Reaching retirement means that many of your once normal expenses will be gone. Things like the cost to commute to work, dry cleaning for your dress shirts or dresses as well as many other work-related expenses will no longer be on your monthly list of bills to pay. One thing that won’t go away however is your tax bill.
For example, while it may seem that a person who has $1 million in retirement savings has plenty of money to get them through retirement, the fact is that federal and state taxes will eat up a large amount of this money. In some cases the amount of taxes that you’ll pay on your retirement savings can be as high as almost 40%!
The fact is, when it comes to the different types of retirement accounts available, including taxable accounts, tax-deferred and tax-free accounts, it’s good to know exactly which ones are the best for your particular situation as well as knowing when to withdraw from these accounts in order to pay the least amount of taxes.
Knowing which accounts to withdraw from first is vital and experts will tell you that you should withdraw from your taxable accounts first during retirement so that you’ll be able to benefit from a lower capital gains tax rate and let your tax-deferred and tax-free retirement accounts continue to grow.
When it comes to other types of assets, any of them that you have owned in a taxable account for more than a year will be taxed up to 23.8%, depending on your tax bracket. Using your taxable accounts to purchase investments that qualify for long-term capital gains or ones that are tax free will minimize your taxes in this case. Growth stocks, tax efficient mutual funds as well as exchange traded funds are the best for these and, if you happen to own individual municipal bonds they should also be in your taxable accounts. It’s also recommended to keep at least two years’ worth of living expenses in these accounts, using a low risk account like a money market account to do so.
Tax-deferred accounts like traditional IRAs, 401(k)s and any other type of retirement savings plans are next. These are usually taxed at your ordinary income tax rate when you withdraw from them, unless any after-tax contributions that you might have made. Be careful not to withdraw from these accounts before you hit the age of 59 ½ because the chance is high that you’ll also pay a 10% penalty if you do. It’s a good idea as a retiree to have a certain amount of stocks as well as stock funds in your IRA as well. These accounts are best for investments that are already being taxed at your ordinary tax rate like bond funds, preferred stocks, real estate investment trusts and individual bonds.
Roth IRAs are the last accounts that you should withdraw from as withdrawing from them at any time is penalty free as well as tax-free. Earnings are tax-free as well as long as you have had the account for at least 5 years and you’ve passed the age of 59 ½. The difference between a Roth IRA and a traditional IRA is that, when you reach 70 ½, with a Roth IRA you don’t have to make minimum withdrawals. You can either leave the money there and also leave it to your heirs to allow them to make tax-free withdrawals as well.
Since withdrawals aren’t taxed from a Roth IRA, you can use them for a wide range and investments including aggressive stock funds since, because of the fact that you don’t have to make withdrawals, they will be more time for your investments to grow. Even better, there won’t be any taxes to pay on any profit you make.
If it seems like a silly game to play to have to keep as much of your hard earned money from getting taxed as possible, it is. It’s vital that you know how to play the game well however as, game or not, Uncle Sam will get his money unless you play it correctly.
If you have any questions about retirement plans, taxes or financial questions in general, please let us know and we’ll get back to you ASAP with advice, answers and solutions.