One of the hardest truths about retirement planning is that all that money you've been saving over the years isn't yours. Most of it is, but you're probably still going to owe the IRS a share in retirement.
But don't let this get you down; start planning instead. Here are three tips that can help you hold on to as much of your hard-earned cash as possible.
1. Choose the right accounts for your money
Retirement accounts are the best place for your savings because they offer tax advantages that taxable brokerage accounts don't. If you contribute to a traditional IRA or 401(k), you'll get a tax break this year. But you owe taxes on your retirement withdrawals. Or you can choose a Roth account. This won't give you a tax break when you make contributions, but you get tax-free withdrawals in retirement.
The right account for you depends in part on how you think your tax bracket could change between now and retirement. If you think you'll be in a lower tax bracket in retirement, tax-deferred accounts are a better choice. But otherwise, Roth accounts will probably help you save the most.
Each account has annual contribution limits and rules, so make sure you understand these before deciding where to house your money. And don't put anything into a retirement account that you plan to spend before 59 1/2. You'll pay a 10% early withdrawal penalty in most instances for withdrawing retirement funds before this age.
2. Convert to Roth IRAs
All retirement accounts have required minimum distributions (RMDs) except for Roth IRAs. These are mandatory annual withdrawals most seniors must take beginning in the year they turn 72.
You can also convert savings from other retirement accounts to Roth savings to avoid RMDs and taxes on your earnings. But to do this, you must pay taxes on the amount you're converting in the year you do it. This is known as a Roth IRA conversion.
For tax-planning purposes, it's usually easiest to wait until the end of the year to do this. Look at where you are in your current tax bracket and try to avoid jumping up to the next one. You might have to spread your Roth IRA conversions out over a few years to convert all your savings without paying a fortune in taxes.
In addition, Roth 401(k)s have RMDs, despite these funds being taxed the same as Roth IRAs. But if you roll your Roth 401(k) funds over into a Roth IRA, you won't have to worry about taking RMDs from your Roth 401(k) at all. You can leave your money to grow for as long as you'd like and even pass it onto your heirs if you don't need it.
3. Borrow money instead of taking early retirement withdrawals
When you need cash, an early retirement account withdrawal isn't your best move. You'll pay a 10% early withdrawal penalty if you're under 59 1/2, unless you have a qualifying reason, like a large medical expense. You could also face taxes if the money came from a tax-deferred retirement account.
Borrowing from your 401(k) is a little better if your plan administrator allows it. You won't owe taxes on your withdrawals as long as you pay them back with interest in an allotted time frame. But doing so still shrinks your retirement savings, and you'll have to save more per month going forward to get yourself back on track.
Ideally, you should avoid taking any money out of your retirement account until you're actually retired. Whenever possible, see if you can save up for an expense over time or try to get a loan instead. If an early withdrawal is the only option, take out as little as possible to minimize the effect on your taxes.
Most of us aren't going to be able to avoid taxes on our retirement savings completely, but once you understand how the IRS taxes retirement accounts, it's not too difficult to figure out how to keep them to a minimum. Check in with yourself every year to look for more opportunities to save.