As a retiree, the last thing you want to worry about is paying out a big chunk of your fixed income to the IRS. Unfortunately, many different sources of retirement income could be taxable, including distributions from your retirement account as well as some of your Social Security benefits.
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The key words there, though, are "could be." Taxes don't have to be a part of your retirement reality if you make certain decisions throughout your career. Recent research from Fidelity, however, shows that very few people are taking advantage of a key technique to avoid owing taxes as a retiree.
A minority of Americans are making this tax-savings move
This tax-saving technique most Americans aren't taking advantage of is investing in a Roth 401(k). Just 12.5% of people who are offered this type of account are making contributions to it, according to Fidelity.
That could be a huge mistake. Roth 401(k)s work differently from traditional 401(k)s. While a traditional 401(k) allows you to contribute pre-tax money, you'll owe taxes on withdrawals as a retiree. With a Roth, you contribute with after-tax dollars but take tax-free withdrawals, deferring your tax savings until later in life.
Now, some people may prefer to take advantage of the up-front tax break, especially high earners who assume they'll be in a lower tax bracket in retirement than at the peak of their earning power. However, by historical terms, tax rates are relatively low right now and are unlikely to change in the coming years due to Washington gridlock. Over time, it's likely tax rates will go up rather than down, due to sizable government debt and a growing focus on addressing income inequality through the tax code. And many people don't actually reduce their take-home pay that much as retirees.
Reaping the tax rewards
That means even those in the peak of their earning power should seriously consider whether there's sound reason to believe they'll actually end up in a lower tax bracket in retirement. Unless there is, you will likely end up far better off deferring your tax savings rather than opting to make pre-tax contributions to a traditional account.
Especially since there's also another factor to consider: The impact that switching to a Roth could have on your Social Security.
Retirees won't have to pay tax on Social Security benefits until their provisional income hits $25,000 as a single filer or $32,000 as a married joint filer. Once income reaches that level, singles could be taxed on up to 50% of their benefits with a provisional income between $25,000 and $34,000, and on up to 85% of their benefits once their income exceeds $34,000. Married joint filers could be taxed on up to 50% of their benefits with income between $32,000 and $44,000, and on up to 85% of benefits once their earnings exceed $44,000.
Provisional income isn't all income, though. It's half of Social Security benefits plus some nontaxable interest income, plus all taxable income. Distributions from a traditional 401(k) falls into the category of taxable income, so they count in determining if you'll owe taxes on your Social Security benefits. But distributions from a Roth 401(k) won't.
That means contributing to a Roth 401(k) instead of a traditional 401(k) allows you to avoid taxes on your investment account distributions and make sure your Social Security is tax-free. If your Social Security checks and 401(k) distributions are your only sources of income, you could end up with a virtually tax-free retirement. Yet just 12.5% of Americans who have this opportunity are taking advantage of it. That could end up being a costly mistake.
Of course, not everyone has access to a Roth 401(k). The good news, however, is that almost anyone can contribute to a Roth IRA (provided your income isn't too high). So you can still have the opportunity to make contributions to a retirement account that will keep the IRS far away from your retirement funds. It's an opportunity you should seriously consider.