Here's What Happens When You Don't Have a Plan for Taxes in Retirement

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Whether you're nearing retirement or still have decades to go, it's never too soon to plan for all that retirement entails -- including personal finances. One factor that will impact how much you have to spend in retirement is the amount of taxes you pay. Your tax rate depends, in part, on whether you've created a plan. Here, we look at what could happen if you don't plan for taxes in retirement.

You dive into the unknown

Going into retirement without a tax plan is like trying to discover a shipwreck with no idea of where the ship might have gone down. You need direction, and the more concise your direction, the closer you'll be to your target.

It's relatively easy to estimate how much income you'll have during retirement. You factor in guaranteed payments like Social Security and pensions and then add the required minimum distribution (RMD) from certain retirement plans, rental income, annuities, part-time jobs, and other sources of income.

If you haven't planned for taxes in retirement, it's much more difficult to estimate how much money you'll actually have to spend each month. Here's a small sample of what you may not be aware of:

• You'll receive an extra standard deduction: Once you turn 65, you'll be eligible for a larger standard tax deduction than younger taxpayers. For example, this year, the standard deduction for single taxpayers age 65 or older is $1,850 higher than the deduction enjoyed by those under 65.
• It's possible to earn too much: The U.S. federal income tax is progressive, meaning our tax rates increase as earnings increase. Let's say you plan to work part-time throughout retirement. Unless you know how close you are to the tax bracket above yours, you won't know if the money you're earning pushes you into a higher tax bracket and leads to higher taxes.
• It's difficult to budget without hard numbers. Without a tax plan, you won't know how much to expect to pay in taxes or how much you'll have left to work with. It's difficult to plan a realistic retirement budget without those figures.

You may fall short financially

Part of planning for retirement is diversifying your income, so you can invest some of the money in tax-free and low-tax investments. The immediate goal of investing is to make money, but another worthy goal is to invest so that you won't be slammed with taxes in retirement. These four account types each carry a unique tax advantage.

Tax-deferred account

Tax-deferred accounts include 401(k)s, 403(b)s, and traditional IRAs. Each reduces your taxable income the year you make the contribution and isn't usually taxed until you withdraw it in retirement. If you're in a lower tax bracket in retirement than you were while employed, you'll end up paying less in taxes.

Roth account

Unlike tax-deferred accounts, money contributed to a Roth 401(k) or Roth IRA consists of after-tax dollars (in other words, you've already paid taxes on it). However, when you withdraw the money in retirement, you don't owe taxes.

Health savings account (HSA)

If you're covered by an eligible high-deductible health plan at work, your employer may offer an HSA.

What sets HSAs apart is that any money you contribute rolls over into the next year and continues to grow tax free. Just as your HSA covers qualified medical expenses tax free while you're still working, it will cover those expenses tax free at age 65 and beyond. However, money withdrawn for any other reason is taxed as regular income.

One final nice thing about these health savings accounts: HSAs are exempt from RMDs.

Taxable accounts

When you invest in a traditional bank or brokerage account, you do so with after-tax dollars. With a brokerage account, you can contribute or withdraw money for any reason without penalty. You can also sell securities without paying a penalty. While investments sold for a profit are subject to capital gains taxes, if you sell at a loss, you may be able to offset gains up to $3,000 of ordinary income. Taxable accounts are also exempt from RMDs.

Even something as simple as living in the wrong state can cause you to fall behind in retirement -- unless you plan for it. While the majority of states do not tax retirement income at the state level, others do. Some states offer reasonable property tax rates, while others are through the roof. Failing to plan for taxes in retirement may mean not knowing what to expect from your home state.

You're likely to have regret

If you would rather have a root canal than explore retirement tax plans, you're not alone. However, if you decide not to plan, you're more likely to regret it. Here are just a few of the regrets you could be stuck with:

• Why didn't I move to another state while I was able to do it?
• I wish I had more money to leave to my family or the causes I believe in.
• Think of all the money I could have invested in a 401(k) during my working years!

Planning may point out where you're falling short, and if you're still working, give you time to turn things around. After all, it's about keeping as much money in your checking account as possible.

Is tax planning ever fun? Nope. Will you have a good time buying tax prep software and really digging into it? Probably not. But that's okay -- that's where a good tax professional can help. A professional can help you identify ways to save money today and throughout retirement. The more planning you do now, the more money you're likely to have in the future.

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