Taxes and Your Retirement

Unfortunately, when you retire taxes typically do not just go away. It is important to plan properly to reduce the taxes you must pay so your money will last longer. You can think of taxes in retirement as coming from three different buckets, with each bucket representing a different tax rate. Below is a summary of different sources for income and how they are taxed.

Ordinary Income Tax Bucket

This is the most common tax bucket and the one where you pay the highest tax rates.  Your most common income sources like pensions, social security (up to 85%), and distributions from retirement accounts like IRAs or 401(k)s are all taxed as ordinary income. Unfortunately, many people build large values in this bucket and neglect the other two buckets. This can lead to paying high tax rates in retirement. Below is a chart that summarizes tax rates for 2020 using the two most common tax filing statuses.

Long-Term Capital Gains Tax Bucket

This bucket is for taxable investment accounts and applies to qualified dividends and long-term capital gains (LTCG), which occur if you sell an investment after holding it for 12 months. This bucket is tax-preferred and the tax rate depends on your tax rate for the ordinary income tax rate. See below to understand your tax rates for 2020 for this bucket:

Tax-Free Bucket

This is everyone’s favorite bucket for obvious reasons but is the hardest bucket to fill. The only options available are muni bonds, which usually only make sense if you are in a high tax bracket or Roth accounts like a Roth 401k or Roth IRA. An important part of planning in retirement often consists of Roth Conversions, which allows you to help fill the tax-free bucket. Roth conversions can be a powerful tool, but please contact us or your tax advisor to see if you can benefit from them.

The ideal scenario is to have diversification from a tax perspective with money in each of these buckets. This allows for greater flexibility in retirement for planning to reduce the taxes you will pay throughout retirement.  We are happy to talk about your individual situation and put together a plan for you.