There is a lot to understand when it comes to paying taxes and many Americans have to take it upon themselves to learn the ins and outs of taxes. One aspect many do not account for is the higher tax rate paid once in retirement.
The insurance company Nationwide surveyed retirees and found that over one-third didn’t take into account how taxes could affect their income during retirement. Less than half said they know how to leverage their financial accounts to minimize their tax burden.
“One of the greatest disruptors of wealth and its potential is taxation,” says John Smallwood, president of Smallwood Wealth Management and author of It’s Your Wealth – Keep It: The Definitive Guide to Growing, Protecting, Enjoying, and Passing On Your Wealth. “Most financial strategies are missing the fundamentals, leaving you to pay much more in taxes than you should over your lifetime.
“There are some fundamental concepts of taxes that apply to the financial planning process. The goal is to have multiple sources of retirement income that balance out taxes and fees. That way, if one or more of the sources dries up, or if tax law changes a source or two, then the impact on your portfolio will be minimal.”
Smallwood highlights four important items related to taxes that he sees are important to know when creating a retirement plan. Tax deferral strategies are one way. This is all based on the concept of moving from a higher tax bracket that you’re in right now to a lower one in the future. But Smallwood cautions, “The tax rate in the future may not be in your favor. If you defer and don’t end up in a lower tax bracket, you can lose. You might end up paying more than if you had not deferred.”
Smallwood also stresses the importance of looking at qualified plans as specific rules and penalties apply when you withdraw from tax-deferred retirement accounts. Withdrawing before age 59½ brings a 10% penalty. At 70½, there are required minimum distributions (RMDs). “With RMDs, there is a 50% penalty for not withdrawing the right amount of money.” he says. “Plus, depending on the account, you have to pay taxes according to your bracket.”
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Another strategy Smallwood emphasizes is compound taxes. He says that in regards to tax strategy, this is the most important parts of a wealth plan. “For example, a 45-year-old with a savings rate of 6% and putting away $51,000 per year could accumulate a healthy balance of $2.5 million by age 65,” Smallwood says. “But with compound taxation, money is eroding all the time. Each year that an account grows, the investor’s tax liability grows along with it. Interest earnings, along with dividends and capital gains, get larger over time as the investment gains in value. If the gains the first year include $30,000 worth of interest but at the 30% tax bracket, then you’ll have to pay $9,000 more in taxes.”
Lastly, systematic withdrawals can significantly reduce the tax impact on an investment portfolio if done correctly. “Let’s say, late in 1989, you placed a lump sum of $100,000 in an S&P 500 index fund with a good track record,” Smallwood says. “Instead of leaving the funds in the account, however, you took $6,000 from the account each year and repositioned those assets elsewhere. After 20 years, the fund balance would have reached $243,191, an annual gain of 7.92% that exceeds the return earned by leaving the funds in the account. Why? Because taking those withdrawals undercuts the impact of compounded taxes. Over time, the tax obligation would be $30,451, or $13,622 less than leaving the money in the account.”
All of this can come across as overwhelming, especially if money and taxes aren’t something you are well versed in. However, starting to learn about these tactics before you hit retirement can be beneficial, even if you are far from this age.
Smallwood says, “Good retirement planning includes all the possible tax implications and gives you options. Organizing income sources so that they hit your tax return the right way should be a deliberate strategy every year.”