Reaching retirement is a financial milestone, but it isn’t the end of the road. Yes. You have saved and invested your money with care over the past few decades (maybe longer). You probably also adopted a few tax planning strategies to maximize your take-home earnings over the years – why stop now?
It is just as important to plan for your taxes in your golden years as it was when you were working, perhaps even more so the older you get. Here are our top tax planning strategies to get you started.
Timing is Everything
First off, make sure you are taking your required minimum distributions. If you have a traditional 401(k) or IRA, you are going to have to take minimum distributions once you reach age 70 1/2, whether you need to or not. It may seem wasteful, but the penalty for missing a minimum distribution is 50 percent of the amount you would have withdrawn. Also, keep in mind that the timing of your distributions can make a big difference in your tax bill. For some people, taking distributions earlier instead of later means that you can spread out your retirement income over a longer timespan. Lower income means less taxes. Remember – you don’t have to spend it, just take the distributions.
In addition, understand that the required minimum distributions are payable before April 1 of the tax year after you turn 70 1/2. After that, you have a distribution deadline of December 31. As such, if you wait until April to take your first distribution, you’ll have to take a second minimum distribution before December 31. The extra income from the second distribution could push you into a higher tax bracket for that year.
There is almost always an exception to the rule, especially in finance. For instance, let’s say you are still working at age 70 1/2 and if you own a stake in your company, it is less than 5 percent. In this scenario, you could delay taking 401(k) withdrawals until you officially stop working. There are important exceptions outside of required distributions as well. For instance, you could consider moving to a state without income tax or taking out a mortgage so that you can use your mortgage interest as a deduction.
Many people like to go with traditional retirement investments because they pay taxes on their distributions after retirement, when their tax brackets are likely lower. However, some people may experience a higher tax bracket after retirement. If you know this in advance, you could put your money in a Roth IRA so that you lock in a lower tax rate and avoid paying more taxes later. The goal is to pay taxes on your capital gains when your income is lowest, taking distributions up to the threshold for the next tax bracket. Ideally, you want to start planning your taxes in retirement between the date you retire and the year you turn 70.
Eggs in One Basket
Consider the types of investments you hold as well. It can be tempting to wrap your portfolio into a single account when you take the plunge into retirement, but what is easy for monitoring your finances may not be easiest for managing your taxes. Most notably, investment profits that qualify as long-term capital gains, such as long-held stocks, have a lower tax rate than many other investments.
Partial is an Option
Your tax situation may see some benefit from partial Roth IRA conversions. While many people think these investment vehicles are an all-or-nothing venture, the reality is that partial conversions are possible – and potentially beneficial. “IRAs is a stonking [sic] great deal during our working years, in retirement these plans get thrown into reverse,” explains Forbes. “IRAs become unstoppable doomsday machines spewing out ever-larger taxable distributions every year, ratcheting up the mandatory payout according to a tune called by the IRS… The suave move is to make a series of partial Roth conversions, which also exempt these payouts from future taxation.” Plus, your forced distribution schedule would be applied against your now-reduced IRA balance so you end up playing less taxes all around.
Planning for taxes in retirement requires forecasting and knowledgeable advice. Expected returns, upcoming changes to the tax code, and predicted inflation levels all make an impact, and these variables are compounded every year. In the end, creating a plan that best satisfies your financial needs after you stop working is best accomplished with the help of a trusted advisor.
Not all of the tax strategies listed within this article may apply to your situation. To be sure, schedule a call with a Berson+Corrado representative.