Are you paying too much in taxes in retirement?
We all want to enjoy every aspect of retirement. From giving up the nine-to-five, to traveling, enjoying time with family, and spending more quality time in your man-cave or she-shed. The last thing anyone wants is unexpected taxes when they begin to withdraw from their retirement accounts.
It used to be that when you found yourself out of cash, you could go to any ATM. You’d have to pay a fee if it wasn’t associated with your bank, but it was yours in no time. Not only would you trigger a fee with your bank, however, you’d also have to pay an ATM transaction fee for the machine itself. If you were only trying to access a small amount of cash, the fees might have made you reconsider the withdrawal. While ATM fees haven’t gone away, we’ve been relying on them less and less in the past several years as digital banking and transactions have become more popular.
When it comes to taxes, fines, and fees, your retirement account can feel like an ATM. You can take out money if you need to, but if it’s not within the rules and regulations of your specific plan – you may take a hit that keeps ringing for years to come. The value of a financial advisor in these cases cannot be understated.
Be aware – your retirement accounts are not ATMs.
According to research by E-Trade, almost 60% of investors ages 18-34 have already withdrawn money from their retirement account – a number that has nearly doubled since 2015. It’s hard to overstate the impact even a small withdrawal can have on the future of your retirement savings. While many of us may not bat an eye at a convenience fee, remember that the people who own private ATMs make around $20,000 to $30,000 a year in passive income. When you’re finished adding up all the fines, fees, and taxes you’ve paid each year – someone else can be making an income on your money. That’s not how you want to spend your hard-earned cash.
The Rules of Contributing and Withdrawing
There are a few main account types one generally considers funding for their retirement. And they all have different, ever-evolving rules based on how much you can contribute each year, how long you’ve had the account, how old you are when you withdraw, and how much income you earn. These factors barely skim the surface, so we’ll briefly touch on some of the main highlights and pain points of more popular retirement accounts.
1. Traditional IRAs, 401(k)s, and other tax-deferrals.
Traditional IRAs and 401(k)s are two of the most popular retirement accounts for plenty of good reasons. Chief among those reasons is that both types of accounts are tax-deferred, meaning you’re able to contribute tax-free until you begin withdrawing from those accounts. When you contribute to these accounts, you reduce the amount of taxable income for the current year, which is a nice plus, in addition to the fact that this full amount — savings, dividends, and investment gains, also known as capital gains — continue to grow and compound over time.
While 79% of companies sponsor 401(k)s nationwide, only 41% of employees offered to take advantage of them. If your employer is matching contributions, not partaking is like leaving free money on the table.
Tax-deferred is not tax-forgiven. Even if you hold off as long as you can, required minimum distributions (or RMDs) begin at age 72 – and then, yes, you have to pay taxes on every withdrawal. As you’ll find, retirement accounts are meant for your retirement, so trying to withdraw money before that time can be complicated and costly.
What is your “retirement” based on? Almost always, your age. Of course, people retire sooner than anticipated all the time. In fact, the average retirement age is 61. Does that mean you can or should start collecting benefits then? A rock-solid financial plan is your best bet to avoiding the tax penalties that can rob you of a healthy retirement. Generally, for those under the age of 55, you can withdraw from your 401(k) without penalty if you take out a loan from your 401(k), have a hardship that meets certain criteria, and if you rollover to an IRA after you leave the job that sponsored it.
2. Roth IRAs and Roth 401(k)s
Roth IRAs are popular as well and can be a great individual retirement account (IRA) option. The major difference between a Roth and a Traditional IRA is that you pay taxes on the money you contribute as you contribute, and you can’t deduct those contributions on your annual taxes. Though common, not everyone qualifies for these accounts.
Roth IRAs grow through two primary vehicles: your contributions and earnings. Your earnings come from things like dividends and investment gains from stocks, bonds, mutual funds, ETFs, and the like. While you can withdraw your contributions with no additional taxes, fines, or fees at any time, there are limits on what you can withdraw from your earnings without penalty.
If you’re over the age of 59½ and have had the account for at least five years, you should be able to withdraw your contributions and earnings tax-free at any frequency. If you’re younger than 59½, you can still withdraw contributions and earnings, but you’ll owe income taxes as well as a 10% penalty on the earnings. Of course, there are some exceptions to this rule that will allow you to avoid the penalty – such as major medical expenses, health insurance if you’re unemployed, and college costs. As we’ve discussed before, withdrawing this money should absolutely be a last resort.
3. Bank/Brokerage and Other Taxable Accounts
A bank or brokerage account does not offer tax benefits – when your investments earn income or dividends, you will pay taxes on those. You see commercials for these all the time – think Robinhood, E*Trade, TD Ameritrade, Charles Schwab – because they generally require few obstacles to begin investing, and you can pull your money out at any time.
While you wouldn’t want a brokerage account to be your only retirement option (or any of these – diversifying your income streams is key), it’s not necessarily a bad thing to have another income source, especially if you can preserve your principal investment.
Bank accounts are similar in that they offer no tax benefits but typically only serve as a place to store cash. Additionally, their only growth options are based on interest rates which, when averaging between 0.08% and 2.10%, don’t offer much in actual growth. Brokerages, however, allow you to store cash, stocks, and other securities.
This is not an exhaustive list of retirement options, taxes, fines, or fees. There is a myriad of exceptions and options you may not have previously considered. Health Savings Accounts, or HSAs, are one. Some argue HSAs may be a superior retirement savings vehicle than 401(k)s, but of course, it all depends on your unique situation. HSAs are tax-advantaged accounts designed for people who have High Deductible Health Plans to help pay for their out-of-pocket medical expenses. It can be a complicated task, but it allows you to put away “pre-tax or tax-deductible dollars into an account and have them grow free from taxes.” As long as you use the money for medical costs, it remains tax-free even when you withdraw.
Build a Retirement Plan with a Tax Strategy
At Fullerton Financial Planning, our goal is to help you enjoy your retirement with confidence, not worrying about whether or not you have enough money to enjoy it. Our certified fiduciaries and experienced investment advisors have decades of combined experience helping people find answers to difficult financial questions. Sit down with a Fullerton Financial Advisor today to discover if you are on the right track for your retirement goals.
We understand how important your financial future is to you and your family; we also understand how difficult making these plans can be. If you want to know how tax code updates affect your retirement plan, or if withdrawing at a particular time will be detrimental – don’t spend your time analyzing the rules. When you schedule a call with Fullerton Financial Planning, we’ll show you the best way to review your retirement plan for any tax implications.
Don’t leave your financial future to chance. Let us help you create a personalized plan so you can enjoy the retirement you’ve worked so long and hard for.
