If you’re a professor with a university retirement account containing hundreds of thousands of dollars, you have a great start on a successful retirement. But most, if not all, of that money is likely taxable after your retirement, possibly leaving you with less than you may have been anticipating.
But there are steps you can take to reduce the tax liability on your retirement savings.
Professors have access to three types of tax structures, or as we like to call them, savings buckets:
- the “pre-tax” bucket, into which the majority of university retirement plans fall
- the “tax-free” bucket, perhaps a Roth account, and
- the “capital gains” bucket, which is for equities and other assets
At most universities, professors contribute to a retirement plan, and the university may match a certain percentage of the contribution. Both are considered pre-tax, and none of that money hits the person's tax return in that year. It compounds tax-deferred. When that money comes out of the account, in retirement, it will be subject to state and federal income taxes. Generally what we see if someone has accumulated $1 million, 90 percent of that is going to be in a pre-tax retirement account, and the remainder is going to be in a bank account or maybe some side mutual funds.
Therefore, at retirement, there's not much flexibility. If the family needs $100,000 a year, most of that $100,000 is going to come out of the retirement plan, and income taxes will be assessed. If the professor needs more money because of health issues, because of a change in residence, or some other emergency or opportunity, withdrawing another $50,000 may put him or her in the next higher marginal income tax bracket. That means it becomes more expensive to take that money out.
Investments not in the tax-deferred university retirement plan and not in the tax-free bucket go into the capital gains bucket. When assets in this bucket are sold at a gain, a capital gains tax is assessed. In most cases, this will be less than the ordinary income tax assessed on distributions from the university retirement plan.
However, if there are funds in the tax-free bucket (like a Roth plan), professors can take the money out and there is no tax.
Professors have been advised over the years to defer, defer, defer. They were told when they retired, taxes would be lower than at the time the money was banked. No one told them that the government could change the tax brackets, so their income might be less but the brackets might be higher. That's a trap that can be very expensive to fall into. But there is a way around it.
If you're in the position today of having $1 million saved, with $900,000 in a retirement account, and you plan on working another five years, some steps for you to consider include:
- bypass the tax deduction for the upcoming year for additional contributions into the retirement plan other than the mandatory, or
- take some excess savings and use your university's Roth plan or some other after-tax account.
Now is the time to consider ways to reduce what could otherwise be a difficult tax burden in retirement.