5 Ways Taxes Could Ruin Your Retirement Savings — and What To Do

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Many things can be considered the enemy of retirement savings; but among these, taxes have to be near the top of the list. After you have worked hard to save and grow a retirement nest egg, it can feel like you’re simply handing over your hard-earned money to the government when you withdraw from your account.

Now, the truth is that any money taxable to you in retirement comes either from money that was never taxed when you contributed it to your account or from interest and capital gains. Nevertheless, it doesn’t ease the sting much when you see what’s really left in your account after the IRS takes its cut.

Here are some of the ways that retirement taxes can ruin your savings, along with suggestions as to what you can to help minimize them.

Withdrawals Taxed as Ordinary Income, Not Capital Gains

When you take money out of a pre-tax retirement plan, such as a traditional IRA or most 401(k) plans, whatever you take out is taxable income. But that’s not even the worst part.

Even if all of the profits you generate within that account are long-term capital gains, you’ll still have to pay taxes at your ordinary income tax rate. With investments you hold outside a retirement account, you’ll benefit from lower long-term capital gains tax rates on investments you hold for longer than one year; in fact, depending on your income, you may not owe any capital gains taxes at all on your long-term profits.

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Regardless of your income or holding period, all of your distributions from pre-tax retirement accounts get hit with regular income tax.

Distributions Can Push You Into a Higher Tax Bracket

Any taxable distributions you take from your retirement plans not only adds to your tax bill, but it can actually push your rate higher. Since your withdrawals get included as ordinary income, they could push your income over the limit and into the next tax bracket, further increasing the amount you’ll owe on your distributions.

Additional Income Can Make Your Social Security Taxable

If you earn less than $25,000 as a single filer, you won’t have to pay any taxes on your Social Security payouts. However, if you withdraw enough money from your retirement savings to push your income above that level, you may owe taxes on up to 50% of your Social Security benefits. If you earn more than $34,000, you’ll face taxes on up to 85% of your Social Security.

For joint filers, that income threshold starts with a tax of up to 50% at $32,000 and goes up to 85% on incomes above $44,000.

RMDs Force You To Sell Investments

For most retirement accounts, the government forces you to take required minimum distributions above a certain age. For decades, that age was 70.5, but recent Congressional action has pushed it to 73.

Nevertheless, when you take your annual required minimum distributions, not only will you face an additional tax bill, you’ll also be forced to liquidate part of your account — even if you don’t want to or if it’s bad timing to be a seller.

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Even Your Pension Is Taxable

Generally, employers that offer pensions are responsible for making contributions and investments on behalf of employees. Yet, even though you don’t get your own tax break for the money that goes into a pension on your behalf, you’re still responsible for income taxes on the money you receive from it.

Steps You Can Take To Counteract Taxes

All of these examples are meant to highlight the big role that taxes have in diminishing the value of your retirement assets. But, rather than letting it get you down, take this opportunity to face the very real effect that taxes could potentially have on your retirement savings and factor that information into your financial planning calculations.

You’ll be much better off if you face your retirement with your eyes wide open rather than hoping that whatever you save will get you by. Take proactive steps to counteract the effect that taxes can have on your retirement, and you’ll be better off in the long run. Some suggestions include:

  • Use Roth accounts wherever possible; while you won’t get a tax deduction on your contributions, you’ll be able to take tax-free distributions.
  • Take as little out of your retirement accounts as you can to help minimize your tax bill.
  • Factor in your other income when you’re deciding how much money to withdraw from your retirement accounts.
  • Ask your employer to contribute to a Roth account on your behalf, rather than a traditional pre-tax pension or 401(k) account.
  • Maximize the taxable income in your retirement accounts and minimize the tax consequences of any regular investment account you may have. For example, since you’ll be paying ordinary income tax on any withdrawals anyway, put high-income investments in your retirement accounts and save your long-term capital gain investments for your regular investment accounts.
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