With social security set to end one year earlier than expected, taxes on pension benefits can only get worse, not better. Currently, 15% of your social security benefit is tax-free. For the other 85%, it all depends on your “provisional income”. So it’s important to be able to manage your retirement income, and one way to do that is to make sure you save in the right places.
Provisional income is your gross income — salaries, pensions, interest, dividends, and capital gains — plus tax-free interest plus half of your total Social Security benefit. If your provisional income exceeds $ 34,000 on a single return or $ 44,000 on a joint return, up to 85% of your benefits may be taxable at your tax rate (see Calculate taxes on social security benefits).
Fortunately, there are planning opportunities for retirees and non-retirees to help reduce the tax burden. Here I discuss three of these strategies, but to learn more about social security planning, join me for a free webinar on September 30, 5 things you need to know about social security (register here).
1. How to use the Roth IRA to control your retirement taxes
Retirees usually have the majority of their holdings in taxable pension accounts. Withdrawals from traditional IRAs and 401 (k) s are considered gross income for the calculation of the preliminary income insurance for social insurance. However, qualified withdrawals from Roth IRAs are not income tax free.
Some may want to convert traditional IRAs to a Roth for tax-free withdrawals in the future. There are some reservations to keep in mind. Those who are still working can contribute to a Roth IRA if their income does not exceed certain thresholds. For those whose incomes are too high, megadörren Roth can be an option.
In retirement, I tell my clients to withdraw from the Roth IRA only when their total income can push them into the next tax bracket or when their total income makes their social security taxes taxable. For example, say a married client with $ 40,000 in provisional income needs another $ 10,000. That client may consider withdrawing $ 4,000 from their 401 (k) and $ 6,000 from a Roth IRA. In this way, their total income does not exceed the preliminary income limit of $ 44,000.
2. Health savings accounts can also be practical
Uses one health savings account (HSA) is another great way to keep your future taxes down. For those with an HSA, remember that you must have a high-deductible medical plan at work to contribute to an HSA distribution for most medical and dental expenses are tax-free. For my working clients, I always encourage them to fund their HSA every year but try not to use it – save it for your retirement costs instead.
HSA withdrawals are tax-free when used to pay for Medicare or other eligible medical expenses at retirement. And unlike withdrawals from a traditional 401 (k), qualified withdrawals from an HSA are not taxable and will not make your social security taxes taxable either.
A trick for those who want to increase their HSA account is to make a one-time transfer from an IRA. Currently, the IRS allows a real once in a lifetime transfer from their IRA to the HSA. The IRA’s distribution amount is limited to the annual HSA grant – up to $ 7,200 for a family by 2021 – and must be done directly from the IRA to the HSA, but is not included as income (IRS Pub 969).
Use full life insurance as a tool
The proposed Biden tax increase aroused interest in life insurance in 2021. Life insurance with cash value, for example full policies, has many benefits, including the possibility to borrow from the insurance without affecting income taxes. Money borrowed from an entire life policy is a tax-free loan, and if it is not repaid, the death benefit decreases.
For my customers, their whole lives give us additional options. For example, we can borrow from the policy for a given year instead of taking 401 (k) withdrawals, which can lead to their social insurance being taxed. Or if a customer needs a large cash infusion for a remodeling project or vacation, we may consider borrowing from the entire life policy tax-free instead of taking a taxable breakdown from their 401 (k). The whole life does not make sense to everyone, especially those who are older, because it can be too expensive. But for those who still work and have a family, it is another tool in the toolbox for financial planning.
Financial planning is about thinking ahead and creating alternatives for your future self. If you are still working and have the opportunity to save money, you want to be aware of where to save. Each account has its own advantages and disadvantages, so it’s about balance.
If you save all your money in a traditional 401 (k), it helps in taxes today, but will hurt later in retirement when you withdraw money. The key is to think about tax diversification. Tax diversification is about having some money that, when taken out, is taxable in the future and some that is tax free. If you can combine these two — tax-free with taxable — you have a better chance of lowering your future tax burden. Your future I will thank you.
This article is written by and presents the views of our contributing advisor, not the Kiplinger editorial staff. You can check the advisor’s records with SEK
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CFP®, Summit Financial, LLC
Michael aloi is a CERTIFIED FINANCIAL PLANNER ™ practitioner and accredited asset management advisor ℠ with Summit Financial, LLC. With 17 years of experience, Michael specializes in working with managers, professionals and retirees. Since joining Summit Financial, LLC, Michael has built a process that emphasizes the integration of various aspects of financial planning. With the support of a team of in-house real estate and income tax specialists, Michael offers its clients coordinated solutions to widespread problems.
Investment advisory and financial planning services are offered through Summit Financial, LLC, an SEC Registered Investment Adviser, 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600 Fax. 973-285-3666. This material is for your information and guidance only and is not intended as legal or tax advice. Customers should make all decisions about the tax and legal implications of their investments and plans after consulting with their independent tax or legal advisors. Individual investor portfolios must be constructed based on the individual’s financial resources, investment objectives, risk tolerance, investment time horizon, tax situation and other relevant factors. The views and opinions expressed in this article are those of the author only and should not be attributed to Summit Financial LLC. The Summit Financial Planning Design Team hired attorneys and / or CPAs who act exclusively in non-representative capacity vis-à-vis Summit’s clients. Neither they nor Summit provide taxes or legal advice to clients. All tax information contained herein was not intended or written for use, and may not be used, for the purpose of evading U.S. federal, state, or local taxes.