4 Top Ways to Avoid Tax Pain at Retirement

Source: Thinkstock

Source: Thinkstock

Retirement costs money — an enormous, mind-boggling amount of money. Here’s a thought exercise for some context.

Imagine you are one of the lucky few college graduates that rolls out of the diploma mill and into a well-paying job, and at age 24 you’re earning a handsome $50,000 per year. Being financially savvy, you save 10 percent of your income each year. For the next 43 years, you remain consistently employed, you receive regular raises, your investments achieve satisfactory returns, and there are no financial catastrophes. This is about as good as it gets, and by age 67 you’re sitting on a nest egg worth nearly $1.4 million (keep in mind that this is a fantasy scenario for most Americans, who are woefully underprepared for retirement).

This, combined with Social Security (assuming it’s still around in 43 years), is the money that will be available to you through a retirement fund that is expected to last about 20 years. And to be clear, this is probably enough — well within the “comfortable” zone that is targeted by many financial planners, who advise people to replace at least 70 percent of their pre-retirement income in retirement. Those who are bullish tend to shoot higher, targeting closer to 100 percent of pre-retirement income or more, depending on how well investments are performing.

In this scenario, between the the two income sources, you’re still earning a six-figure income throughout retirement. And with the notable exception of Roth-style savings vehicles, most income sources in retirement are taxed. This includes withdrawals from a traditional tax-deferred 401(k) or IRA as well as Social Security receipts and most pension payments.

As at any interface with the Internal Revenue Service, savvy financial planners have developed strategies to reduce this tax friction. Just as ”most investors are familiar with the idea of maximizing their assets by minimizing taxes during their earning and wealth-building years,” says Ken Hevert, vice president of retirement products at Fidelity, “limiting taxes on those savings in retirement is equally important.” Here are some strategies outlined by Fidelity to do just that.