Taxes in Retirement Q&A

As a former CFO and chartered accountant, Ian Welham, RFC® wants to make sure you don’t pay more taxes than you have to. Here he explains what people don’t realize about taxes in retirement.

Q: What factor do taxes play in retirement?

IAN: Many retirees are not prepared for the tax bill that awaits them in retirement.

Q: Why do you say that?

IAN: I’ve had people tell me, “Most of my retirement savings are in 401(k) and IRA accounts, so I don’t have to worry about taxes.”

Q: What do you tell them?

IAN: I try to explain that when we make contributions to qualified plans such as IRAs and 401k’s, we don’t avoid taxes. We simply postpone them. It’s true we owe no tax on the money going in. But at retirement, the tax holiday ends. We pay tax on every penny that comes out – including the original contribution.

Q: OK, but won’t I be in a lower tax bracket in retirement?

IAN: You could be, but not necessarily. Especially when you consider that up to 85% of your Social Security benefits may be subject to income taxes if household income is above certain thresholds. There can even be double taxation on Social Security income. Plus, there’s one other critical issue.

Q: What’s that?

IAN: Required minimum distributions (RMDs). RMDs force us to withdraw money at age 70 1/2 whether we want to or not. These RMDs can push you into a higher tax bracket.

Q: Can you give an example?

IAN: Sure, here’s a typical case we see almost every week. Jim and Julie are retired and have $106,000 of income from Social Security and pensions. They’re in the 12% tax bracket and their federal tax bill is $6,249.

The couple has over $1.6 million in 401(k) and IRA accounts. Next year they turn 70 1/2 and are required to take Required Minimum Distributions of $60,000, pushing their total income to $166,000. This will force them into the 22% tax bracket and raise their taxes to $21,161.

Their tax bill will more than triple and they stand to lose $14,912 of their RMD to Uncle Sam. A scenario like this is quite common, and people are shocked when we bring it to their attention. With adequate planning, it’s possible to avoid this type of tax surprise.

Q: Do most brokerage firms and financial advisors pay this much attention to taxes?

IAN: From what I’ve seen, this is the critical aspect of retirement planning many retirees and financial planners overlook. We believe it’s a critical component in the retirement planning process. Because one mistake can cost you – and your heirs – substantial money down the road.

Q: Is there anything that can be done to avoid this kind of tax hit?

IAN: There are several strategies available. One is tax diversification.

Q: What is tax diversification?

IAN: Most people are familiar with portfolio diversification, where you make sure not to have too much of your savings in one single stock or sector or asset class. In other words, don’t put all your eggs in one basket. Tax diversification is the same thing.

Q: How do you diversify your taxes?

IAN: There are 3 possible tax buckets – taxable, tax-deferred, and tax advantaged. If all your retirement income is coming from one bucket, you may have limited options and face a big tax bill like Jim and Julie. Instead, it may make sense to have some of your retirement income be tax free, for example. That’s an area we explore with clients.