When it comes to taxes, we all lives by the same tax rules, but it’s up to us to decide if we take advantage of them, or they take advantage of us. This doesn’t mean we should break rules so that we pay less in taxes but to know the rules so that we can take advantage of them. This could give you more money in your pocket down the road to spend on vacations, family events, and other experiences that you enjoy.
There are a lot of things you should do with your money before you start to file. I’ve seen people who made hundreds of thousands of dollars in tax mistakes because they took money from the wrong account or just didn’t do the right thing.
Here are five tax strategies that you should be thinking about.
Becoming Tax-Efficient In Retirement
When it comes to investing, there are three different places that you can put your money. You can put your money in a Tax-Deferred account, an After-Taxed account, or a Taxable account.
Each one of these accounts can use the same investment. For example, you can put an S&P 500 index fund in any one of those three buckets, but when you take the money out, it just gets taxed differently.
Tax-Deferred Account
With a Tax-Deferred account, you get a tax break now but then have to pay taxes on the money when you take the money out.
For example, if you’re in the 22% federal tax bracket and have a state tax rate of 5.75%, for every dollar you put into this account, you would save $27.75 in taxes and this money would then grow tax-deferred until you take the money out.
Let’s say at retirement, the person falls into the 22% federal tax bracket and have a state tax rate of 5.75%, for every additional dollar you take out of your tax-deferred account, you would pay $27.75 in tax until you reach the next federal tax bracket of 24%. Tax rates could change in the future and the current federal rates are expected to go back to the previous rates in the year 2026.
If you’re closer to retirement, a tax-deferred account could make more sense since the account doesn’t have the time to grow to benefit from the Tax-Free bucket.
Tax-Free Account
With a tax-free account, you don’t get a tax break now but then you don’t have to pay taxes on when the money is taken out. For example, if a person is in the 22% federal tax bracket and has a state tax rate of 5.75%, for every dollar they put into a tax-free account, they would not save $27.75 in taxes, but then this money would then grow tax-free for as long it is in the account.
Let’s say at retirement, the person falls into the 22% federal tax bracket and has a state tax rate of 5.75%, for every additional dollar you take out of your tax-free account, you would pay $0.00 in taxes and all distributions don’t get counted toward Adjusted Gross Income which Medicare Part B premiums are calculated from.
Taxable Account
A taxable account is an account that is not designed for retirement but to have you’re money grow more than a checking account or a certificate of deposit. So there is no penalty for taking the money out of before 59 1/2. You just have to pay taxes on the growth if you make a certain amount.
The tax implications on a taxable account fall into two categories:
Short-Term Capital Gains: Are investments that are held less than 366 days. Any growth is then taxed at the highest tax bracket you’re in. So if your salary as a single filer is $50k, then you would most like have to pay 22% federal taxes on the growth.
Long-Term Capital Gains: Are investments that are held for more than 366 days. If you fall into the 12% tax bracket or lower, you pay 0% in tax, if you are between the 22% and 35% tax bracket, you will pay 15%, and Latinos in the 37% tax bracket will pay 20%.
The idea is that you want to have tax diversification among your investments and you want a certain amount in each pot. This is where tax planning is really helpful so that you can have the lowest effective tax rate and keep more of the money that you earned.
Not Rolling Over Your Employer’s Retirement Plan Into Another Account And Just Taking The Money Now
No one is really staying at their current job until they retire in this new economy. And usually, their old company is telling them that they either need to take the money as a distribution, rollover the money into an IRA, or rollover the money into their new company’s retirement plan.
If you decide to take the money as cash, this is going to be considered a distribution, where if you’re under 59 1/2 years old, you then have to pay taxes and a 10% penalty on that distribution.
If you live in Virginia and are in the 22% federal tax bracket, have a state tax rate of 5.75%, and have $10,000 in an 401k at your previous company and choose to take the money. You’re not going to get the $10,000, you’re going to get $6,225.
You also lose out on all the future growth of that $10,000, which is supposed to help you with your retirement.
If you’re going to rollover the money into a different account. You can choose between your company plan or you can open an IRA. Here are some pros and cons between the two:
Company Plan Pros:
- Low Fees
- Could have access to institutional shares that have low fees
- Can avoid taking required minimum distributions at age 70 1/2 if you’re still working
Company Plan Cons:
- Limited investment choices
- Can have overlapping investment if you have multiple accounts
- Limited bond options
- Less flexibility with withdrawals
- Estate planning can be difficult to execute
IRA Pros:
- Can take advantage of Roth Conversions
- More access to a vast array of investment choices
- Estate planning is easy to do with an IRA
IRA Cons:
- Have to take an RMD at 70 1/2 for a Traditional IRA
- Might not be protected in a lawsuit or bankruptcy
- A broker could convince you to rollover your funds into an inappropriate financial product
Not Taking Advantage Of A Taxable Account
With inflation hovering around two percent, any money outside of your emergency fund and your short term goal fund is losing money to inflation. If it’s money that you don’t need for a while but still want to grab the money before retirement, a good option is to open a taxable account.
These accounts are different from retirement accounts because there is no early withdrawal penalty and you can take advantage of long term capital gain taxes, which can be lower than the current rate you’re paying now.
This can be helpful if you expect to be in a higher tax bracket in the future. Plus if there is a loss with one of your investments, you’re able to write that loss off in your taxes while you can’t do that with a retirement account.
A taxable account is also very valuable when it comes to obtaining lower interest rates since you can use these accounts for collateral. I’ve seen interest rates cut in half because a taxable account was used collateral for a loan. You have to look at your current situation to see if a collateralized loan is right for you. This is just an option.
Not taking advantage of Roth Conversions
Right now with the current tax rates being at their all-time lowest until 2026, you might want to consider moving some of your tax-deferred money into the tax-free bucket.
If you’re young enough or don’t plan to touch your tax-deferred accounts, plus have money to pay for the conversion, a Roth conversion is something to consider.
A Roth conversion converts money that is tax-deferred to a tax-free account. The idea is that you have to pay taxes now on any amount that you converted. The mechanics of doing Roth Conversions can be tricky and you should consult a professional to help walk you through the process and to see if it’s the best option for yourself.
Taking Social Security Out At The Wrong Time
When it comes to social security, anywhere from 50% to 85% of your benefit is taxed. If you’re doing something like Roth Conversions, then social security is something that you most likely want to hold off on.
Most people want to take social security as fast as possible, but if you have other investments, you might want to dip into those accounts first so that you can have more guaranteed money in the future.
With social security, every year you delay in taking your benefit, you get an 8% increase in your benefit. This is a pretty great return to get and not 100% of the benefit is taxed.
There are a lot of factors to consider like health and other investments, which would determine the optimal time to start collecting. But if you collect too soon, then it can cost you money down the road.
Have A Plan
One of my favorite lessons is that one minute of planning can save you ten minutes in execution time. This is like getting a 1000 percent return on your time.
All these strategies require planning to fully maximize the benefits and some strategies you should focus more on than others. I’m so glad that I learned these lessons in my late 20s so that I can maximize my financial resources in the future.
One of the things that you want to control, is taxes because when you’re retired and not working, an increase in taxes can have a significant impact on your standard of living. To give yourself more security and less uncertainty, have a plan for your tax situation in the future.
Here are five strategies that you should be thinking about and hopefully they get you moving in the right direction. It is also wise to consult a professional if you’re going to implement any one of these tax strategies as well.
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