As we approach retirement, most of us are seeking the answers to lots of questions: “Do I have enough saved?” “Should I stay in my home or downsize?” “What’s the best strategy for claiming Social Security?” And there are many others.
One important question that all who are approaching retirement should consider is how taxes will impact their retirement income. Especially since most retirees are “spending down” their retirement nest egg, making it last as long as possible is a high priority. So, the more you can minimize the “tax bite,” the longer you’ll be able to depend on your nest egg to take care of your needs.
Now, most tax advisors will tell you that it’s not a good idea to let the tax “tail” wag the investment “dog”; you should strive for good performance with your investments, and as we all know, when you make money, you must pay taxes. But there are some things you can do to prepare yourself to make better and more tax-efficient decisions about your retirement income that can help you avoid paying more than your fair share.
Know how different income sources are treated by the IRS.
Many retirees have multiple sources of retirement income: Social Security, pensions, annuities, tax-favored and taxable investment accounts, and even passive income from a business such as rental real estate. As we have written previously, each of these income types is subject to differences in tax treatment, and the more you know about the specifics, the more you can strategize about which “buckets” to utilize for income in order to maximize tax-efficiency. For example, your Social Security benefits are only taxable up to a maximum of 85%, and if you make less than $44,000 per year as a married couple, the rate is less. On the other hand, retirement distributions from Roth IRA or 401(k) accounts are tax-free, since the account was funded with after-tax dollars. Retirement income from traditional IRAs and 401(k)s, however, is taxed as ordinary income, since these accounts are funded with pre-tax dollars. If you sell an investment in a taxable investment account for more than you paid for it, and if you held the investment for a year or more, you will owe long-term capital gains tax at the rate of 0, 15, or 20%, depending on how much other income you have. For those in higher tax brackets, capital gains tax may be less than the tax paid on ordinary income. Qualified dividend income is also taxed at the same rate as capital gains, depending on your income. Short-term gains (on investments held less than a year) and unqualified dividends are taxed at your ordinary income rate.
Try to let your tax-advantaged accounts grow as long as possible.
While you should consult with your financial advisor about the specifics of your situation, it may be to your advantage to allow your tax-favored investments to compound and grow as long as possible, since they have the advantage of no taxation. The longer you can allow them to grow, the better positioned you’ll be when it’s time to begin withdrawing from them for retirement income.
Think ahead on RMDs.
When you reach a certain age (73 for those born before December 31, 1957, 75 for those born later), you must begin taking required minimum distributions (RMDs) from your traditional tax-favored accounts, such as IRAs, 401(k)s, and 403(b)s. Because this income is not coming from a Roth account, it will be taxed as ordinary income. Depending on your level of income from other sources, your RMDs could push you up into a higher tax bracket. This means that it’s important to work closely with your financial and tax advisors to form a strategy for taking the income in the most tax-efficient way possible. For example, you might want to start drawing down your tax-favored accounts before your RMDs kick in, to allow you to spread the payments over a longer period of time.
Consider a Roth conversion.
A Roth conversion is the process of moving (pre-tax) money out of a traditional IRA into a Roth account. You pay taxes on the amount of the exchange, in return for never having that money taxed again, either as the Roth account grows or when you take the money out in retirement. But the mathematics around these conversions can be a bit tricky. Is it better to pay taxes now vs. when the money comes out? The traditional (and rather simplistic) rule of thumb has been: if your tax rate in the future will be higher than it is today, then this move will save you money. If not, then it will cost you money. If the rates are the same, then the Roth conversion will be an essentially neutral transaction, from a tax standpoint. The other benefit to a Roth IRA account is the absence of required minimum distributions (RMDs). With a traditional account, taxpayers must begin taking RMDs by age 73, which can sometimes thrust them into a higher tax bracket. But with a Roth IRA, there is no RMD requirement; account holders can leave the money in the account as long as they wish.
At The Planning Center, we know that our clients are seeking better ways to make their retirement income stretch as far as possible; this includes tax planning that takes retirement income strategies into account. If you have questions about how taxes could affect your retirement income, please get in touch with us; we want to help you look for the answers you need.
