When it comes to planning for retirement, the impact of taxes is an area that is sometimes neglected. Taxes have the potential to eat away a considerable portion of your retirement savings if proper planning is not done.
For instance, if you invest $1 million in a typical IRA or a 401(k) plan, the portfolio may only be worth $800,000 or less once taxes are taken into account. In a similar vein, if your investments are kept in a conventional brokerage account that is subject to taxation, the income that those investments generate may also be subject to taxation.
One solution to this issue is to increase the amount of money you put away in savings and investments during your working life. This will allow you to have more money available to pay your taxes at the end of the year. One further thing you can do to minimize the amount of money you have to pay in taxes is to make investment and account decisions that are tax-efficient. There are a few different sorts of income received during retirement that are exempt from taxation.
Withdrawals from a Roth IRA
Using a Roth account is the most straightforward approach of evading paying taxes on the money you’ve saved for retirement. The Individual Retirement Account (IRA) and the 401(k) plan are both capable of being established as Roth accounts, which do not provide a tax benefit for contributions but do provide tax-free withdrawals after the age of 59 12 years old.
If you have a Roth account, you will essentially be paying your taxes in advance at the time that you make a contribution rather than owing them when you take money out of the account. Despite the fact that if your income is beyond specified thresholds, such as $144,000 for single filers or $214,000 for joint filers, you won’t be able to make contributions to a Roth IRA, you are free to convert your standard plan to a Roth IRA at any time. On the other hand, you will be required to pay income taxes on the amount of the conversion, just as you would be required to do if you withdrew the money.
Because of this, it is often more prudent to open a Roth IRA earlier on in your career rather than risk being hit with a significant tax bill while you are at the height of your earning potential.
It is not a prudent strategy to base one’s retirement savings on an inheritance as a general rule. To begin, there is never any guarantee that a person will get an inheritance, and secondly, the amount that is bequeathed is almost never sufficient to finance a lengthy retirement.
On the other hand, the majority of Americans will, at some time in their lives, be the beneficiary of an inheritance, which can frequently serve as a valuable addition to existing retirement funds. The fact that an inheritance is exempt from taxation is without a doubt the most favorable monetary aspect of receiving one. Even in the extremely unlikely event that there is an estate tax to be paid, the beneficiaries are not liable for footing the bill for it.
Municipal Bond Income
Municipal bonds are debt obligations that can be issued by governments at the state, city, or other municipal level. Their primary purpose is to raise money for public works projects, such as the construction of schools, roads, and other infrastructure. As a result of the federal government’s provision of tax relief for municipal bonds, investors are exempt from paying taxes on the interest income generated by any municipal bond they hold.
Generally speaking, if you acquire a bond that was issued in your own state, you are eligible for a tax exemption from your state’s taxes as well. Because of this, the value of municipal bonds is significantly increased in states with high tax rates like California. In addition to the fact that they are exempt from taxes, they are generally safe investments, which means that they can also be a valuable source of income during retirement.
Withdrawals from HSA
A health savings account, sometimes known as an HSA, is a type of individual retirement account that incorporates aspects that are advantageous of both standard and Roth IRAs into a single product. Contributions to a health savings account (HSA) qualify for a tax deduction, and any earnings accrued within the account are exempt from taxation.
Withdrawals are not subject to taxation so long as they are utilized to pay for qualified medical expenditures, which is a pretty broad category. In that case, you will be subject to a severe penalty equal to 20% of the amount that you withdraw. However, the clincher in terms of preparing for retirement is the fact that after you reach the age of 65, you are permitted to withdraw money from your HSA for any reason at all and are exempt from having to pay any kind of penalty.
If you use it for something other than healthcare, you’ll still have to pay the regular income tax, but you won’t have to pay the penalty. However, because HSA funds can be withdrawn at any time without incurring taxes, the ideal approach to use an HSA is to pay for qualified medical costs as they arise.
Payments Under the Social Security System*
Although it is true that Social Security payments are typically exempt from taxation, this is not always the case. It’s true that you won’t have to pay taxes on your Social Security retirement benefits if you only use them to cover your basic living expenses. However, if your annual income is above a specific threshold, a portion or perhaps the majority of your payments will be subject to taxation. The following is a breakdown of how taxation on Social Security will work in 2022, according to both income and filing status:
Individuals whose combined income is between $25,000 and $34,000 may be subject to paying taxes on up to 50% of their benefits, while those whose combined income is more than $34,000 may be subject to paying taxes on up to 85% of their Social Security income.
Those who file their taxes jointly and have incomes between $32,000 and $44,000 may have to pay tax on up to 50% of their Social Security income. Those who earn more may have to pay tax on up to 85% of their benefits.
The term “combined income” is defined by the Social Security Administration as the sum of an individual’s adjusted gross income, nontaxable interest, and one-half of their Social Security benefits.
Proceeds from a Life Insurance Policy
In the same way that waiting for an inheritance is not the best method for funding a retirement plan, waiting for a payout from life insurance is also not the best strategy. Having said that, there is a distinct possibility that at some point during your senior years, you will be entitled to a payout of some kind from your life insurance policy.
Because these payouts are typically in the range of hundreds of thousands of dollars, they have the potential to drastically alter the amount of money you have saved for retirement. In addition, similarly like inheritances, the receiver does not have to pay taxes on the proceeds from a life insurance policy if they collect the money all at once rather than in installments.