Why you need to think about your retirement taxes now


It may seem extreme to plan today for the taxes you'll pay 20, 30 or even 40 years from now, but financial planners say smart workers do just that. "Taxes are likely to be one of, if not the largest expense in retirement," says Jeff Fosselman, a senior wealth advisor at Relative Value Partners in Northbrook, Illinois.

[See: How to Reduce Your Tax Bill by Saving for Retirement.]

After decades of deferring tax on your retirement savings, the tax bill becomes due in retirement. You need to plan ahead if you want to minimize the taxes you will pay during your retirement years.

Income tax is due on retirement account withdrawals. Paul Markowich, a certified financial planner and executive vice president at Firstrust Financial Resources in Philadelphia, says too many seniors face a "tax torpedo" in their later years. They may have saved all their money in traditional IRA or 401(k) accounts, which have taxable withdrawals that will cut into your spending power.

"All too often, people have this thought in their mind that they'll be in a lower tax bracket," says Charlie Harriman, a financial planner with Cloud Financial in Huntsville, Alabama. However, that may not be the case for people who save a significant amount. Plus, Harriman notes the tax code could be completely different decades from now, and it is possible tax rates will rise.

Traditional 401(k)s and IRAs require participants to begin taking a taxable required minimum distribution, known as an RMD, each year after they reach age 70 ½. "The RMD is something people gloss over," Markowich says. However, for someone with a significant nest egg, that RMD – and its associated taxes – can be quite large.

[Read: How to Pay Less Taxes on Retirement Account Withdrawals.]

Tax diversification is often overlooked. Workers often spend a great deal of time diversifying their investments, but it's equally important to diversify the taxation that comes with a person's savings. "If pre-tax money is all your savings, then you're going to be floored at how much you'll pay in taxes [in retirement]," Markowich says.

Pre-tax money includes funds put into traditional 401(k)s and IRAs. Those contributions are tax-deductible while you are working, but are subject to regular income tax when withdrawn in retirement. When finance experts talk about tax diversification, they recommend workers also have money available that will not be subject to income tax in retirement, such as investments in Roth accounts or cash value life insurance.

Fosselman says workers may also want to consider how to maintain some tax deductions going into retirement. "I work with a lot of people now who keep their mortgages," he says. "They think their investments will earn more than what they pay in interest, and they like the income tax deduction [for mortgage interest]."

[Read: Tax Breaks for People Over 50.]

Options make Roth accounts accessible. Roth accounts are a relatively new retirement savings option, and older workers may already have a significant amount of money stored in traditional 401(k)s and IRAs. Others may make too much money to contribute to a Roth IRA, which the IRS limits to those with a modified adjusted gross income of less than $132,000 ($194,000 for couples) in 2016.

In both cases, workers may assume they are destined to pay taxes in retirement, but there are ways around them. Those with a traditional IRA can convert it to a Roth account at any time. Doing so requires a person to pay taxes on the converted amount, but Harriman says that may be preferable to waiting until retirement when tax brackets could be vastly different.

Converting to a Roth IRA is also a way for high earners to get the benefits of tax-free withdrawals in retirement. These workers may be able to contribute to a traditional IRA and then convert it to a Roth account, a process known as a backdoor Roth IRA. "It's a silly nuance in the law," Fosselman says. "I can contribute to a traditional IRA on day one and convert to a Roth on day two."

Even if workers decide not to convert to Roth accounts, they may find it's in their best interest to calculate and plan for the amount of taxes they will have to pay in retirement – even if it will be decades before they are sitting on the beach, drink in hand.

Copyright 2016 U.S. News & World Report

RELATED: 10 things we've all said while filing our taxes
10 PHOTOS
10 things we've all said while filing our taxes
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10 things we've all said while filing our taxes

"It's only January, I have plenty of time!"
You're relaxed, you're casual, what even are taxes anyway? You don't care! It's so far away that filing taxes isn't even remotely on your radar, to be honest.

Photo credit: Getty

"The imminent act of filing is upon me and I literally have nothing ready..."
Tax season is now approaching and that creeping anxiety about getting everything done on time is starting to set in. It's essentially biting at your heels and you know you have to get moving.

Photo credit: Getty

No words. Just emotional paralysis.
You're screwed. You need to start doing your paperwork but you physically do not know where to even begin. It's time. It's happening.

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"I HAVE A MILLION THINGS I NEED TO DO, WHY ARE THERE SO MANY PAPERS AND QUESTIONS, SOMEBODY HELP ME!"
That anxiety you felt creeping in earlier? Now it's full-fledged onset. This stage is often accompanied by screaming out loud, pulling hair, crying, etc.

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"Wait, did I get all of my papers in? Did I check that one box correctly? Does it look like I'm trying to evade some of these taxes? What if I go to jail? Can I go to jail for that? WHO WILL FEED MY DOG WHEN I AM IN JAIL?!"

It's like handing in an exam in school and wishing you could grab it back and double check your answers one more time.

Who was that celebrity you heard about that went to jail for tax evasion? Because now you're convinced that's totally going to be you.

Spoiler alert: as long as you did everything to the best of your knowledge and ability, you probably won't go to jail. And even if you do, you'll find someone to walk your dog.

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"I got this, I'm almost done, a few more papers and I'm in the clear. I just have to pound through the rest of it. Go me!"

"Go you" is right! Now you're on cruise control and you're on track to get everything done well and on time. You're unstoppable in the delight of the world that is tax filing.

Photo credit: Getty

"Thank god that's over with, now I can relax! What to do with all this stress-free free time!"
Finally, relief. Your papers are filed and sent out into the universe. It's off your back at last. Now on to more important things, like Netflix.

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"When is my return coming? Is this going to be my life for the rest of my life? Yep, it is. So about that return..."
Now, you wait. You want that money. And the inevitable truth that your life will now be a neverending cycle of filing taxes and waiting for your return.

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"SCORE my return was so much better than I expected! I'm buying a new dress. Or five. Probably five, why not?"
You're on a total life-high now. The possibilities of what you can spend your return on seem endless and even if you don't, having a nice bonus hunk of cash in your pocket feels pretty good. It made all of that stress completely worth it.

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"Honestly filing wasn't even that bad this year. And now I don't have to think about it anymore. Well at least not for another year. But no use in worrying about that now!"
Alas, acceptance. You know you'll fall victim to the vicious cycle again when next year rolls around. But truthfully, you wouldn't have it any other way. Okay, you obviously would. But you'll never change your procrastinating ways!

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