You don’t pay taxes during retirement. You pay taxes up front and then your contributions AND earnings grow tax-free, which you withdraw tax-free too.
  • You can withdraw funds in any amount without worrying about increasing your tax bracket. If you need funds in an emergency, you are free to withdraw them without tax consequences (as long as you are 59 ½ or older and have had the account for at least 5 years).
  • Roth IRA distributions don’t affect your Social Security income so you don’t have to worry about suddenly paying taxes on Social Security or higher taxes on other retirement distributions.

3. Rollover IRA funds to a Roth IRA

If you have a large amount of funds in a traditional IRA, you may consider rolling them over to a Roth IRA.

Before you do, give careful thought to your tax brackets. The best way to avoid the tax torpedo is to time the rollover during a time when you’re in a lower tax bracket than is anticipated for the future.

You can do this at any time, pre-retirement or during retirement – it’s up to you. It really just depends on your tax bracket so that you minimize the taxes you pay (you’ll owe taxes on the amount you roll over right away).

Diversifying your retirement funds between traditional and Roth IRA accounts helps offset large tax liabilities during a time when you need the funds the most.

4. Delay social security

If you aren’t careful, up to 85 percent of your Social Security benefits could be taxable. While delaying Social Security benefits sounds ideal (who doesn’t want a larger check every month), it can hurt you in the end. Your tax liability will quickly swallow up the increased check amount and then some.

This requires careful planning and forecasting to determine when you’ll be in your highest tax bracket and how can you avoid it? Oftentimes it means taking Social Security income right when you’re eligible to offset pushing yourself into that higher tax bracket.

Plan your Retirement with a Professional to Avoid the Tax Torpedo

Don’t take your tax situation for granted. Whether retirement is 30 years away or around the corner, it’s never too early (or late) to plan. The largest mistake you can make is not addressing your tax situation during retirement.

The tax torpedo can sneak up on you, leaving you with less money in your pocket and more money in Uncle Sam’s pocket if you aren’t careful. Together, let’s plan your retirement so that you maximize your tax savings and offset the liabilities you could face during retirement.