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Achieving Tax Freedom in Retirement

By Roberta L Nestor

For Connecticut residents,“Tax Freedom Day” has come and gone.  That is the date each year that represents when we have worked enough to fully pay all our federal and state income tax liabilities for the calendar year.  In our state, working individuals achieved tax-freedom on April 25th of 2021.  Tax Freedom Day is specific to those who are still in the workforce.  But how and when can retirees achieve tax freedom?

That would depend on how you saved before retirement.  Were your retirement contributions pre-tax or after-tax?  Roths were introduced as a part of the Taxpayer & Relief Act of 1997 and was named after Senator William Roth.  Back then there was a cap of $3,000 for Roth contributions, today that cap is $6,000 – if your income is within IRS limits.  Roth 401k plans were allowed in January of 2006; however, most employers were slow to make them available to employees.  Today, approximately 70% of employers have the Roth option available.

Picture a retirement without having to pay taxes on your income!  Every dollar of your contributions and their earnings would be completely free of state and federal taxes.  The big question is, is it better to pay taxes now, while you are working, or would it be better to pay taxes during retirement?  Today, most of us have a choice of paying now or paying later.

One of the most common myths about retirement is that you will be in a lower tax bracket.  Historically, tax brackets are based on whatever your income is, regardless of whether you are retired.  Separate tax tables for retirees do not exist.  So, will you be in a lower tax bracket at retirement?  You could, it is an unknown, and dependent on what our tax brackets will be in the future.  If you have saved well, and if you want to maintain the same lifestyle, chances are you will still be in the same tax bracket.

According to the Congressional Budget Office, our present tax rates are historically low.  The Tax Cuts and Jobs Act that was effective for tax years starting in 2018 will expire at the end of 2025.  Now would be a great time to pay taxes on contributions to your retirement plan.  Maintaining a high level of tax-deferral is an unknown liability because we do not know what future tax rates will be.

Also consider the many tax consequences for retirees when they are taking income from traditional tax-deferred retirement plans.  Hefty withdrawals can impact the taxation of social security, Medicare premiums or even push up your tax bracket.  Because of the new “10 Year Rule,” tax-deferred inheritances further impact taxes for your children when they ultimately inherit.

The good news is this is not an all or nothing decision.  For example, you can elect to have 50% of your retirement contributions as pre-tax and the other half as a Roth contribution.  This can eliminate some of the risk of being in a higher bracket during retirement.  You can change the election and allocation anytime.  Contributing all or a portion of your 401k to the Roth does not interfere with your employer match.  You will receive your match (tax-deferred) regardless of how you designate your own contributions.

We understand investment diversification, now it is time to start understanding tax diversification.  Tax diversification can enhance your retirement income and help you to achieve your own “Tax Freedom.”

Roberta L. Nestor is a financial advisor practicing at 759 Boston Post Road in Milford, CT offering retirement, long term care, investment, and tax planning services.  She offers securities and advisory services as a Registered Representative and Investment Adviser Representative of Commonwealth Financial Network – a member FINRA/SIPC and a Registered Investment Adviser.  Fixed insurance products offered through Nestor Financial Network are separate and unrelated to Commonwealth.  Commonwealth Financial Network or Nestor Financial Network does not provide legal or tax advice.  You should consult a legal or tax professional regarding your individual situation.  Roberta can be reached at Nestor Financial Network, 203-876-8066 or roberta@nestorfinancial.com.

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