One big misconception a lot of people have about retirement is that they won't have to pay a lot of taxes. In reality, there are many different income sources that the IRS could get a piece of.
For example, dividends you receive in a regular brokerage will be taxed, and you'll face capital gains taxes if you sell investments at a profit. And if you have your retirement savings in a traditional IRA or 401(k) plan, those withdrawals will be taxable as well. Even your Social Security benefits may be taxable, depending on your situation.
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The good news is that there's an easy way to set yourself up with tax-free income in retirement. But in some cases, you may need to plan for it ahead of time.
Rely on a Roth retirement plan
Roth retirement plans aren't funded on a pre-tax basis like traditional retirement accounts. But they offer the benefit of tax-free gains and withdrawals.
Here's the catch, though. It's not a given that you'll be able to fund a Roth retirement plan directly.
If you income is too high, you're barred from contributing to a Roth IRA. And if your company doesn't offer a Roth 401(k), or a retirement plan at all, for that matter, then that, too, is off the table.
You can, in situations like these, contribute to a traditional retirement account and do a Roth conversion so you're able to withdraw from your savings later in life without having to pay taxes on that money. But a Roth conversion is something you need to time very carefully.
Be strategic with your Roth conversion
When you do a Roth conversion, the money you move over counts as taxable income that year. That could have huge implications.
For one thing, a Roth conversion could propel you into a higher bracket. But it could also impact your finances down the line.
If you do a Roth conversion this year with plans to sign up for Medicare in two years, you could face surcharges on your Part B premiums due to your 2026 income reaching a certain level. So it's important to plan for a Roth conversion carefully. And if you're looking to move a large sum of money into a Roth, you may want to spread it out over several years to minimize the tax impact.
But all told, if you like the idea of avoiding taxes on at least some of your retirement income, it pays to find a way to save in a Roth account. You may not be able to contribute directly, but that doesn't have to stop you as long as you plan accordingly.
