If asked to list your retirement expenses, you'll probably remember housing, food, transportation, and even recreation. But there's a lot more to retirement costs than just these everyday things.
Irregular expenses — those you only pay once or twice per year or every few years — are important, too, but can easily slip through the cracks. One, in particular, can derail your budget if you're not planning for it right now.
Your retirement savings don't just belong to you
While you're working, taxes come out of your paycheck every month, unless you're self-employed. At tax time, all most people have to do is file a return and they receive a refund check from the government. But that's not how it works for retirees.
Most seniors will still owe some taxes on their retirement savings, and because they're no longer earning a paycheck, they must remember to set aside these funds on their own. It's not too difficult if you planned for taxes before you retired, but if you forgot, you could drain your retirement savings faster than you anticipated.
The average household headed by an adult 65 and older has an annual income of $55,656, according to the latest Bureau of Labor Statistics Consumer Expenditure Survey. But about $6,211 of that goes to taxes, leaving just $49,445 to cover other expenses.
This is just an average and may have little bearing on your retirement scenario, but it shows that taxes can take up a sizable chunk of your savings. This is particularly true for higher-income retirees.
If you fail to plan for taxes, there isn't much you can do about it once you're retired, other than cut your expenses. Planning before you retire is key to keeping your retirement savings on track.
How to hold onto more of your retirement savings
Planning for retirement taxes begins with choosing the right place to house your savings. While there are many retirement accounts, they all fall into one of two categories: tax-deferred or Roth.
Tax-deferred account contributions reduce your taxable income this year, but then you pay taxes on your withdrawals in retirement.
Roth account contributions don't give you a tax break this year, but because you pay taxes upfront, you can enjoy tax-free distributions in retirement. The type of account that's best for you depends on how you think your taxable income today compares to your taxable income in retirement.
So, which account should you choose?
Those who believe they're in a higher tax bracket today than they will be in once they retire could save more by delaying taxes until retirement, while those who think they're in the same or a lower tax bracket today should consider paying taxes upfront if they have access to a Roth account.
It's theoretically possible to avoid all retirement taxes by keeping all your money in Roth accounts, but this isn't the case for most retirees. If you keep any savings in tax-deferred accounts, you need to start planning for tax bills in retirement.
You can use your estimated retirement expenses and the current tax brackets to help gauge what you might owe. But tax brackets change over time, so review your retirement plan periodically to ensure you're still saving enough.
If you've been contributing to tax-deferred accounts but you think Roth accounts might be the better fit for you, you can always consider a Roth IRA conversion. This is where you pay taxes on some of your tax-deferred funds this year in order to change them into Roth funds. Before you do this, look at where you're at in your current tax bracket and avoid jumping up to the next one if you can. It might be better to do several smaller Roth IRA conversions over a few years rather than one large one this year.
Those who have both tax-deferred and Roth savings also have to decide how they'll withdraw their money in retirement. You may choose to use your tax-deferred withdrawals until you approach the top of your tax bracket and then use Roth savings for the rest of your expenses. Or you could try a proportional strategy. For example, if you had 70% of your savings in tax-deferred accounts and 30% in Roth savings, you would withdraw 70% of the funds you need for the year from your tax-deferred accounts and 30% from your Roth accounts.
You never know exactly how much you'll spend annually in retirement, so you may not get your tax estimates exactly right. But as long as you're mindful of the fact that you'll likely owe taxes in retirement and you budget for them along the way, you can probably avoid major financial deficits in your senior years.
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