Real quick, before reading this blog post consider reading Road to Retirement in Seven Steps first. It was created to explain how to understand your personal finances and get you on the road to financial freedom. I highly recommend completing the entire post before reading this one as it has key information on how to get started with your finances. It goes over debt, income, and ways to find money to invest in the stock market.
Additionally, How to Invest in the Stock Market in Six Simple Steps goes over the key components of investing and how the stock market works. Also, How Much Do I Need to Retire? is another post that will help you understand the amount of money you need to retire so you can set goals and get headed in the right direction. While these are not required readings to understand this post, they do provide context as they were written as a series.
Okay, thanks for reading. Now, on to this blog post on the 10 Things You Need to Know About Retirement Planning and Taxes in 2022.
Table of Contents
1. Tax Overview With Social Security
2. Overview of Retirement Products and Implications for Taxes
3. Investment Vehicles and Retirement Products
4. The HSA – The Retirement Account That Is Not a Retirement Product
5. Brokerage Accounts: How do you use them?
6. Tax Rates for Long-Term Capital Gains 2022, from the IRS
7. Roth IRA Conversion
8. Getting the Most Out of Your Retirement Funds
9. How to Invest Your Money
10. Where to Invest Your Money When Given an Option on Management Companies
Today, 57% of retired Americans rely on Social Security income. However, the average annual Social Security benefit for retired workers was only $18,528 in 2020. Meanwhile, average annual spending by Americans older than 65 was $47,579. This means that to survive, retirees need to have supplemental income to make up the difference. Unfortunately, it’s not coming from pensions as they comprise only 4% of the main source of retirement income. Therefore, we need to do everything we can to ensure that we have enough money in our investment portfolios – yet despite the availability of employer-sponsored retirement products for people to participate in, approximately 37% of the 162 million eligible workers actively participate in a 401k.
You worked hard your entire life and now you are retiring. Some people retire not because they want to, but because they are older and no longer allowed to keep their job, or they become incapable of completing the tasks, or they’re forced to retire because of health reasons. The ideal scenario is retiring because you want to. Whatever the reason, having the right amount of money during your retirement years to fit your lifestyle is hard to achieve unless you’re careful with your investments.
Another troublesome factor is when your investments lose money to taxes and administration fees paid to the companies that manage your money. The good news is there are ways to reduce your expenses, earn more money for your retirement, and develop a tax strategy. Here are 10 ways to plan for your retirement income to ensure you get the best returns.
Where to Invest Your Money: Retirement Products, Investment Vehicles, and Tax Planning
Tax Overview With Social Security
Tax planning is such an important part of your retirement planning, and the impact can be considerable. Every financial transaction we make has a tax implication. The more knowledgeable you are about taxes' impact, the better decisions you will make. This is highlighted even more while you are in retirement because you are no longer working and every dollar counts. This post will get you headed in the right direction. (Working with a tax accountant is a good idea to help you go deeper into your specific circumstances.)
Let’s start with Social Security and how it is taxed.
Social Security income is subject to federal, state, and local income taxes depending upon where you reside. While many states do not tax Social Security, where you live in retirement should be a consideration in retirement planning.
Next, The IRS (Internal Revenue Service) looks at how much provisional income you have and requires you to include 50% of your Social Security as part of the equation. Provisional income is defined by the IRS as the sum of your wages, taxable and non-taxable interest, dividends, pensions, self-employment earnings, and any other income. So, that means you need to include all income plus 50% of your Social Security income.
Here is an example of how it works:
Provisional Income: $40k
Social Security Income: $20K
Social Security Income at 50%: $10k
Provisional Income plus 50% Social Security Income: $50k
Based on this example, there is a total income of $50k according to Social Security equation.
If you hit certain income thresholds as indicated in the table below, you will have to pay income tax on 50% of your Social Security payouts, and if you surpass that threshold, it jumps to 85%. Here are the thresholds where taxpayers may be taxed according to the IRS for 2022:
Let’s be clear about what this table is saying. If you are married, filing jointly, and have income greater than $44,000, or if you’re filing single with income more than $34,000, you will be taxed on 85% of your Social Security benefit. This means that despite how much you contributed to Social Security over the years, you can be taxed at 85%. Remember that this is income, not expenses. If your expenses exceed those thresholds, you better have other income sources.
Looking at the above equation, your Social Security would be taxed at 85%.
One exception is that a Roth IRA withdrawal does not count toward income and isn’t taxed by Social Security, which is a key part of your retirement strategy – more on that later.
Overview of Retirement Products and Implications for Taxes
There are several places where you can invest your money in preparation for retirement. However, we are going to focus on the main investment vehicles and their features so you can take advantage of each one. These features impact your money going in as well as its growth, withdrawals, and taxes. Keep in mind that these retirement products are investment vehicles for long-term investments. They have tax advantages that allow your money to grow tax-free or tax-deferred for years.
Investment Vehicles and Retirement Products:
401k: Employer-based – employee contribution plan
Traditional IRAs: Individual Retirement Accounts (IRA) – individual contribution plan
Roth IRAs: Also an IRA – individual contribution plan with a different tax structure
Roth 401ks: Employer-based – employee contribution plan, a newer hybrid product
In the interest of simplification, we are going to limit the products we discuss to these three: Traditional IRA, Roth IRA, and Roth 401k. Typically, you roll over an employer-sponsored 401k to a Traditional IRA when you retire because a Traditional IRA has better investment options, lower fees, and more control, to name a few of its advantages.
The major differences between the three retirement products include how the money goes in and how it comes out from a tax perspective. Here is a simple grid on the differences between the products:
The wonderful thing is that you can use these products in multiple ways. How you use them is your retirement strategy! But first, the HSA.
The HSA – The Retirement Account That Is Not a Retirement Product
Another product to consider is the HSA (Health Savings Account) when you have a High-Deductible Health Plan (HDHP). The HSA was created to help with out-of-pocket expenses with your medical insurance. While this is not an actual retirement account, we can use it as one as it has the best of all the accounts when you take taxes into consideration.
It’s all about free stuff when it comes to the HSA:
Lowers your income tax because contributions are tax-deferred (free money)
Employers are contributing money (free money)
Grows tax-free (free money) and you can invest your HSA money in the stock market
Withdraws tax-free (free money) when you have a medical receipt
The contribution amounts change every year, so consult the IRS and your employer to find out the amounts you can invest. As of 2022, contribution limits for self only coverage are $3,650 or $7,300 with family plans.
The way you want to use this product is to put money into the account and allow it to grow. Sit back and watch your money grow tax-free – the good life!
What if you have medical expenses in the interim? Use cash to pay for your medical expenses instead of the HSA. We want this money to grow with all these great tax benefits for as long as possible.
How do I withdraw the money? When you’re ready to use the money in retirement, submit a qualifying medical expense. The medical expense doesn’t have to be during the same year that you withdraw the money, so keep track of your expenses and receipts.
What if you don’t have enough medical expenses? An HSA acts like a Traditional IRA except that the age to start withdrawing is 65.
Brokerage Accounts: How do you use them?
Since there are limitations to investing and withdrawing money with retirement accounts, you may need to put money into a brokerage account. You fund these accounts with after-tax money. Since you have paid the taxes on this money already, you only pay taxes on the capital gains and dividends when you withdraw the money. Withdrawing the money can happen in two ways: in the short term or long term.
Short-term capital gains tax occurs when you hold the asset for less than a year, and you are paying taxes on the amount gained when you withdraw the money. This is taxed as ordinary income and impacts your tax bracket.
Long-term capital gains are defined as assets that are held for more than a year and they are not taxed as income. Below are the tax brackets for long-term capital gains. Notice that there is a section with 0%! This means that you pay ZERO dollars on long-term capital gains up until these thresholds.
Tax Rates for Long-Term Capital Gains 2022, from the IRS
This means that you can use this money without paying any additional taxes if you hold them for a year if you qualify for the 0% tax bracket. Brokerage accounts are especially important if you are considering retiring early since there are no age limits for withdrawing these funds, whereas the retirement accounts require you to be at least 59.5 years old.
How do you use these vehicles to your advantage?
Now that we have gone over these investment vehicles, how you fund them is the next piece. Here is an order for you to consider if you have limited funding. The order was set up based on getting free money first, followed by the best tax strategy.
The idea is that you have a budget and you know how much you can invest for the year. If you have a spouse, they can contribute to many of the same accounts and double the amount you can invest in these various retirement products.
If you are just starting, invest in as many as you can. Make it a goal to invest more money as time goes on to take advantage of compound interest. If you need suggestions on how to get started, read Road to Retirement in Seven Steps.
The table shows that you can invest $30,150 per person. If you have a spouse who is working and has these options, this amount can be doubled. Meaning that you would be able to invest a total of $60,300 for the two of you, not including the brokerage accounts per year. From a monthly perspective, this is $5,025 per month for your family – a great deal of money, but also a great deal of opportunity to take advantage. Start with what you can and increase over time.
We also want to take this one step further and consider the Roth IRA conversion you can do before and after you retire.
Roth IRA Conversion
A Roth IRA conversion is when you convert your Traditional IRA to a Roth IRA account. While there are rules on how much money you can contribute to a Roth IRA, there are no rules on how much you can convert to a Roth IRA. You also do not need to convert it all at once.
However, if you convert the money, this is a decision with tax ramifications – you will have to pay taxes on the income. You need to make sure that you can cover the taxes that are due by using cash or other means instead of using the money in those accounts as it will trigger a penalty, which of course translates to less money to use in retirement.
This decision to convert the money or not depends on what you think your tax bracket will be in the future as compared to today. If you didn’t convert it and kept it in a Traditional IRA, when you reached the age of 72, you would be mandated to withdraw the money. This money withdrawn would be taxed as income, pushing your taxes to a higher bracket.
However, if you have the same or a higher tax bracket in retirement, then converting the money makes sense because you pay the taxes now, it grows tax-free, and withdrawals are tax-free. Take note that withdrawals from a Roth IRA don’t count as income toward Social Security. If you converted your money to a Roth IRA and withdrew some of it, it would not impact your Social Security benefit. This may be hard to achieve, so work with a tax accountant.
There are pros for converting the money as a part of your retirement planning:
You must pay taxes now, but you may save on overall taxes.
There are no Required Minimum Distributions (RMDs).
You can withdraw your contributions.
While you must wait five years for the mone