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Anatomy of a tax return (Part 4) - Retirement income

February 05, 2023

Retirement income may or may not be taxable and offers a significant opportunity for tax planning sometimes years or even decades before you actually retire.

It’s a perfect example of why financial planning is not just for those nearing retirement or those with large sums of money and why tax planning is part of financial planning to minimize the taxes you pay in your retirement years. 

Retirement income can take many forms such as a company pension or profit sharing plan, distributions from your IRA accounts or taxable savings accounts, annuity distributions and Social Security to name a few.

Income that you receive from retirement accounts may be taxable or not taxable.   It might even be taxable at the federal level but not taxable at the state level depending on which state you live in.

Much of a person’s retirement income comes from tax deferred accounts.  If you draw money from an account that had pre-tax money put into it during your working years, you will most likely have to treat that income as taxable when its withdrawn to use in retirement.

You may have tax deferred money that was put into an account after you paid tax on it (think Roth IRA or Roth 401K) and when it comes time to withdraw money in retirement years that should not be subject to tax since it was contributed after tax was paid on it years earlier and was able to grow tax deferred across the years.

When you draw that money though could have a significant impact on whether its taxable or not.  Generally if you withdraw money from a retirement account before age 59 and a half, you can be subject to both income tax and a 10% penalty on top of that.

In my tax practice I’ve seen someone come to me to do a tax return after they had withdrawn large sums of IRA money at age 59 and 3 months because their financial advisor did not advise them of the tax consequences of an early withdrawal. 

That was a $30,000 penalty because they did not wait 3 more months to withdraw the money.  Another reminder to consider working with a financial planner who is allowed and willing to advise of tax consequences of your actions.

There can be an opportunity to avoid taxation on a retirement fund distribution.   If you are charitably inclined, if your charitable giving comes directly from your IRA to the charity without passing through your hands first you might qualify for a Qualified Charitable Distribution (QCD) in which case that distribution might avoid being treated as taxable income and that lowers your taxable income from which your tax owed is calculated.

A more advanced approach might be to convert taxable IRA money into a Roth account.   You pay the tax on it now which on the surface might not seem like a good idea because you are paying tax now instead of years in the future but when done under the right circumstances might help to avoid a larger tax bill years or decades from now. 

Considering that you might be living 10, 20, 30 or more years on your retirement funds it makes good sense to be learning how that works many years before you plan to retire so as to maximize the tax benefits.  Your future self will appreciate the effort you put into this now.

Talk to your financial advisor about these future tax planning ideas and concepts.  If they won’t give any tax advice I encourage you to find a planner who is willing to talk tax effects since the tax you pay on your future retirement income can take a significant percentage out of what you will have to live on when your paychecks stop.

The information in this and other articles is intended to be educational in nature only.  Not tax, legal or investment guidance for you specifically.  Each person’s situation is unique and you must seek appropriate professional guidance that can address your unique situation.

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