Taxes & Your Retirement Plan

Retirement taxes

You know, retirement is one of the biggest reasons Jen and I get up and go into the office each day. Helping folks prepare for this new and exciting phase of their lives with success is the most rewarding job we’ve ever had. Retirement is the result of years of hard work, planning, saving and sacrificing so that one day you can blow out the candles on your retirement cake and enjoy the fruits of your labor. When you retire, you get to leave behind a lot of unpleasant things —the daily grind, commuting, maybe a few co-workers who got on your nerves. But more and more often these days, we see folks realizing a rather nasty fact – they can’t leave behind the tax bill. In fact, for many retirees, income taxes could be their single largest expense in retirement.

I often find that when we meet new folks in our office, they are pleased with themselves for the balances they have accumulated in their retirement plans. In fact, I recently met with a couple from Sandwich, let’s call them John and Mary. They are in their mid-fifties who are looking to retire in about 8-10 years.  They had read a recent column on building retirement systems and came in to get a second opinion. 

For decades John and Mary have socked away money in their company retirement plans, even while raising two kids.  John works for a technology company and has a hefty 401k, while his wife, Mary, has a 403(b) plan from her job as a school teacher. Together they have amassed almost $1.4 million in their retirement plans, along with $50,000 in CDs, their fully-paid off home, and a small brokerage account with mutual funds. They were excited to start planning their days in retirement within the next few years and wanted to make sure they hadn’t missed anything.

Now, John and Mary are practical folks, so they didn’t expect they would get to have all of their tax-deferred retirement funds without paying any taxes on the money. They understand any distributions would be taxed as ordinary income. 

But they were quite surprised to learn they might have to pay tax on part of the Social Security income they receive, too. And it didn’t stop there. In fact, the three of us spent the better part of the meeting reviewing all of the tax considerations that retirement poses so that we could anticipate – and then potentially minimize – their tax bill in retirement. So, this week with our time together, I’d like to highlight a few of the more common taxes that can sneak up on even the best retirement plan, and some strategies to potentially mitigate them.

While distributions from a traditional IRA or other qualified retirement plans are taxed as ordinary income in the year received, other questions arise such as if there is pension income. If so, well, that income might be taxed, too, as ordinary income. You see, some states do not tax pension payments while others do—and that just might influence you to consider moving when you retire. States can’t tax pension money you earned within their borders if you’ve moved your legal residence to another state. For instance, if you worked in Minnesota, but now live in Florida, which has no state income tax, you don’t owe any Minnesota income tax on the pension you receive from your former employer.

Then there is Social Security. Many folks who receive Social Security benefits will pay income tax on a portion of their benefits because their combined income from Social Security and other sources pushes them above the very low thresholds for taxes to kick in. The IRS calculates your “adjusted gross income” from Social Security and all other sources to determine if you’ll be taxed. Get this, in 2021 up to 85% of Social Security benefits are taxable for an individual with a combined gross income of at least $34,000, or a couple filing jointly with a combined gross income of at least $44,000.

With all these potential taxes due, it can be challenging to know just how much you need to save before you’ll be able to retire – and stay retired. A tax surprise in retirement could have a big impact on how long your money will last. To address this, you need to educate yourself on these potential tax pitfalls and take steps well in advance to head them off. Here are a few strategies to consider.

First, consider the Roth account. Contributions are made with after-tax dollars, so withdrawals of contributions and earnings from a Roth IRA are not taxed provided the withdrawal meets IRS requirements, which include holding the account for at least five years and taking withdrawals after age 59-1/2. Many pre-retirees convert some or all of their taxable retirement plan funds to a Roth IRA, paying the taxes due now (at today’s relatively low rates), so that withdrawals in retirement can be tax free. And with the likelihood of higher tax rates coming in the near future, this strategy can make a lot of sense. When you’re ready to take withdrawals in retirement, higher tax rates won’t bother you because these funds will be tax free.

Life insurance is another common way to receive income in retirement on a tax-advantaged basis. In addition to providing a potentially tax-free benefit to your beneficiaries, life insurance can offer numerous tax benefits now and in retirement, including the potential for tax free income through the use of policy loans against the policy. Any loans outstanding at your death are simply deducted from the remaining death benefit. 

There are many other options too, which might include making tax-free gifts or utilizing appropriate annuities. And of course, after reviewing the behavior of their current investment strategy, we decided that it was time for John and Mary to transition from an inappropriate accumulation strategy to a more appropriate distribution strategy that incorporates downside risk mitigation to potentially help avoid those catastrophic losses in times of market stress.  Should you?

The bottom line is this, educate yourself now so you can employ the right strategy and fully enjoy the fruits of your labor in retirement.

And as always – be vigilant and stay alert, because you deserve more!

Have a great week folks.

Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, an SEC Registered Investment Advisor with offices in Falmouth, Duxbury, Mansfield. Jeff can be reached at 

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