Ah yes, April 15th. A national holiday of sorts, if accounting is your thing. For the vast majority of us, April 15th is a dreaded deadline when we submit all of our financial activities from the previous year to the IRS to determine how much they owe us. Or, more forebodingly, how much we owe them.
Tax reporting is stressful enough when we are working. Tax reporting changes drastically when we enter retirement. We now must consider how much of our Social Security benefit is subject to tax, how much we’ve distributed from tax-deferred accounts, etc.
At Financial Enhancement Group, we take care of people through all walks of their financial journey. Most people go through three phases of finance, which we call Accumulation, Preservation, and Distribution. Planning and targeting a few primary focal points during your financial journey, if done right, will allow you to control taxation in retirement.
In the accumulation phase, focus primarily on the following:
• Saving the correct percentage of your income; the younger you are, the smaller that percentage needs to be.
• Building tax diversification between three types of accounts:
o Tax-Deferred Accounts: IRA's, 401(k)s, 403(b)s
o Tax-Free Accounts: ROTH IRA's
o Taxable Account: Brokerage accounts and bank accounts
During the preservation stage, where the amount of assets that you currently have is more important than the amount that you are saving, focus on the following:
• Reducing your liabilities and your standard of living in preparation for the last phase of finance, distribution
• Making sure your investments are in line with your risk profile
The last phase of finance is distribution, and the two most important things to focus on during this phase of finance include the following:
• Managing market volatility through your distribution points
• Managing the taxes that you pay on your distributions and income sources
Inevitably, taxes are coming in retirement, and how you prepare for them will help you control how your dollars are taxed. If all your savings are in tax-deferred accounts, you cannot control taxation, because every future dollar you withdraw will be taxed. Therefore, it is essential to start building tax diversification inside your retirement vehicles.
To illustrate the importance of tax diversification, let's assume hypothetically that you and your spouse need $10,000 a month net (after taxes) to maintain your standard of living in retirement. After reviewing all income sources, you realize you will need to withdraw from your investments in order to accomplish your income needs. If proper tax diversification has previously been established, I might recommend you withdraw from your tax-deferred assets up to the top of the 12% marginal tax bracket. For anything above that amount, you could take a distribution from a taxable account or Roth. This prevents those pre-tax dollars from being subjected to the next marginal rate of 22% and reduces your overall tax liability.
Seeking the guidance of a fiduciary financial professional, like Financial Enhancement Group, will help ensure that you have done proper tax planning to control your tax liability in retirement. Happy Planning!
Financial Enhancement Group is an SEC Registered Investment Advisor.
