Taxes may be the only certain thing in life besides death, but the tax environment is a very uncertain place. Every time the government decides to increase spending, we can expect our tax situation to change. Electing a new president, governor, or mayor can result in a rise in taxes. Worse, just as a simple consequence of inflation our tax rates are constantly shifting. This is a dangerous truth for retirees who want to safeguard their postretirement income.
If you have a Roth IRA or Roth 401(k) then you are able to take tax-free income as long as you’re making qualified distributions. But if you don’t have Roth plans, then the distributions you take from your retirement savings have to be added to your other income, including Social Security, on your annual tax filings. Together, these will determine what—if any—income taxes you have to pay each year.
In order to prepare to meet your annual tax obligations, you’re probably going to need to take an added amount from your savings—unless you plan to maintain your regular income distributions and cut spending in order to pay the taxes. If you take extra money out to cover taxes, not only does that money disappear forever, it also no longer has the opportunity to accumulate gains in your account. And each time the tax rates rise and you’re forced to take an even higher distribution, you lose more potential for future growth.
One way to help reduce your tax liability is to take advantage of various tax deductions and credits. Sometimes, changes to tax deductions and credits create an advantageous situation for seniors, allowing them higher deductions than they had the previous year. But again, this is not guaranteed. And just as one year might bring higher tax deduction and credit opportunities, the next might bring less as credit and deduction limits change or end. Keeping on top of tax code changes—or hiring an advisor who does—is really the key here.
Sadly, the unstable tax environment doesn’t just affect a senior’s annual income tax. It can also crush their budget when property taxes, sales taxes, and capital gains taxes go up—as they so often do. With an advisor’s help, you can create an income plan that considers the potential effect of taxes and helps preserve your savings from them while also ensuring you take advantage of all exemptions and deductions you’re currently qualified for.
In the next volume of the THREATS TO POSTRETIREMENT INCOME series, we’re going to talk about how both inflation and legacy planning have unexpected, often damaging coordinating roles in the possible destruction of a senior’s postretirement income plans.