Taxes Can Derail Retirement

Art by Brian Rea

As more American workers are expecting to rely on defined contribution (DC) plans and individual retirement accounts (IRAs) to fund their retirement years, concerns are growing about how to best manage lifetime income streams.

As part of this effort, according to Daniel D’Ordine, founder of DDO Advisory Services, late- and even mid-career retirement savers should start doing much more advanced planning for how they can minimize income taxes in retirement. Depending on where they live and how they have structured their retirement income, retirees may find themselves paying unexpectedly high taxes each year to both the federal and state governments, D’Ordine warns.

Should an individual’s retirement income stream stem mostly from Social Security, he would be unlikely to pay a great deal of income tax, D’Ordine says. However, if the person has accumulated other significant income sources such as a 401(k) or defined benefit (DB) plan, then taxes will be assessed on what is commonly described as “combined income.” Depending on how the public and private sources of income are structured, the federal government can assess taxes on up to 85% of Social Security benefits, contingent on combined income and other factors such as marital status.

At the state level, taxes on retirement income will also vary considering the participant’s sources of annual income. Currently, 13 states levy their own taxes on Social Security.
“Generally speaking, states in the South tend to have lower taxes than states in the North,” notes Sandra Block, senior editor at Kiplinger. “That’s why a lot of people like to move to Florida—there is no income tax there.”
There are many planning opportunities to take advantage of today from a tax-optimization perspective, even for those in their 20s, 30s and 40s, experts agree.

The first step to mitigating future tax expense, according to Angie O’Leary, head of wealth planning at RBC Wealth Management, is to consider diversification with respect to account types and their prospective tax requirements. Plan sponsors, for their part, can establish a Roth IRA option.

According to D’Ordine, participants often have questions about the tax burden associated with annuities. Those who buy a lifetime annuity with a lump sum of money are guaranteed to receive a set, predictable payment throughout retirement, but how will this be taxed?

“Annuities add some security and take a bit of the pressure off,” D’Ordine says. “Much of the monthly payment in this case will be considered return of premium, but the rest of it will be taxable. There is a lot to consider.”
For participants retiring early, who may need income before claiming Social Security benefits, D’Ordine mentions the possibility of purchasing a limited-term annuity, say a five-year, where a majority of the money received monthly is considered return of premium.