Retirement ... and Taxes

Online exclusive

Retirement ... and Taxes

Online exclusive

As you look forward to retirement, you probably daydream about the end of Monday morning meetings, interminable conference calls and perhaps even W-2 forms. Indeed, life does change substantially when you retire. But there’s one staple of your working life that you won’t shake: income taxes.

Even though retirement won’t be income-tax free, there are additional resources available to help you manage your tax burden in a way that makes sense for your particular circumstances. Here’s a look at several strategies to help plan for taxes in retirement. 

Mix It Up

If you’re still planning for retirement, consider investing in a Roth IRA or a Roth 401(k). Both of these Roth accounts are funded with post-tax income, meaning they’re taxed up front. The advantage comes later because the distributions you take from these accounts in retirement won’t be taxed again.

Assuming your investment grows during the time it’s invested, you come out ahead. Either way, you’re shielded from unexpected tax hikes down the road.

“As tax rates go up, and different surtaxes are added, tax-free income options like a Roth account become more attractive,” says Warren Arnold, a senior financial consultant for Northern Trust. Few clients had Roth accounts a decade ago, but the popularity and profile of such accounts have risen quickly — a trend he expects to continue. 

Converting a traditional IRA to a Roth IRA might be another option. You’ll need to include the amount as income at tax time, but it should allow for tax-free withdrawals years later. (For 2014, you’re eligible if your adjusted gross income is under $129,000 for single filers and under $191,000 for joint filers.)

Your Retirement Income, Custom-Fitted

One factor that makes Roth accounts attractive is their flexibility, especially when paired with other, more traditional retirement accounts. While you work, you likely don’t have much choice in determining the tax liabilities associated with your annual income. “There’s precious little that an employer can use to compensate you that’s not taxed as ordinary income,” Arnold says.

With a Roth account though, you have options. If you have both Roth and traditional retirement accounts, you may be able to blend income from each, enabling you to land on the correct side of annual income tax thresholds.

For example, let’s say you and your spouse need to withdraw $300,000 from Roth and traditional retirement accounts in 2014. If all $300,000 is subject to income tax (and it is your only income), then the first $226,850 will be taxed at a relatively modest 28% rate, but the remaining $73,150 will be subject to a more aggressive rate of 33%. Yet if you have a Roth account, you’ve already paid taxes on the money you withdraw, so you can pull $73,150 from the Roth account and none of your income should be exposed to the higher tax rate.

The strategy is straightforward, and the key to success is to think ahead. “It means working with your accountant earlier in the year than April 14,” Arnold says. “It does require a fair bit of planning to make sure you’re drawing your income from the right source throughout the year.”

Looking to the Next Generation With Your IRA? Act Now

As the government hunts for additional revenue streams, it might target money-transfer vehicles that are currently being used differently than originally intended, says Suzanne Shier, director of wealth planning and tax strategy at Northern Trust.

“People who are thinking about combination retirement and estate planning should not expect that the current planning opportunities for inherited tax-preferred accounts will continue indefinitely,” Shier says.

One example is inherited IRA accounts with long-term payouts. Right now, certain payouts on inherited IRA balances can be extended over the lifetime of the beneficiary, offering maximum tax flexibility. Shier cautions however, that the government might shrink those payout periods to just a few years.

Set It and Forget It? Not With Taxes

Perhaps you met with your advisor just before you retired and crafted an income and investment strategy to steer you through the next several years. Your best move now is to keep your head down and continue to follow that strategy, right? 

Only if you live in a vacuum in which tax laws never change. The United States is no such place. In fact, U.S. tax laws change so frequently that Shier recommends meeting with a financial professional at least every two or three years to make sure your plan still makes sense in light of current laws. In addition, she suggests meeting with advisors after any significant life event such as marriage, divorce, births and deaths.

If you’re not yet retired, you may want to meet with an advisor each year to re-evaluate automatic deductions pulled from your paycheck to make sure they still support your retirement goals. Shier says any change to the benefits package offered by your employer, or a new benefits manager at your company, may also warrant a review of your retirement plan and the tax effects of your strategy. 

Go Ahead, Move to Florida — But Only if You Love Florida

The Sunshine State has no state income tax, which is one reason why it has long appealed to retirees hoping to hold onto their retirement savings in addition to working on their tans. Arnold cautions not to read too much into the tax advantages of one state versus another. “They all tend to make it up somewhere,” he says, meaning states with low income tax or low retirement income tax are likely to have higher sales tax, real estate tax, vehicle registration or other revenue-generators.

In addition, there could be changes coming. Some states, including Illinois, do not currently tax retirement income. But as they seek additional revenue, future tax treatment is uncertain.

So before you plan a tax-prompted relocation, examine your potential new state’s complete tax picture and outlook.

Taxes are a fact of life both during and after your career. At least in retirement you have additional flexibility to deal with your tax burden in the most efficient way possible. Taxes are never fun, but with diligent planning and a smart strategy, they won’t stand in the way of a fulfilling retirement.


Summer 2013; updated February 2014