If you have to worry about taxes in retirement, that’s a good thing. Why? It means you’ve done your part and saved. It’s a great problem to have! It certainly beats the alternative – having a low tax rate because you don’t have enough. It’s also a problem you can avoid or, at the very least, be able to minimize with some planning. Incorporating a plan to reduce taxes in retirement can go a long way to improving your bottom line.
Welcome to retirement – no meetings, no boss, and no paycheck
Except for that last part, life is good. Paying taxes is probably not a big concern when planning retirement, but it should be. Retirement is about managing cash flow. Aren’t taxes a part of cash flow? Don’t assume that since you’re retired, taxes will be lower. They may not be.
Retirement Tax Bites
There are several ways that taxes can eat away at your retirement income. Here are the most common:
The usual suspects
Most people save for retirement in tax-deferred retirement accounts, 401(k)s, 403(b)s, IRAs, pensions, etc. That’s awesome, but those distributions are taxed as income. Think about how much income you’ll need in retirement. The more you need, the greater your distribution and the higher the tax. It’s a vicious cycle!
Required minimum distributions (RMDs)
At age 73, you must begin taking RMDs from those above-mentioned retirement accounts. You must take out the minimum amount whether you need it or not. If you don’t, you’ll face a 25% penalty, although the penalty drops to 10% if you take the necessary RMD by the end of the second year following the year it was due. So, for example, if you fail to take an RMD due in 2023, the penalty is knocked down to 10% if you withdraw the necessary funds by December 31, 2025.
Social Security
Many don’t realize that Social Security benefits may be taxable if you have other “substantial income.” Social Security’s definition of substantial and my definition of substantial are two different things.
If you file as single and your adjusted gross income + nontaxable interest(like muni bonds) + ½ of your Social Security benefits is
- between $25,000 and $34,000: 50% of your benefits may be taxable
- more than $34,000: 85% of your benefits may be taxable.
If you file jointly and have
- between $32,000 and $44,000: 50% of your benefits may be taxable
- more than $44,000: 85% of your benefits may be taxable.
It doesn’t take much, certainly not what I’d call substantial income, to trigger Social Security taxability. Also, those numbers are not increased for inflation, so more people will get caught yearly.
Create tax efficiency in retirement
If you want to avoid or reduce your tax liability in retirement, you need to plan early, from both savings and timing standpoints. But because there will be points in your life when some of the options may not be appropriate or possible, you need to strike while the iron is hot. Be ready when these options are available and appropriate.
Delay Social Security
Everyone’s situation is different, but generally, if you’re financially able and healthy, you should delay taking Social Security. You can start collecting at age 62, but every year you delay, your benefit will grow by roughly 8% up until age 70. I’ll take an 8% annual return any day of the week.
It’s more complicated than deciding between taking Social Security at 62 or full retirement age of 66 – 67. Taxes, honestly, are not the most important factor in deciding when to take Social Security, but if you can coordinate Social Security with your IRAs (including RMDs), Roth IRAs, taxable accounts, etc., it will benefit your bottom line.
Roth IRA
A Roth IRA is funded with after-tax money, and withdrawals from Roth accounts are tax-free if you’ve had the account for at least 5 years and are over 59½. On top of that, Roth distributions are not counted toward Social Security taxability, and there are no RMDs for Roth IRAs.
The bad news is there are income limits that may prevent you from contributing to a Roth. Other options include the back door Roth IRA strategy and the….
Roth conversion
You can convert all or part of a qualified account, such as a 401(k) or IRA, to a Roth IRA. It is one of my favorite strategies. You get all the benefits of a Roth IRA while removing assets subject to RMDs. That doesn’t mean you should go out and do a conversion immediately. There must be a well-thought-out analysis.
That analysis should look at
- Your current tax rate
- The future expected tax rate
- Future cash needs
- Expected RMDs
That’s just the shortened list. If done correctly, a Roth conversion has the potential to change your retirement tax liability significantly, but please seek guidance from your CERTIFIED FINANCIAL PLANNER™ professional before undertaking.
Taxable accounts
These accounts always get forgotten regarding retirement, but individual or joint taxable accounts are a great way to save for retirement.
- The principal from investments is tax-free
- long-term capital gains are taxed at lower rates than your income tax rate
- You can even harvest (sell) investment losses to reduce your taxable income
- Short-term capital gains are taxed at your income tax rate
Long-term capital gains and Qualified dividends in taxable accounts are
- Tax-free for those in the 10% and 12% tax brackets
- Taxed at a 15% for those in the 22%, 24%, 32%, and 35% tax brackets or up to $518,900 (filing single) or $583,750 married-filing-jointly)
- Taxed at a 20% rate for those whose income is over $518,900 (filing single) or $583,750( married-filing-jointly)
Charitable contributions from your IRA
If you’re 70½ or older, you can donate up to $100,000 annually directly from your IRA to a qualified charity without paying taxes. It is 100% excluded from income! It must be direct. If you withdraw $10,000 from your IRA and then donate the cash, the IRS taxes it before you donate, and that donation is a deduction. That’s not as beneficial as a complete exclusion of income. The QCD at one time matched the RMD age, but while increasing the RMD age to 73, the SECURE Acts 1.0 and 2.0 left the QCD age at 70 1/2.
Donations don’t have to be big to qualify, and they don’t have to occur simultaneously. Want to donate $100 a few times a year? If you’re over 70½, you can use your IRA, reduce taxes, and help your favorite charity. It’s a win-win situation.
You need to plan in advance
I covered a lot of topics. These ideas and strategies can interact with each other to improve your retirement tax liability. The concept is to create multiple sources of income in retirement. Whether it’s income buckets, income streams, an income buffet, or income bricks – whatever analogy your advisor uses, the idea is to design a retirement income strategy.
Everyone wants to pay as little as possible regarding taxes, and that feeling is magnified in retirement. Getting a plan in place with multiple options allows you to do that. Don’t you want the money you saved to be available for your enjoyment instead of going to Uncle Sam?
Any questions? Please feel free to contact me to learn more.
