There is an old saying about finances that states, “It's not what you make; it's what you keep that counts.” The phrase refers to the concept that as people recognize income, their real returns are the money that is left over after taxes are paid. The lower the tax rate, the more money is saved.
The prospect of managing tax rates in retirement is complicated because different investment accounts have different rules regarding income recognition for tax purposes. For example, it may make sense to take elective distributions from a retirement account today because it will reduce future taxes. This strategy works for retirees with tax-deferred retirement accounts who will essentially be forced to take required minimum distributions (RMDs) that put them in higher tax brackets starting at age 73. In this scenario, the retiree would take distributions before the required minimum distribution age so that their RMDs and marginal tax rates would be lower in the future.
There are generally four types of accounts that can be utilized for retirement tax planning: tax-deferred accounts, Roth accounts, taxable accounts, and Health Savings accounts. Every type of account can be useful for implementing a financial plan that minimizes taxes in retirement. Investors, as a rule, should recognize income in a way that avoids triggering extreme spikes in income and tax rates in a single year.
We do not know what tax rates will be in the coming years, but it is probably safe to conclude that rates will trend higher due to the federal government’s need to reduce its budget deficit and fund Social Security. Tax rates are already set to rise in 2026 when the tax reductions under the Tax Cuts and Jobs Act expire for individuals. Given the likelihood of changes in tax rates, potential tax legislation must be factored in when designing and updating financial plans.
Without proper planning, retirees may also find themselves paying more taxes than they expect due to “hidden” taxes that are not specified in the standard tax rates. Some of the “hidden” taxes include early retirement plan distribution penalties, excess retirement plan contribution penalties, RMD penalties, taxes on Social Security distributions, the Net Investment Income Tax, and increased premiums on Medicare insurance.
Fulcrum Wealth Advisors can perform specialized calculations to ensure that its clients' plans are as tax-efficient as possible in the short run and/or the long run.
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