One of the most overlooked aspects of retirement planning is the effect federal income taxes or state income taxes have on someone trying to live on a fixed or pension income. No matter your tax bracket, these unexpected hits to your retirement accounts can take a significant bite out of your nest egg without proper planning.
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For example, a $1 million portfolio in a 401(k) plan or traditional IRA might be worth $800,000 or less after taxes. Similarly, if your investments are in a regular, taxable brokerage account, the income that money generates may also be taxable.
One way to work around this tax situation problem is to save and invest even more during your working years so that you have extra money to pay your taxes. Another is to be tax-smart with your investments and account choices to reduce your tax liability to an absolute minimum once you hit retirement age.
While there are many surprisingly hidden costs in your tax years during retirement, several types of retirement income aren’t taxable. Here are a few.
The easiest way to avoid taxes on your retirement money is to use a Roth account. Both IRA and 401(k) plans can be structured as Roth accounts, which don’t offer a tax deduction on contributions but allow tax-free withdrawals after age 59 ½.
Essentially, with a Roth account, you’re paying your taxes upfront at the time that you contribute, rather than owing them on your distributions. While you can’t contribute to a Roth if your income exceeds certain levels — $161,000 for singles or $240,000 for couples who file jointly in 2024 — you can convert your traditional plan to a Roth at any time. However, you’ll have to pay income taxes on the amount of the conversion, just as if you withdrew the money.
For this reason, it typically makes more sense to start a Roth earlier in your career rather than facing a huge tax bill during your peak earning years.
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It’s not usually a good idea to rely on an inheritance as a retirement plan. For starters, receiving an inheritance is never a sure thing, and additionally, the amount bequeathed is rarely enough to fund a long retirement.
However, many Americans do receive an inheritance at some point in their lives, and it can often be a good supplement to existing retirement savings. Financially speaking, the best part of an inheritance is that it is tax-free, so long as you don’t live in Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania, which still impose inheritance taxes.
