3 tips for making retirement less taxing
Cash Flow and Retirement
By Russell Rolnick - Managing Director
Recent retirees often are surprised by the size of their tax bills. As they soon learn, income taxes during retirement can be significant. However, with some planning, it’s possible to soften the blow. Here are three tips to consider implementing.
1. Create a bucket list
This isn’t the kind of bucket list that includes scaling mountains and writing a novel. Instead, you should estimate your cash flow needs in retirement and take inventory of your income sources, segregating them into one of three “buckets”:
- Taxable — such as mutual funds, brokerage accounts, and rental property income,
- Tax-deferred — including traditional IRAs and 401(k) plans, and
- Nontaxable — for example, Roth IRAs and Roth 401(k)s.
As you withdraw funds in retirement, carefully select from these buckets to maximize tax efficiency. Some people tap their nontaxable and taxable buckets first to avoid paying taxes on withdrawals from tax-deferred accounts. But this approach can backfire by triggering hefty required minimum distributions (RMDs) once you reach age 72 (see tip number three).
To avoid this result, consider withdrawing tax-deferred funds until you reach the upper end of the 12% tax bracket ($81,050 for joint filers in 2021). This strategy generates modest current taxes while drawing down your tax-deferred accounts to minimize future RMDs. The next funding tier might come from brokerage accounts, which typically generate long-term capital gains taxed federally at between 15% and 23.8%. To maximize tax-free growth, withdrawals from nontaxable accounts should be delayed as long as possible.
2. Delay Social Security
You can begin receiving Social Security benefits as early as age 62 or as late as age 70, but unless you need the money sooner, it’s generally best to wait. For one thing, the longer you put it off, the higher your monthly benefit will be, giving you a substantial benefit as long as you or your spouse live long enough to offset the initially lost income. In addition, as much as 85% of your Social Security income is taxable, depending on your income level. So, for many people, it makes sense to postpone the start of Social Security benefits until their taxable income is lower because they’ve stopped working.
On the other hand, you may expect your taxable income to increase in the future because, for example, you’ll need to take sizable RMDs from traditional IRAs or 401(k)s. In that case, it’s important to consider the impact of those RMDs on Social Security taxation when determining the right time to start receiving Social Security benefits.
3. Manage RMDs
Under current federal law, you’re required to begin distributions from traditional IRAs and employer-sponsored retirement accounts when you reach age 72. The RMD for a given year is calculated by dividing your account balance by the “distribution period.” Generally, this means your life expectancy is under the government’s Uniform Lifetime Table. But if your spouse is more than 10 years younger than you, the distribution period is your joint and survivor life expectancy.
Because RMDs usually consist of ordinary income, they can generate significant taxes. But if you retire before age 70, you can use the period between retirement and the onset of Social Security benefits and RMDs (when you’ll likely be in a lower tax bracket). By taking distributions from traditional IRAs or 401(k)s during that time in amounts that won’t push you into a higher bracket, you can minimize taxes on those distributions and lower future RMDs.
Other strategies involve:
Employer-sponsored plans. You may be able to defer RMDs from your 401(k) plan. Some plans permit participants to postpone RMDs so long as they continue working (even part-time) for the company that sponsors the plan.
Qualified charitable distributions (QCDs). If you’re charitably inclined, and at least age 72, you can kill two birds with one stone: A QCD allows you to transfer up to $100,000 per year tax-free directly from a traditional IRA to a qualified charity. There are several potential benefits: You can satisfy your charitable goals, reduce your IRA balance without tax consequences, and if you’re age 72 or older, QCDs can be applied toward some or all of your annual RMDs.
Roth IRAs. Another effective strategy is to execute a Roth IRA conversion, recognizing current taxable income while you’re in a lower tax bracket. Roth IRAs aren’t subject to RMDs (see “A window of opportunity”).
Get the timing right
Minimizing taxes in retirement is a delicate balancing act, requiring careful timing of distributions from various income sources. Work with a financial professional to develop a plan that addresses your goals and considers your situation — ideally before you retire.
A window of opportunity
If you have significant balances in one or more traditional IRAs, the window between retirement and age 70 or 72 can be an ideal time to convert some or all of these into Roth IRAs. Most or all of the amounts converted will be taxable as ordinary income. But completing the conversion while you’re in a lower tax bracket will keep taxes to a minimum.
To ensure that the conversion itself doesn’t push you into a higher tax bracket, you may need to do it in annual phases. For example, you could convert a portion of your IRA balance each year. Once the process is complete, you’ll essentially have converted taxable assets into nontaxable assets and reduced, or even eliminated, the need for future RMDs.