One of the most important issues with retirement is taxes. When there is limited income, such as in retirement, it is more important than ever to get the most out of every dollar. Spending a good portion of retirement money on taxes doesn’t help the retiree. The goal of preparing for retirement and successfully managing retirement is maximizing income during retirement.
When planning for retirement, it is important to factor taxes into the plan. The benefit of planning is that it is possible for most people to actually save on taxes when they plan accordingly. Identifying the key areas and then planning to maximize those areas will help you save on taxes today and into the future.
I completely understand how frustrating it is when you’ve been responsible and saved diligently for your retirement throughout your working career, but the tax bites keep on coming. Over the course of time, those accounts most likely grew substantially, observes the Citizen Times in its article ““Try this strategy to save on taxes in retirement.” The growth comes from maximizing annual contributions and the power of compounding interest, which is what 20th century genius Albert Einstein is quoted as saying is the most powerful force in the universe.
If you are nearing retirement or have just retired, you’ll want to use tax-efficient ways to withdraw money from your investment accounts. There used to be a common rule of thumb from the financial investment community that said just leave those tax-deferred accounts alone and use the money from your taxable accounts until you reach age 70½. You can then start taking Required Minimum Distributions, or RMDs.
However, there is a problem with this strategy today…it has to do with income. This recommendation assumed your income decreased as you entered into retirement…and this may not actually be the case. If your income has gone up as you enter retirement, this strategy might not be the best one for you if you want to save taxes. This, of course, assumes that you don’t need the income to live and have a choice to leave it in your retirement account.
It is also important to remember that RMDs (Required Minimum Distributions) are taxed as ordinary income at the time of withdrawal. This means they have the potential to push you into a higher federal tax bracket than you expected. Let’s look at a pretty common example to illustrate how this works. Let’s say you are a 63-year-old married woman born in 1953 with $1 million in tax deferred accounts. You decide to take an RMD of nearly $47,000 at the age of 70½, combined with $47,000 from Social Security or a pension or rental property income, and you could be bumped into a higher tax bracket pretty quickly.
Another impact to consider is the reduction of individual income tax rates that went into effect this year because of the Tax Cuts and Jobs Act, which expires in 2025. Since those tax cuts may not be extended or may be changed, future tax rates might go up again in 2026. When that tax cut expires you would need to review your tax burden again and possibly change your decisions at that time.
So what can you do if you are retired or approaching retirement?
If you are a retiree between 59½ and 70½, consider a Roth conversion. Proactively convert a portion of your tax-deferred accounts into a Roth IRA on an annual basis. You’ll have to pay federal income tax on the amount you convert every year. However, you’re taking advantage of lower rates before those provisions mentioned above expire and before the RMDs begin. The goal is to convert only the amounts you need to keep you in your current tax bracket.
It is important to do this correctly to ensure you get the proper benefits. I would suggest you meet with your estate planning attorney and your tax advisor to work out the numbers so you don’t trigger a higher Medicare premium or the 3.8% Medicare surtax. Even though this may seem more cumbersome, having a plan in place to take advantage of these tax benefits could save you thousands in the end. Keep in mind it is important to align this with your estate plan. This way you can have the plan you want and take advantage of the tax breaks that are offered to you.