The Average American Retirement Plan Has a Major Blindspot

Some people think saving for retirement and retirement planning are the same thing — but they’re not. Saving for retirement is part of retirement planning. But you also need to figure out how to manage that money, both now and in the future, to help it last as long as possible.

Choosing the right investments and knowing how much you can safely withdraw per year in retirement are both helpful. But there’s another important step that too many Americans are forgetting — and it could lead to one angry Uncle Sam.

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Who owns your retirement savings?

It’s natural to think the money in your retirement accounts is yours. You worked for it, you chose to set it aside for your future, and you want to choose how to spend it. But this isn’t always how it works.

When you put money into a tax-deferred retirement account like a traditional IRA or 401(k), the government subtracts your contribution from your taxable income for that year. If you earn $50,000 this year from your job but put $5,000 into your 401(k), you’d only pay taxes on the remaining $45,000 next spring.

Eventually, though, the government expects a share of your savings. When you withdraw your cash later, you’ll pay income taxes on your initial contributions and all of your earnings.

This can be advantageous to those who expect their taxable income in retirement to be lower than it is today. They avoid high taxes when they’re earning a lot of money and pay a lower tax rate on their withdrawals later. But you’ll still have to worry about a tax bill in retirement.

It’s something too many people overlook when planning for their futures. Just 30% of workers have a plan to reduce taxes in retirement, according to a recent Northwestern Mutual survey. Twenty percent said they hadn’t thought about paying taxes in retirement at all.

Ready or not, you’ll still get the bills. Without a plan to reduce them, you could spend more than you anticipated each year and drain your savings prematurely.

How do you reduce your taxes in retirement?

There are several strategies you can use to reduce your taxes in retirement.

Use a mix of traditional and Roth accounts

Roth retirement accounts are almost identical to their traditional counterparts but are taxed differently. You don’t get an upfront tax break when you make Roth 401(k) or IRA contributions.

But since you pay taxes on your contributions right away, the money grows tax-free afterward. When you take it out in retirement, the IRS effectively treats it as if it doesn’t exist, as long as you’re at least 59 1/2 at the time and have had your account for at least five years.

Those with both types of savings can strategically withdraw cash from each to limit their tax liability. For example, if it’s the end of the year and you’re bumping up against the top of your tax bracket, you might choose to stop tax-deferred retirement account withdrawals and rely only on your Roth savings for the rest of the year. Then, you could go back to using some of each the next year.

Those who want Roth savings but don’t have any could open and contribute to a Roth IRA. Most workers can contribute up to $7,000, or $8,000 if they’re 50 or older. But there are income limits that prohibit high earners from contributing directly. In that case, you could do a Roth IRA conversion, where you change tax-deferred savings to Roth savings by paying taxes on the converted funds now.

Stash money in a health savings account

Health savings accounts (HSAs) are designed for healthcare expenses but also make great retirement accounts. Contributions will earn you an upfront tax break, like traditional retirement account withdrawals, and medical withdrawals are always tax-free. You can also make taxable non-medical withdrawals, though you’ll pay a 20% penalty if you’re under 65.

An HSA can be your go-to place to store cash for retirement medical expenses so you don’t have to withdraw these funds from a traditional retirement account and add to your tax bill. But you can only contribute if you have a health insurance plan with a deductible of $1,600 or more for an individual, or $3,200 or more for a family.

Qualifying individuals can stash up to $4,150 here in 2024, while families can save up to $8,300. Adults 55 and older can save an additional $1,000 as a catch-up contribution.

Give strategically

Charitable donations to qualifying tax-exempt organizations can reduce your taxable income in retirement. Those with extra cash in retirement can use this to their advantage to reduce their tax liability — perhaps even dropping themselves into a lower tax bracket.

These tips may not all work for you, but they’re worth keeping in the back of your mind as you approach retirement age. Remember, too, that tax brackets and even retirement account rules can change over time, so you may have to adapt your approach as you go to keep your retirement taxes as low as possible.

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