Planning for taxes in retirement can be a balancing act

Personal Finance. By Katherine Vogt, AMNews staff. May 8, 2006.

From owning a bicycle shop to starting a bed and breakfast, John C. Johnson, MD, an emergency physician in Valparaiso, Ind., hasn't been shy about putting his money into different types of investment vehicles.

When it came time for Dr. Johnson to start thinking about how he would draw income in retirement, he decided to follow the same philosophy -- put his money into different investment vehicles. And in doing so, he found a way to spread out his potential tax liability during those years.

"Essentially, with a little planning during the year we can pretty much peg the tax rate I'm going to pay" in retirement, he said.

Dr. Johnson's philosophy is echoed by financial advisers. They say that just as you need a balanced diet for a healthy life, you also need a balanced mix of income streams during retirement to avoid the heartburn of higher-than-expected taxes in your golden years.

The tax shock could come in a number of ways, even for those who have presumably done everything else right in preparing for retirement. Pretax contributions to plans such as 401(k)s become taxed distributions when you start withdrawing from them. You might not have mortgage and dependent deductions that helped lower your taxable income. And if you've sold your practice or your share of it, you now have a new source of income to be taxed.

There are different ways to achieve this balance, and each individual situation could warrant a different approach. But it is commonly done in part by making sure the person has a mix of money in traditional retirement plans, which provide a tax break at the time they are funded but whose distributions are taxed later, as well as some assets that have been funded with after-tax money and will not face income taxes upon withdrawal.