The debate over the future of income tax rates will only get more intense as the election approaches. You may already be tired of listening to the arguments and wish they would just make a decision and be done with it. However, if you’ve been participating in a tax-deferred account and are approaching retirement, this is a very important issue.
The biggest mistake in retirement planning is not saving enough. The second biggest mistake is not saving tax efficiently. New retirees are often very surprised to find out how much income taxes affect their cash flow. They have been led to believe they should defer their income because they will be in a lower tax bracket when they retire. They have indeed benefited at tax time by deferring their income. Unfortunately it is time to pay the piper, or in this case Uncle Sam. These days Uncle Sam is very hungry.
Many people enter retirement with all of their savings tied up in a tax deferred account like their 401(k) or 403(b). A retiree in a 25% tax bracket will need to withdraw $1.30 from their account for every $1.00 they want to spend in order to cover the tax. Those drawing Social Security benefits may have an even bigger tax bite if the withdrawal makes even more of their benefits subject to tax.
Tax implications are very important to consider when planning your retirement income. A simple way to calculate the amount of money to save for retirement is to take the annual income needed from savings and divide it by 4%. This strategy comes from the 4% prudent withdrawal rule that says a diversified portfolio has a high probability of maintaining principle if withdrawals are no higher than 4% annually. If you need $50,000 per year from your investment portfolio, you would need to accumulate $1,250,000 before your retire. Saving this amount all in a 401(k) would mean you only have $38,000 to spend after taxes. You would have the entire $50,000 to spend if you saved it all in a Roth IRA. Where you save your nest egg is as important as how much you save.
The battle over the future of income taxes makes planning even more difficult. Tax rates go up for everyone in 2013 if the current tax laws are allowed to expire. The President said he only wants to increase tax rates for taxpayers earning more than $200,000. Taxpayers with incomes under this amount should still pay attention to the debate. There are several tax provisions that need to be dealt with because they already expired. The biggest issue is the fate of the alternative minimum tax (AMT). The break on AMT expired at the end of 2011. Twenty million new taxpayers will be affected by the AMT this year if the law does not get extended. The AMT could affect taxpayers with incomes as low as $50,000 – $75,000 depending on their deductions. Other important provisions such as deducting sales tax in lieu of income tax, tax-free transfers from an IRA to charity for those over 70 ½ and write-offs for college tuition and related expenses all expired last year and could be extended. These are important issues we all need watch.
The best way to prepare for this uncertainty is to diversify your savings so that you can withdraw your savings in retirement in the most tax efficient way. This is the New Three-Legged Stool™ strategy for retirement planning. The strategy attempts to take advantage of all three types of savings, tax-deferred, tax-free and after-tax. Tax-deferred savings like 401(k) and IRA accounts give you immediate tax benefits. Tax-free accounts like Roth IRAs are the best place to withdraw from in retirement. After-tax accounts allow you to hold investments that have preferential tax treatment like long-term capital gains and tax-free municipal bonds. Having money in all three places affords the opportunity to determine how much tax you ultimately pay. Simply draw some money from all three places to keep your taxes low.
Tax reform will probably be addressed in 2013 no matter who wins the election. What form it takes and whether meaningful reform becomes law is anyone’s guess. Don’t allow yourself to be at the mercy of the tax code when you retire. Act now to diversify your savings so you have flexibility in 2013.
- The second biggest mistake in retirement planning is not saving money tax efficiently.
- The AMT tax break already expired in 2011 and could affect your tax return this year.
- Planning for uncertainty requires diversification. This applies to where you hold your investments as much as it applies to the investments themselves.