For most retirees, taxes are the largest expense in retirement. The tax code is long and confusing, but the good news is that there are strategies to keep more of your nest egg. In this article, I discuss the exact steps we take with our clients to reduce their tax bill in retirement.
Brennan Decima
I recently met with a couple who had decided to retire this year. The husband is 58, and had recently moved his mom into memory care. His mom’s decline had caused him to really reflect on what was important to him. He had postponed traveling for years, and wanted to take advantage of his good health while he was still capable. His wife, had turned 55 earlier this year and decided she didn’t want her husband having all the fun without her. As we started to look at the statements, it was clear they had done a wonderful job preparing for the next chapter.
The majority of the nest egg was held in he and his wife’s 401k, and they were worried about the impact of penalties and taxes on their retirement planning. The couple’s main objective for our meeting was to discuss how to lower taxes in retirement.
Fortunately, I have helped thousands of retirees reduce their tax bill in retirement. There are many ways to do this, as long as you understand how the tax code works.
In this article, I discuss the strategies you can use to lower your tax bill in retirement.
Key Takeaways
- Required Minimum Distributions can dramatically increase taxes and Medicare surtaxes
- Roth conversions prior to Medicare and RMD age can help reduce your overall tax bill in retirement
- Understanding where you are in your bracket is critical for deciding where to pull retirement income from
Don’t let the Tax Tail Wag the Retirement Dog
Before we dive into strategies, I want to make a key point. Paying taxes is not always a bad thing. I am not going to turn away a client and the revenue just because I might pay more in taxes. We don’t want to be so focused on lowering taxes that it deprives us of enjoying retirement. We do however want to make sure that we are not paying any more in taxes than is absolutely necessary. The goal is to pay the lowest amount of taxes necessary for our desired dream retirement.
The clients I discussed above are considered early retirees. They decided to leave the workforce before turning 59.5, and were not yet eligible to claim Social Security benefits or Medicare. For those that have saved well, and retire early, they have more time to and more levers available to them to lower their overall retirement tax bill.
The first question my client asked me, was how they would fund their travel if they had to pay all of these penalties to tap into their 401k. Neither of them were 59.5. I explained that we would do a detailed review of what bucket makes the most sense to tap into first, or what combination of accounts we should use. However, if leaning on the retirement accounts was the optimal spot, they were both eligible to take distributions from their employer plan, as long as they did not roll those 401(k) accounts into an IRA. This is due to the Rule of 55.
Most people save for retirement using qualified accounts. A qualified account is an account that gives you a tax deduction when you contribute, and the earnings grow tax deferred. When the money comes out of the qualified account, the taxes are then due on the withdrawal. When you withdrawal, the amount you withdrawal is added to your ordinary income.
Examples of a qualified account include Individual Retirement Accounts (IRA) and employer sponsored plans like 401(k) and 403(b).
When you put money into these accounts, you avoid paying taxes at the time the income is earned. However, the IRS eventually wants their tax on that money.
What is the Required Mandatory Distribution?
The requirement to withdraw money from a Traditional IRA or 401(k) account once you reach a certain age is called the Required Minimum Distribution (RMD).
The age you are required to take the RMD depends on when you were born. If you are born after 1960, your RMD’s start at age 75. If you are born between 1951-1959, your RMD starts at age 73. For the clients we mentioned above, this may seem like a distant problem, but the earlier you start to plan for it, the bigger the tax saving potential becomes.
When required distributions start, taxes are now due on that money.
If you’ve put a lot of money into your employer savings plan or IRA account, and you have been investing for a long time, there is a good chance this balance has grown substantially. This can mean that you are required to take out a large sum of money in retirement. This is because of the RMDs.
Being forced to take a lot of money out of the account can mean paying a lot of taxes. So the bigger your qualified account balance is, the more taxes you may owe.
Why do people use qualified accounts if they have a large tax bill in the future?
A lot of clients that we work with are senior executives. They earn good income, and have large bonuses. They are usually in the top tax bracket. By saving in a qualified account, this allows them to dramatically reduce their current tax bill. Since they don’t have to pay taxes on that money, that money can also be invested and grow. This allows for more compounding and a larger balance in retirement. In essence, they are avoiding paying taxes at the top rate, to allow for more compounding and potentially being able to take it out later at a lower rate.
In retirement, the large majority of individuals have the opportunity to control their tax bracket at a certain point. This allows them to plan distributions from their qualified account at potentially a much lower tax bracket. However, if not addressed appropriately, this benefit can turn into a detriment in your 70s and beyond.
Related: How to reduce the cost of Medicare in Retirement
Traditional IRAs vs. Roth IRAs
As beneficial as getting a tax deduction is when you are in a high bracket, there is another type of retirement account that offers a different benefit.
The retirement accounts we discussed above are qualified accounts. With qualified accounts, you get a deduction when you contribute, and pay taxes when you withdrawal.
A Roth IRA account works a little differently. With a Roth IRA, you do not get a deduction when you put money into a Roth IRA. However, you do not pay taxes when you take money out. All of the earnings, dividends and interest on a Roth IRA are tax free.
With a Roth IRA, there are:
- no taxes on growth, dividends, interest
- no taxes when there is a distribution
Since Roth IRA distribution is not taxed, the IRS is not as concerned about you taking a distribution. The distribution doesn’t make them any money. There is no Required Minimum Distribution on Roth IRA’s.
Strategies to Lower Your Retirement Tax Bill
Fortunately, my new clients have plenty of years to get ahead of the RMD. Let’s discuss some of the strategies we are currently using with our clients.
Planning Before the RMD
First, let’s discuss the years between when you start retirement and when RMDs begin.
If you retire at age 60 and RMDs start at 75, you have 15 years to make a meaningful difference in future taxation. The first 5 years before Medicare are even more impactful. For those that retire prior to 65, it is critical to address this opportunity before Medicare IRMAA costs potentially kick in. In my client’s case, they have 7 years before Medicare, and 17 years before RMD’s. This is a meaningful runway to address future tax risk.
The years before RMD create a powerful opportunity to:
- Lower future taxes for you and the surviving spouse
- Improve future flexibility
- Help create a bucket for large later in life expenditures
Maximizing Roth Conversions
For all of our clients, we start with a detailed evaluation of their tax forms to determine how much money we can get out of their qualified accounts without moving them into a higher tax bracket. This allows us to identify where the income should come from, and what can be converted.
There is no restriction on who can convert to a Roth. There is no limit on the amount a client can convert to a Roth. For most of our clients, we take out a portion of their qualified accounts(enough to keep them in the same tax bracket) and convert this amount to a Roth IRA.
When you do this, taxes are owed on the distribution from the qualified account.
Why would you want to pay taxes on this money before you are required to?
Two Reasons
- For those with large qualified balance, this potentially allows them to take a small amount out at a lower tax bracket, as opposed to being required to take a larger amount out later at a higher bracket.
- The tax brackets for single filers are more compressed than joint brackets. Taking money out at joint rates protects the surviving spouse from having to take money out at single filer rates when you pass.
With a Roth ladder, you spread the distributions out over multiple years. The more years you do this, the more principal and growth you remove from the RMD equation. This allows you avoid paying a larger tax bill when RMD’s start.
This strategy of partial Roth conversions prior to RMD age can dramatically reduce your family’s future tax obligation.
How does Social Security Impact Roth Conversions
If you’ve been contributing to Social Security, you are entitled to receive Social Security retirement benefits. (assuming the social security fund doesn’t go bankrupt)
You are eligible to receive social security retirement benefits as early as age 62 or you can delay starting the payments until age 70.
For many clients we talk to, they are eager to take Social Security as early as possible. I get it. Why delay getting a paycheck if you have it available to you? However, for those that have saved a substantial amount of money, taking Social Security early can be a costly mistake. For those that have millions in savings, the optimal strategy is to delay Social Security benefits for as long as possible.
How to Determine if delaying Social Security Benefits Makes Sense For You?
It depends on your other potential retirement income sources. Those sources typically include:
- Employer Pensions
- Cash
- Annuities
- Investments in Brokerage Account
- Business Income
- Rental Income
If you have access to a handful of these other options prior to 70, it may make sense to delay your social security benefits.
Why the heck would someone delay their Social Security Benefits?
Because delaying Social Security has two major benefits:
Benefit #1: The Social Security Administration Pays You More if You Delay
For every year you delay claiming your Social Security benefits, the Social Security Administration will pay you more money. Your benefit will increase by roughly 8% a year for each year you delay.
There aren’t two many other investments that provided a guaranteed 8% out there. If you have one, I would love to hear about it.
If you delay your Social Security benefits, you can increase your benefit payment.
Benefit #2: You create more room in your tax bracket for a Roth Conversion Ladder
Social Security Payments are partially taxable and are part of your income calculation. When you delay Social Security, you are potentially lowering your reportable income.
By keeping your income lower by delaying Social Security, you now have more opportunity in your bracket to consider Roth Conversions.
Giving to Charity in Retirement
For my clients who have done a great job accumulating wealth. Making an impact regularly comes up in our conversations. However, I often find that the charitable donations clients are making are not making an impact on their tax return. Fortunately, with strategic planning you can make a larger impact for the charity or your tax bill.
Qualified Charitable Donation (QCD) from a Required Minimum Distribution (RMD)
While you can always donate to charity to support a cause, you don’t always get a deduction. If you use the standard deduction, your charitable gifts are not making an impact if they come from non-retirement accounts. However, once you reach 70.5, you have the option to use the standard deduction, and make a Qualified Charitable Distribution on top of it.
What is a Qualified Charitable Distribution?
A QCD is a direct donation from a qualified account to a charity. As opposed to donating cash or securities from a brokerage account, this is an above the line deduction as opposed to a below the line deduction. This means that the amount given as a QCD is not included in your taxable income. You can then use the standard deduction to lower your tax burden even more.
How Do You Lower Taxes in Retirement? Strategic Income Planning Before 73
Each individual has a unique tax and income need. It is critical to work with a Fiduciary Advisor that reviews your tax return, understands your income needs, and builds a retirement income strategy designed for you. With strategic planning, you can dramatically reduce your retirement tax bill, and have more of a nest egg to enjoy your retirement.
Disclaimer: This article is for educational purposes only. This is not considered tax or investment advice. Consult with a qualified tax professional to determine if these strategies are appropriate for your family.
