It's a shame to see senior citizens save and invest responsibly all their lives, and then end up giving away a large chunk of their nest egg in the form of taxes -- especially unnecessary taxes. Here are three mistakes that could cause you to pay more taxes than you need to, and what you could do instead.
What to do with your 401(k) or traditional IRA?
After retirement, senior citizens have several options with their employer-sponsored retirement plans like 401(k)s. Perhaps the worst of these is to take a lump sum distribution. Furthermore, the same can be said about other tax-deferred retirement accounts like traditional IRAs.
Now, if you're over 59 1/2 years old (or 55 if you're no longer working), it's true that you can probably take all of your money out of the plan without paying a penalty. However, keep in mind that the money you take out of the plan is added to your taxable income for the year, and a lump sum distribution could put you in a sky-high tax bracket.
For example, if you are married and you and your spouse have 401(k) accounts worth $500,000, a lump sum withdrawal would put you in the highest (39.6%) tax bracket. Even if you had no other income, this means that more than $144,000 could be taken (or about 29% of the total) right off the top.
On the other hand, if you simply withdrew $50,000 per year, you would find yourself in the 15% tax bracket, and lose a lot less of your hard-earned money to the IRS.
You have several other options, and all three are better ideas than a lump sum. You could:
- Leave the money in the plan and withdraw as you need the money.
- Buy an annuity with the money and have guaranteed income for life.
- Roll the money over to an IRA, giving you more flexible investment options.
Watch out for gift taxes
Many senior citizens start to give away their money later in life, so they can watch their loved ones enjoy it while they're still around. While this is a great idea, make sure you're aware of the gift tax you might have to pay. This is not an issue for most people, but if you have a large amount of assets, including what you plan on leaving to your heirs, it's worth paying attention to.
Currently, you're allowed to gift up to $14,000 per person each year without triggering the gift tax. This may sound like a generous exemption, but gifts over this amount are fairly common -- like a gift of a down payment to buy a house, for example.
Fortunately, there are some tricks you can possibly use to get around the $14,000 exemption. For example, if you're married, you can give this much from each spouse. In other words, a husband and wife could gift each of their children up to $28,000 per year. By the same logic, if any of those children are married, you could make a separate gift to your child and their spouse.
So, a couple could gift another couple up to $56,000 per year without exceeding the gift tax exemption. Or, you could spread a large gift over several years in order to stay under the cap. Even if the amount you give is over this amount, you won't have to pay a gift tax until your cumulative taxable gifts (to all people) exceed $5.43 million for your lifetime, including property you leave to your heirs.
Use your taxable funds first
When it comes to using your retirement savings, the order you use your accounts can make a big difference in how much you pay in taxes over the long run. Simply put, you want to leave your tax-advantaged accounts alone for as long as possible.
In other words, you shouldn't even touch your 401(k) or IRA until all of your savings in regular, taxable brokerage and savings accounts is exhausted. This is money that's subject to annual taxes on capital gains and dividends, and because of this, it grows slower than tax-deferred accounts.
Of course, once you turn 70 1/2, you're required to begin making withdrawals from your 401(k) and traditional IRA accounts, so these should be next in the withdrawal order. You want to let this money grow and compound tax-deferred for as long as possible, but the penalties for ignoring the required minimum distribution rules are harsh.
Finally, any money in Roth IRA accounts should be used last. Roth IRAs don't have any required minimum distributions, and not only does the money grow and compound without taxes, but your withdrawals are tax-free as well.
Don't give away any more than you need to
You've worked hard all your life building your nest egg -- why let taxes take a bigger bite out of your wallet than they need to? After all, saving money on your taxes now could mean more years of worry-free retirement later on.