You’ve spent decades saving for retirement. You contributed to your 401(k), built your IRA, invested for the future, and worked toward the day when you could finally enjoy the money you accumulated.
But there’s one important piece of retirement planning that’s easy to underestimate:
Taxes.
The balance shown on your retirement accounts isn’t necessarily the amount you’ll have available to spend. Depending on where your retirement income comes from, withdrawals may be subject to federal and state income taxes—and those withdrawals can potentially affect the taxation of Social Security benefits and even what you pay for Medicare.
That’s why effective retirement income planning isn’t simply about determining how much money you have. It’s also about understanding which accounts to draw from, when to take withdrawals, and how those decisions may affect your overall tax picture.
The Hidden Tax Bill Inside Your 401(k) and IRA
Traditional 401(k)s and IRAs can provide valuable tax advantages while you’re working. Contributions may be made on a pre-tax basis, allowing more of your money to remain invested for retirement.
But those taxes generally aren’t eliminated.
They’re deferred.
When you begin taking distributions from tax-deferred retirement accounts, those withdrawals are generally treated as ordinary taxable income.
For someone entering retirement with a significant portion of their savings in a traditional 401(k) or IRA, this can create a challenge. The account balance may look substantial, but a portion of that money may ultimately be owed in taxes as it is withdrawn.
This makes tax planning in retirement an important part of determining how much income your savings can actually provide.
Social Security Benefits May Be Taxable Too
Many retirees are surprised to discover that Social Security benefits can be subject to federal income tax.
Whether your Social Security is taxable depends on your overall income situation under federal tax rules.
That means withdrawals from traditional retirement accounts, pension income, investment income and other sources can potentially affect how much of your Social Security benefits are included in taxable income.
This creates an important retirement-planning question:
Where should your next dollar of retirement income come from?
Taking additional money from a traditional IRA may have a different tax impact than using cash savings, selling investments in a taxable account or taking a qualified withdrawal from a Roth account.
The answer will be different for every retiree.
Required Minimum Distributions Can Change the Picture
Another potential retirement tax trap appears later in retirement through Required Minimum Distributions, commonly known as RMDs.
Under current federal rules, many retirees eventually must begin taking annual distributions from certain tax-deferred retirement accounts.
The problem is that you may not necessarily need that money for living expenses.
But once RMDs begin, those distributions can increase taxable income whether you need the additional income or not.
For retirees with substantial tax-deferred savings, future RMDs can potentially push taxable income higher than expected.
This is one reason retirement tax planning before RMDs begin can be valuable.
The Medicare IRMAA Surprise
Taxes aren’t the only consideration.
Higher retirement income can also potentially increase what you pay for Medicare.
Certain higher-income Medicare beneficiaries pay an Income-Related Monthly Adjustment Amount (IRMAA) in addition to their standard Medicare premiums.
Large IRA withdrawals, investment gains, Roth conversions or other taxable-income events may affect the income used to determine future Medicare premiums.
That doesn’t automatically mean those financial moves should be avoided. A strategy that increases taxes or Medicare costs today could still make sense if it improves a retiree’s long-term financial position.
The important point is understanding the potential consequences before making the decision.
Why Tax Diversification Matters in Retirement
Investment diversification gets plenty of attention, but tax diversification can also play an important role in retirement planning.
Retirement assets generally may be held across several different types of accounts, including:
- Tax-deferred accounts, such as traditional 401(k)s and IRAs
- Taxable accounts, such as brokerage accounts
- Tax-free accounts, such as Roth IRAs, when applicable requirements are satisfied
- Cash and other savings
Having money available from different tax categories may give retirees greater flexibility when deciding how to generate income each year.
Instead of automatically withdrawing from the same account every month, a coordinated retirement withdrawal strategy can consider taxes alongside spending needs, investments, Social Security and other income sources.
Could Roth Conversions Help?
For some retirees, the years between leaving the workforce and beginning RMDs may present a potential tax-planning opportunity.
One strategy sometimes considered is a Roth conversion.
A Roth conversion involves moving money from a traditional retirement account into a Roth IRA and generally paying income taxes on the converted amount in the year of conversion.
Why voluntarily pay taxes today?
In certain situations, paying taxes at today’s rate could potentially reduce the amount held in tax-deferred accounts later, reduce future RMDs and create a source of potentially tax-free qualified retirement income.
However, Roth conversions aren’t appropriate for everyone.
A conversion can increase taxable income and may affect other areas of your financial plan, including Medicare premiums. The timing and amount of a conversion should therefore be considered carefully as part of a broader retirement tax strategy.
The Order of Your Withdrawals Matters
One of the biggest mistakes retirees can make is viewing every retirement account as interchangeable.
They’re not.
Taking $50,000 from a traditional IRA can have very different tax consequences than taking $50,000 from another source.
That’s why a thoughtful retirement income withdrawal strategy considers more than simply which account has the largest balance.
It may include questions such as:
When should you claim Social Security? When should you begin pension income? Which accounts should you spend first? Should you realize capital gains this year or later? Could a Roth conversion make sense? How might an IRA withdrawal affect Medicare costs? And how much taxable income should you intentionally recognize each year?
These decisions can interact with one another.
Retirement Planning Is Also Tax Planning
A successful retirement strategy isn’t just about accumulating the largest possible nest egg.
It’s about turning those assets into sustainable retirement income.
And taxes can play an important role in determining how much of that income you actually get to keep.
Planning ahead may provide more flexibility than waiting until Required Minimum Distributions, Social Security, Medicare and other retirement-income decisions are already underway.
At Mac Wealth, we believe retirement planning should look at the complete picture—your investments, income needs, Social Security, pensions, retirement accounts, taxes and long-term financial goals.
Because the goal isn’t simply to accumulate wealth.
It’s to create a retirement income strategy designed to help you use your wealth effectively throughout retirement.
This material is for informational and educational purposes only and is not intended as individualized tax, legal or investment advice. Tax laws and regulations are subject to change. Consult with a qualified tax professional regarding your individual circumstances.