How can I best plan for a tax efficient retirement?
For many retirees, even those who have meticulously planned their retirement income, the amount of taxes they are expected to pay may come as an unwelcome surprise.
It's understandable. This is a new form of income that they may not be familiar with.
"Sometimes they think that because they are retirees, they don't have to pay income taxes. Then they are surprised," says Chris Chen, a certified financial planner at Insight Financial Strategists. "Sometimes they think that Social Security is tax-free, which it is not."
Or, he says, surprises pop up from mismanaged expectations. "When they take an IRA distribution, they may not withhold taxes, or they may have a job of some kind which pushes their Social Security and retirement account distributions into a higher tax bracket."
Chen says that a major failing in being hit with these kinds of taxes is short-term planning. If you're only planning one year at a time, sub-optimal tax situations will arise.
Rather, he suggests, make a plan for reducing taxes, by planning over multiple years.
Evaluate your income needs
First, determine your retirement cash flow needs, says Lauren Zangardi Haynes, certified financial planner at Spark Financial Advisors. And identify your sources of income.
You'll need to determine when Social Security will start. How much (if any) pension income will you receive? Do you get a temporary boost in pension income until you reach Social Security full retirement age?
Zangardi Haynes says you need to be aware of required minimum distributions, or RMDs. That's when IRA owners and qualified plan participants are forced to withdraw from their retirement accounts. Withdrawals must happen by April 1 following the year a retiree reaches 701/2.
"Sometimes people pull from Roth IRAs or taxable accounts early because they don't want to pay taxes on traditional IRA withdrawals but then end up with oversized RMDs in their 70s," she cautions.
While looking at your income and expenses, Zangardi Haynes says, you may find some tax advantage by making charitable distributions directly from a traditional IRA. These charitable contributions may count towards your RMD if you are over age 701/2.
Use tax diversification
One of the best ways to position yourself for retirement is to have three buckets of assets: taxable, non-taxable, and tax-deferred, says Michael Troxell, a financial planner and a CPA with Modern Financial Planning. For example, you'd have brokerage accounts, a Roth IRA and a traditional IRA.
"This way, you can sort of cherry pick when pulling out income for retirement," says Troxell. "For example, one could pull out their IRA money until they max out the 12% tax bracket, which is $77,400 if you're married."
Next, he says, you could pull out from your brokerage account. You'd need to pay capital gains rates on any long-term gains there.
"Lastly, you would pull from your Roth IRA," Troxell says. "Ideally, the Roth would be last since you would want that money to grow tax-free for as long as possible."
Plan for the tax window
What happens for retirees, often, is that all these income sources in retirement can turn on at once, says Adam Beaty, certified financial planner with Bullogic Wealth Management. And if you're not prepared for the time between when you retire and age 70 — called the tax window — you can be hit hard and miss out on lowering your future tax bill.
"At age 70 they will be required to take their required minimum distributions," he says. "They will also be required to turn on Social Security if they haven't already."
If combined assets are high enough, the required minimum distributions will cause 85% of Social Security to be taxed. Plus, they are paying on the taxes from the distribution.
"This is usually a big surprise tax bill that can be avoided if they take the right steps," he says. The tax window will allow the client to make some moves to lower their future tax bill, if a retiree is diversified with the three types of accounts — always taxable (IRA/401(k)), never taxable (Roth IRA/Roth 401(k)), and sometimes taxable (brokerage account).
"During this tax window, they will likely have very low income and thus, be in a low tax bracket," Beaty says. This is when he recommends taking assets from an always-taxable account and putting them in a never taxable account.
"By paying taxes now, in a lower bracket, we can save them money in the long run," he says. "If Social Security is not on, this may be a good time to start spending money out of the always taxable accounts and save the never taxable accounts for after 70."
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