With the likelihood of higher taxes in the future, it’s important to do as much planning as you can today to minimize your taxes during retirement. While nobody knows what the future holds, taxes generally go up over time, meaning even in retirement you could be faced with significant tax bills.
Fortunately, there are steps you can take today to help minimize your taxes in the future. Here are four ways you can help lower your taxes in retirement.
1. Know the Difference Between Each Retirement Account
401(k)s are tax-deferred. You contribute pre-tax income, and your employer may match your contributions up to a certain percent. When the time comes to start withdrawals, the money will be taxed as ordinary income. You can invest up to $19,500 in a 401(k) for 2020, plus an additional $6,500 catch-up contribution if you’re over 50 by the end of the tax year.
Roth 401(k)s are tax-free. Unlike a traditional 401(k), you fund a Roth 401(k) with after-tax dollars. This means your withdrawals are tax-free and penalty-free, as long as you’ve had the account for five years and are at least 59½. As an added benefit, there are no income limits on Roth 401(k)s. It makes this type of retirement account an attractive option for high-earners.
IRAs, or individual retirement accounts, are tax-deferred. Your withdrawals in retirement will be taxed as ordinary income. You can contribute up to $6,000 in 2020, plus a catch-up contribution of $1,000 if you are 50 and older.
Roth IRAs are tax-free. Because you contribute after-tax income now, you get tax-free withdrawals in retirement.
2. Know What Type of Investments Should Go Into Different Accounts
Investments That Should Go In Taxable Accounts: Index funds, ETFs, buy-and-hold stocks and tax-exempt municipal bonds should be held in taxable accounts.
Investments That Should Go In Tax-Free Accounts: Fixed income, REITS, commodities, liquid alternatives and other actively managed investments should be held in tax-deferred or tax-free accounts so you can grow the account without paying taxes along the way.
3. Prepare Now For Required Minimum Distributions
Under the CARES Act, all RMDs have been suspended for 2020. But you should plan for them to be reinstated at any time. If you have a 401(k) or a traditional IRA, you’ll have to start taking required minimum distributions (RMDs) every year.
If you turned 70½ in 2019 or earlier, you may have already started to take your first RMD by April 1 of the year after you reached 70½. For the rest of us, if you turn 70½ in 2020 or later, you can now wait to take your first RMD by April 1 of the year after you reach 72. To make sure you comply with the complex rules, our advice is to consult with your financial professional.
4. Consider a Roth Conversion
If you have a year with a particularly low-income level compared to normal, consider doing a Roth conversion. The conversion is a taxable event, so you’ll face a higher tax bill the year you convert, or you can slowly convert your accounts over a few years to help break up the tax implications. Critically, by converting to a Roth, any future withdrawals will be tax-free. Additionally, Roth IRA’s have no RMDs, so you aren’t forced to withdraw money every year.
All of these tips involve your retirement account, so consult with a financial or tax professional to make sure any of these changes are best for your individual situation.