You work, you pay taxes. By the time retirement finally rolls around you probably think you would be due for a tax break. Small chance. Taxpayers between the ages of 55 and 65 paid 18% of all income taxes back in 1997. Today, their share is 27%. Even those over 65, who are likely retired and making less income, pay nearly one-fifth of all income taxes, according to the non-profit Tax Foundation. Let’s map out where the tax traps may lurk in your life after work.
Turning a negative into a positive
One thing you probably never had to worry about during your working years is negative taxable income. Sounds like a good thing, right? Like maybe the IRS owes you money. Actually, if you paid estimated taxes for the year, you really could receive a tax refund. But better yet, taking an IRA distribution in a year when your tax liability is low – or zero – can be a good thing. Especially if you are taking Required Minimum Distributions (RMDs)
“When our clients retire, we make sure their taxable income is not negative because their income is lower but deductions and exemptions could result in negative taxable income,” says Robert Riedl, a wealth manager in Milwaukee, Wisconsin. “We would recommend doing a retirement distribution in order to generate positive taxable income and utilize a portion of their lower income tax bracket while increasing their personal investments.”
Opt for tax free
A fee-only financial planner, Johanna Fox Turner of Mayfield, Kentucky, is also seeing the underwater taxable income trend – and offers another solution.
“I see too many tax returns showing negative taxable income and IRA RMDs,” Turner says. “Take advantage of Roth conversions whenever possible. Timing is everything and if you are not coordinating your investment advisor’s advice with that of your CPA, you could be throwing tax dollars away. Our rule of thumb is that a client needs to fill up the 15% tax bracket ‘bucket’ with conversions every year.”
Getting taxed twice
One of the biggest tax traps springs from your 401(k). Nearly one third (29%) of Americans have taken out a loan on their employer-sponsored retirement plan, according to TIAA-CREF. Few realize the potential tax consequences.
“When you take the ‘loan’ you withdraw your tax deferred money, says financial and tax planner Curt Sheldon of Alexandria, Virginia. “In other words, you haven’t paid taxes on the money inside your 401(k). When you pay back the loan you pay back with after-tax money. So you pay taxes on the money you put in and you pay taxes on that same money when you take it out. You get taxed twice on the same money. That is a great way to sabotage your retirement.”
Ironically, nearly half (46%) of those who took out a loan from their 401(k) were doing so to pay off debt, says the TIAA-CREF report. More than four-in-ten (44%) regretted the decision.
Eggs and baskets
“Put all of your eggs in one basket – and then watch that basket.” This noted contrarian quote is attributed to both Andrew Carnegie, famously rich — and Mark Twain, famously poor. Regardless of which egg quote came first, Martin Federici, an investment advisor based in Dallas, Pennsylvania, is buying more than one basket.
“Putting all of your money into one type of investment/investment vehicle [is a retirement tax trap],” he says. “We can never be sure of when or how much the tax landscape can change, so diversifying investments among different types of accounts and considering the taxable ramifications of those investments — asset allocation and asset location — is usually wisest.”
Knowing where the tax traps are hidden allows you to side-step those unexpected pitfalls in your retirement income plan.
Graham Ober manages content and community for NerdWallet’s financial advisor platform- Ask an Advisor. Formerly an investment banker, Graham is passionate about helping people make smarter decisions with their money. He writes about money-savings tips, personal finance and investing. Follow Graham on Twitter @EGOber
