Long term tax planning is one of the best things you can do to increase your income in retirement. However, it is often overlooked. If you are thinking about tax planning, consider this a tax saving instead.
Here are some steps you can take now and in retirement to better control how much money you owe for tax time.
To save on taxes now, lower your taxable income
Contributing to a 401 (k) or traditional IRA will reduce your taxable income for the year. The money you deposit in these accounts also increases your deferred tax until you withdraw it when you retire. It’s not too late to start reducing your 2020 tax burden. IRAs are unique in that they have until April 15th this year to contribute and lower your 2020 taxable income.
In addition to the tax benefits that you now receive, maximizing your contributions is an important part of increasing your retirement benefit. You can store up to $ 19,500 in your 401 (k) in 2020 and up to $ 6,000 in your IRA (and these limits are the same for 2021).
If you are 50 years of age or older, you benefit from catch-up contributions. You can save an additional $ 6,500 in your 401 (k) and an additional $ 1,000 in an IRA. By the time you are 50 years old, you should take a close look at your retirement accounts to see if you are on track to meet your savings goals.
To save taxes in the future, diversify your tax liability
When considering your retirement plan, it is important to consider the types of accounts that you are saving and investing in. Deferred tax accounts like your 401 (k) and the traditional IRA now offer tax breaks. You contribute pre-tax money, but you owe the IRS something when you withdraw cash in retirement.
Tax-exempt accounts such as a Roth IRA or Roth 401 (k) will offer tax advantages in the future. Your money will be taxed before depositing into the account. However, you can withdraw it tax-free in retirement. Thanks to our current historically low tax environment, we are focused on converting our clients’ traditional IRAs into Roth IRAs. When you switch to a Roth, you pay taxes, which is why some people like to do a partial switch. This means they are only moving as much money as they can pay taxes this year and moving more money next year.
Taxable accounts include your brokerage and savings accounts. You will be taxed on the interest you earn, as well as dividends or profits. Investment accounts are an important part of your overall financial plan, especially during your working years as you grow and accumulate your savings for retirement.
How much you deposit into your retirement account during your years of work, and what types of accounts you deposit into, will affect how much you will pay in taxes now and in retirement. By diversifying your savings and investment accounts, you can better control your tax situation in retirement. You have more flexibility in how much to withdraw from which account.
Donate to charity
The Law on Tax Cuts and Jobs has nearly doubled the standard allowance. As a result, fewer people list their taxes. With proper tax planning, there are new ways to donate to charity and still receive a reward. One strategy to consider is to support donor advised funds. Your contributions will be invested and grow tax-free until you decide to donate to a qualified charity. Depending on your situation, a contribution to a donor-recommended fund can help exceed the standard deduction so you can list your deductions at tax time.
You can also consider the bundling strategy. Instead of donating to charity every year, you can save your donations and donate twice as much every two years. For example, let’s say you donate $ 10,000 to charity every year. If you started bundling this year, you will wait to make this donation and take the standard deduction for your taxes. Next year, donate $ 20,000 ($ 10,000 for 2021 and $ 10,000 for 2022) and list your taxes that year. Bundling may or may not work for your personal situation depending on how much you plan to donate and how close you are to having enough prints to exceed the standard trigger threshold.
The pooling can also be in your favor when you donate to a fund recommended by donors. Consider preloading two years’ worth of donations and contributing to a fund recommended by donors this year. Take as many single prints as possible this year and the standard print next year. Talk to your financial advisor and tax advisor to find a strategy that works best for you.
Plan for RMDs
Retirees must make the required minimum payouts (RMDs) and pay tax on that money from the age of 72. Some retirees don’t need the money from their RMDs, others don’t want the withdrawals to count towards their annual income as it can push them into a higher tax bracket. Qualified charitable distributions allow you to deduct your RMDs from your tax return when you donate that money to charity. The money will be sent untaxed directly from your IRA to a qualified charity, including nonprofits and religious organizations. You need to transfer the money directly to avoid paying tax on the withdrawal. If you withdraw the money first, and then write a check to a charity, you owe the IRS.
Many retirees are unsure of how much money to withdraw and when to withdraw it. It is important that you have a strategy for your RMDs well in advance of your 72nd birthday. A financial advisor can help you plan your RMDs so you don’t miss the deadline and pay a fine.
Meet with a financial advisor
It’s never too early to meet with a financial advisor. He or she will help you decide what types of accounts to save and invest, and can help you set savings goals to keep you informed. If you are five to ten years away from retiring and haven’t met a financial advisor, this is the time to get serious about planning. A comprehensive plan takes into account taxes, social security, health care, and estate planning.
This article is written by our contributing advisor and presents the views of our contributing advisor, not the Kiplinger editorial team. You can review advisor records with the SEC or FINRA.
Founder and CEO of Drake and Associates
Tony Drake is a CERTIFIED FINANCIAL PLANNER ™ and the founder and CEO of Drake & Associates in Waukesha, Wisconsin. Tony is an agent for the investment advisor and has been helping clients prepare for retirement for more than a decade. He hosts the Retirement Ready Radio Show on WTMJ Radio each week and is shown regularly on Milwaukee TV stations. Tony is passionate about building close relationships with his clients so he can help them develop a strong plan for their retirement.