You work your entire career to save for retirement, so when you finally reach your golden years, you'll want to ensure your money lasts as long as possible.
One obstacle that could potentially throw off your entire retirement plan? Taxes. When you're saving for retirement, you may be thinking about how much you expect to spend each year or how much you'll be receiving from Social Security, but it's easy to forget about how taxes will impact your retirement fund. And if you're making any of these three common mistakes, your savings might be in jeopardy.
1. Not accounting for income taxes on 401(k) or IRA withdrawals
When you contribute money to a 401(k) or traditional IRA, the money is tax-deductible up front. But Uncle Sam wants his chunk eventually, so when you withdraw your savings in retirement, you'll typically need to pay income tax on that money.
Taxes can potentially wreck your whole retirement plan because if you're not accounting for them, you may end up withdrawing more than you should. Say you plan to withdraw a certain amount of money each year to pay all the bills in retirement, but then taxes reduce the amount you can actually spend. You may be forced to pull more from your savings than you'd planned just to make ends meet. Even if you overspend by only a few thousand dollars each year, the result could be you run out of money much sooner than you expected.
To account for income taxes in retirement, the first thing to figure out is whether your state levies taxes on retirement income. All states have slightly different laws regarding taxes, so you could have to pay more or less depending on where you live. Next, consider what tax bracket you'll be in once you retire. If you don't expect your spending to shift much after you retire, your taxes will probably look much as they do now. But if you expect to spend a lot more in retirement, plan to receive a heftier tax bill.
2. Forgetting about taxes on Social Security benefits
Unfortunately, it's not just your retirement account withdrawals that can potentially face taxes -- Social Security benefits may be taxed as well. Some states impose a state tax on benefits and depending on how much you're earning (both in benefits and in outside retirement income), you could face federal taxes on your benefits as well.
To determine how much of your benefits will be taxed at the federal level, you'll need to know your combined income, which is half your annual benefit amount plus any other retirement income -- like retirement account withdrawals or income from a pension. You can only avoid paying federal taxes on your benefits if your combined income is less than $25,000 per year (or $34,000 per year for married couples filing taxes jointly).
If you're earning more than $34,000 per year in combined income (or $44,000 per year for married couples), you could face federal taxes on up to 85% of your benefits. The good news is that no matter how much you're earning, you won't pay taxes on more than 85% of your benefits. But if you're not planning for that expense, taxes could throw off your retirement budget.
3. Not understanding how required minimum distributions work
Required minimum distributions (RMDs) are the amount you must start withdrawing from your 401(k) or traditional IRA once you turn age 72. The reason RMDs exist is that with tax-deferred accounts like 401(k)s and traditional IRAs, you don't pay taxes on your savings until you start withdrawing that cash. And the Internal Revenue Service wants its money eventually, so if you're not already making withdrawals by age 72, you're required to start so the IRS can collect taxes.
Failing to begin taking RMDs can result in some hefty consequences, too. If you don't withdraw enough money, you'll be slapped with a 50% penalty for the amount you should have taken out. So, for example, if you have an annual RMD of $40,000 and you don't withdraw anything from your retirement account, you'll face a fine of $20,000.
Even if you do take your full RMD, timing is important if you want to avoid high taxes. When you take your first RMD, you have until April 1 the year after you turn 72 to make your withdrawal. For every RMD after that, you need to make your withdrawals by Dec. 31 each year. So if you wait until the last minute and take your first RMD in April, you may need to take another RMD before the end of the year. With two RMDs in one calendar year, that could push you into a higher tax bracket and result in significantly higher income taxes.
Taxes can put a damper on your retirement if you're not prepared for them, so be sure to do your research and figure out what types of taxes you may be subject to. The more thoroughly you prepare, the more enjoyable your retirement will be.