If You Don't Watch Out, These 3 Tax Issues Could Blow Up Your Retirement

No matter how you save your money — whether you go for a retirement fund, mutual fund or another method to build up your nest egg — you know the IRS will eventually want its cut. 

You may have a hazy idea that you need to protect your money, but without understanding exactly how to do it, it's also possible to let tax issues slide. If you don't have an accountant to help you with tax advice, it's possible that you could end up making some tax mistakes. 

Here's an example of a possible scenario: Let's say that as you move toward retirement, you still don't have your house paid off, little in personal savings but you've spent years plumping up your 401(k) at work. Let's say you have $2.5 million accumulated in your 401(k). An advisor informs you that you'll be taxed at the highest rate and after you take a tax hit, your $2.5 million will become $1.7 million instead.

Let's take a look at how certain factors, such as retirement savings and your home, could get you into some serious tax trouble later down the road. We'll also discuss what you can do about it.

1. Traditional IRAs and Qualified Retirement Plans

When you have money stashed away in an IRA, 401(k) or another qualified retirement plan, you have to pay income tax on the money you've put in, which can drastically reduce the amount you put into your nest egg. 

You may be tempted to leave the money alone for the majority of your retirement years, but unfortunately, according to the required minimum distributions (RMDs) rule, you must withdraw money from your account starting at age 72. Once you reach that age, you don't have a choice: You have to withdraw money from your account or you must pay tax on it. 

What You Can Do

If you have time on your side, consider both Roth IRA and Roth 401(k) plan options. You can save after-tax money in a Roth IRA and Roth 401(k) — distributions come out of your retirement savings account tax-free after age 59 ½. 

Do all employers offer a Roth 401(k)? No. However, anyone can use a Roth IRA for their purposes. All you need to do is access your already-existing brokerage account or open a new brokerage account if you don't already have one. 

2. Your House

When you decide to sell your home, your primary residence may also give you some tax challenges. The capital gains exclusion gives you massive tax breaks when you sell your home. You'll get a break on the first $250,000 as a single tax filer and $500,000 as a joint filer. In other words, if you saw gains from from $200,000 to $450,000 as a single homeowner, you wouldn't pay any capital gains taxes on the sale of your home. (Unlike paying taxes on capital gains distributions, this option offers a major boon for homeowners.)

Here's the deal, though: The exclusion only applies if you use the home as your principal residence during at least two of the five years preceding the sale. You can also follow specific rules that reduce that requirement to just one year if you find that you need to go into long-term care in a nursing home or other type of facility. However, if you don't meet the requirements, the exclusion can go away completely. In addition, if you switch the home over to a rental property, you may have to pay taxes during the period of time when the home becomes nonqualified. 

What You Can Do

If you want to keep the capital gains exclusion, so keep your home as your primary residence. In addition, you could sell it before it becomes a major tax burden. 

3. Managing Your Money

What are some other ways you can protect your money? Let's take a look at a few, jumping off with what you can do right away: 

• Consider purchasing a qualified longevity annuity contract (QLAC). In other words, you can purchase this insurance product that pays you at any age you choose (usually 80 or 85). You can also defer expenses until you receive QLAC payments. The income you receive can start later than age 70 ½, which reduces your RMDs and associated taxes.
• Consider purchasing fixed and variable deferred annuities. Withdrawing money from deferred annuities means you could move the accumulated value of these deferred annuities into an income annuity that pays regular, guaranteed income. The IRS will exclude a portion of the payment from tax. 
• Stay employed. Some 401(k) plans allow you to delay withdrawals from your account if you stay employed into your 70s or later and don’t own 5% or more of the company sponsoring the retirement plan.
• Look for the Saver's Credit before you retire. You can claim the credit for 50%, 20% or 10% of the first $2,000 you contribute to a retirement account during any given tax year. You can claim a maximum $1,000, $400 or $200. In 2021, the maximum adjusted gross income for Savers Credit eligibility is $66,000 for a married couple filing jointly, $49,500 for a head of household and $33,000 for all other taxpayers.

This list doesn't include all the ways in which you can manage your tax-friendly money, but it can give you a jumping-off point to understand how you can finagle more money into your pocket. 

Understand Taxes Before You Retire

Many retirement calculators don't calculate the taxes you'll have to pay during your golden years, which means that many individuals have no real concept of how taxes actually work or how much your money is actually worth upon retirement. 

When you underestimate the impact taxes may have on your retirement distribution strategy, your entire retirement plan may contain a lot of added risk. When you build your actual distribution plan early on in life (and even in middle age or close to retirement), you want to apply tax strategies directly to your situation so you can keep more of your hard-earned money right where it belongs — in your pocket.