You’ve worked hard and saved all your life. Now being in retirement (or soon to be), it’s a time to enjoy the fruits of that labor. However, managing your finances during this key period requires careful planning, especially when it comes to taxes. This is particularly true with tax rates at somewhat historically low levels and uncertainty going forward as to where rates will be in future years. Proper tax strategies can help you maximize your savings and ensure a comfortable retirement.
Diversification of Portfolios and Tax Risks
So, when we think of diversification, we typically think about how we choose our investments to create a balanced retirement portfolio. But it’s also important to be mindful of how and when your retirement accounts are taxed. It’s another element of doing what’s smart when it comes to maximizing your returns to create that future lifestyle.
Let’s look at various tax issues such as understanding retirement income and how it is affected by taxes, how to minimize taxable income, and what are the more efficient methods for withdrawing from our savings.
Sources of Retirement Income and the Tax Effect
A crucial aspect of retirement planning is knowing the distinct types of retirement income sources and their tax implications. What is taxable versus non-taxable is crucial in managing your finances more effectively.
Taxes and Social Security Benefits
Foremost is social security. Often the backbone of a person’s retirement income stream (particularly with the disappearing corporate pension plan), social security can take a key role in funding your golden years. Yet, it’s a cruel bit of fate. We work hard and turn over to Uncle Sam a fair share of our paycheck (or self-employment earnings), which goes into the Social Security system. Surprisingly (or not), many people only come to realize later that these promised social security payments are taxed in retirement. This must be taken into account. Depending on the other income streams available to a retiree (such as IRAs), this social security tax bite can vary greatly. Other variables to be considered include the year and benefit amount you decide to start taking your payments, your marriage status, employment situation, and any possible earned income. Speaking with a tax specialist or financial advisor with a deeper understanding of retirement issues makes sense.
Other Taxed Income in Retirement: 401(k)s and IRAs
Like social security, other forms of income can be taxed in retirement. For instance, withdrawals made from earnings and pre-tax contributions such as from traditional IRAs, 401(k)s, and other retirement plans are taxed as ordinary income. Remember, contributions to these types of accounts typically reduce your taxable income in the year the contribution was made (dollar for dollar). We all loved getting that tax break each year. Also, and importantly, those decades of earnings gains in our retirement accounts aren’t taxed until we retire. As you are not allowed to keep these monies in such accounts forever, and as Uncle Sam also wants his money, you are forced to take the required minimum distribution (or RMD) from tax-deferred accounts no later than at age 72 (73 starting in 2023, and 74 starting in 2033) and each year thereafter.
Another Source of Income in Retirement: Roth IRAs
Now imagine a world where you’ve paid your taxes upfront, only to be spared the taxman’s bite when in retirement. That’s the beauty of the Roth IRA. Unlike the traditional IRA or 401(k), where you get the tax break in the year you earned the money and pay for taxes on subsequent withdrawals, the Roth offers a tax-free twist. This includes not only the contributions, but all the earnings generated over the years. An extra benefit is that the Roth IRA does not demand RMDs. Again, back to traditional IRAs and 401(k)s, RMDs can start at age 59½ and are required to start no later than age 72 (or older, as noted above). With no RMDs in sight, your money can sit and grow as long as possible in the Roth IRA.
Capital Gains from Taxable Accounts
Also, it is important to consider any gains realized by selling investments held in taxable accounts such as a brokerage account. There may be times when a retiree needs to tap into this source of funds (if available), and tax implications are also at play. When you sell an investment for more than its purchase price (hopefully), that profit will be considered a gain and, depending on its amount, can impact your tax liability. This is particularly important in retirement when managing your income streams is vital. If such sales push you into a higher tax bracket, your overall financial picture may change.
Of course there are strategies to manage such capital gains taxes. As longer-held investments (meaning over a year) are taxed at lower rates, delaying sales of particular assets may be a beneficial approach. This may significantly lower tax liability in a given year. And similar in the sense of timing, it’s smart to be mindful when you sell investments. For instance, if you predict a lower income year coming your way, it might be a better strategy to sell assets (and realize gains) during that period when in a lower tax bracket. Using tax-loss harvesting can also reduce the bite, meaning selling winning assets and assets at a loss to offset the previously mentioned gains. This can also reduce your overall taxable income and keep the tax burden lower.
Strategies for Minimizing Retirement Income Taxes
Importance of Tax Planning
While it may seem obvious, tax planning is often ignored. The first thing to consider as a strategy for minimizing retirement income taxes is to make the effort and start to think about and put into place a retirement tax plan. While we can’t always predict what will happen in the future, let alone a period of time that may be 10 or 20 years away, ignoring tax consequences during your retirement can significantly impact your savings. Only with proper planning and understanding of various tax implications can help preserve your nest egg.
Take Your RMDs
As mentioned above, if you hit the mandatory age, you must take the required minimum distribution (RMD) from any tax-deferred accounts. This is a no-brainer, as when it comes to retirement taxes, failure to take the RMD will result in a severe penalty of 25% on the difference between what you withdraw and what was the required withdrawal amount.
With such a penalty, this should be your first choice when accessing retirement funds. Again, as these withdrawals are taxed as ordinary income, it may make sense to look at your overall financial picture to decide if you do indeed need these withdrawals to live on. While you may not be able to avoid the tax bite, you could also reinvest the money in a taxable account which can continue to grow and be used later.
Converting to Tax-Advantaged Accounts
One effective strategy for reducing taxable income in retirement is to convert a traditional retirement savings account, such as a traditional IRA to a Roth IRA. While this step will often involve the need to pay taxes on that dollar amount converted at your current tax rate, it does offer some significant benefits. Paramount is that any future withdrawals from the newly created Roth IRA account (including the earnings) will be tax-free. This could potentially be a game changer later in life and seriously reduce your tax burden, possibly at a time when you most need it.
Part of the strategic thinking here is that when a Roth conversion occurs, you are locking in today’s tax rates on your money. If you believe that you will likely be in a higher tax bracket when you retire, paying up now can potentially save you later. (Obviously, this is also beneficial if tax rates rise overall in the future…another great unknown.)
Additionally, Roth IRAs have no required minimum distributions (RMDs) during the account holder’s lifetime, thus allowing investments to grow tax-free for longer and providing greater flexibility in managing retirement income. If estate planning is relevant, Roth IRAs can be advantageous as well, allowing tax-free assets to go to your heirs.
As are many things in life, timing is key for such conversions, and it could be more beneficial for you to consider doing such a transaction during a year when earning less income or when taxes can be offset through deductions. As this is a tricky and weighty decision to consider, consulting with a financial advisor or special tax professional can help you decide on the best strategy for your particular situation.
Making Withdrawals Tax-Efficient: A Strategic Approach
Being strategic when making withdrawals from different types of accounts makes sense. Without a mindful approach, you can easily increase your income in retirement and be pushed into a higher tax bracket, thus bearing the brunt of the tax man. So, consider taking monies from traditional retirement accounts, Roth accounts, and taxable accounts in a manner that reduces overall tax liabilities.
The 4% Rule and Taxes
While not necessarily directly related to issues of taxes in retirement, the 4% rule is a guideline used in planning that offers what’s considered to be a sustainable rate of withdrawal from your savings. In a nutshell, the rule says that a retiree can withdraw 4% of their savings in their first year of retirement and subsequently adjust this dollar amount (due to inflation) each following year. The goal of this strategy is to make sure a retiree’s savings last throughout a typical retirement period (roughly 30 years). So, for year one, a $1 million dollar account would provide $40,000 in income. Again, later years would be adjusted for inflation to stay up with rising costs of living.
So, while this rule doesn’t specifically address tax ramifications, it is important to think about the dollar amount and overall income amount a retiree is pulling out per year, as higher incomes will clearly lead to higher taxes. Remember, these monies are generally taxed as ordinary income and must be considered when thinking through an overall retirement income plan.
Taking from Interest and Dividends
The order of withdrawal sources clearly depends on the individual’s situation. That said, withdrawing interest or dividends from investments in a taxable account (after taking your RMDs) may make sense. Why? If you take from interest and dividends only, this means you are still holding your original investment, an investment that can hopefully continue to grow, thus creating even more interest and dividends later on. FYI: interest payments are taxed as ordinary income (unless from municipal bonds or municipal-bond funds), and dividends are typically taxed at lower rates of 0% to 20% (depending on income levels and duration the asset is held).
Again, much of this strategy in being tax efficient in withdrawals depends on an individual basis. For instance, some may advise to tap into a Roth earlier as it is tax free after the age of 59½, while other may advise to hold onto Roth assets as the last choice, since there are no required RMDs, and assets can continue to grow for long periods of time.
Getting Quality Financial and Tax Advice
While there are those who enjoy the intricacies of investing and figuring out the best tax strategies for themselves, there are many others who do not. By partnering with a financial advisor and savvy tax professionals, current and future retirees can create a retirement plan that aligns with their financial and life goals. This can include ways to structure their portfolios to be most tax-efficient and to optimize their withdrawal plans. Importantly, as quality tax professionals stay up to date on the most recent changes in tax laws and other relevant regulations, their strategies and advice will also stay current and effective.
Proper tax planning is not just about following the law and various intricate strategies. It’s also truly about making the most of your hard-earned (and grown) resources, so you can spend more time and energy enjoying the retirement you’ve created to the fullest.
