Taxes are likely to be one of your largest retirement expenses and they may be on the increase in the future. But you can take steps to reduce them so that it’s not as bad in your retirement years. In this post, I’m going to share three things that you can do now to pay less tax over your lifetime and in retirement.
The majority of people who call me have a tax problem, not an investment problem. Many people have been taught to delay taxes by putting money into their 401k or 403b and just let it grow. The concern with this is that triggering the required minimum distribution, or RMD, at age 72 might result in a tax time bomb, especially if future rates are going to be higher than they are now. The IRS sets these withdrawal limits, which may require you to withdraw more money than you need for one year, which results in a higher tax bill.
If you feel, like many people do, that taxes may rise in the future, here are some things to think about to reduce your tax liability in retirement.
Because today’s tax rates are so low, it could be smart to retire early and start taking money from some of those tax-deferred accounts. You could also spend down some of the IRAs or 401ks now, to take advantage of lower tax rates. Only do this if you have already reached the age of 59 and a half, when you won’t be penalized by the IRS for early withdrawals.
If you don’t know if this is going to be a good idea for your situation, calculate your required minimum distribution at age 72, and then what you expect your expenses to be. If the RMD is considerably higher than your expenses, it might be a good idea to start withdrawing money from your IRA or 401k earlier than planned. The goal is to prevent significant withdrawals of tax deferred money at future higher tax rates.
Now, you might be thinking, “I don’t want to withdraw money from my IRA. I like my work and I’m going to continue to work and I don’t need the money.”
This leads me to the second thing to think about.
Roth IRAs, unlike traditional IRAs, are funded using after-tax funds and contributions are not tax deductible. The main distinction is that once you’ve begun withdrawing money, it’s not taxable as long as it’s a qualified distribution.
When converting from a traditional IRA to a Roth IRA, you will incur taxes on the whole amount. But the advantage comes in the long-term. A Roth IRA could make sense if you think your taxes will be higher in retirement than now. As of now, in 2021, there are no restrictions on the number of conversions or the financial sums that can be converted.
One other thing to be aware of is to convert as much as possible without entering into the next higher tax bracket.
Aside from Roth conversions, you might be able to contribute to your Roth IRA if you’re still working. The maximum contribution in 2021 is $6,000 or $7,000, if you’re over 50. But be warned: contributions are subject to income limits. A Roth IRA is not available for singles who are making more than $140,000 per year. Nor for married couples who are earning more than $208,000 per year.
By knowing what you will pay tax on ahead of time, you won’t get caught off guard. Also, you can easily plan out when you’d like to pay these certain amounts of tax. Understanding the difference between the three major sources of taxed retirement income can aid in the development of income planning strategies to reduce taxes in retirement.
Here are the three most common types of taxed retirement income to discuss with your financial advisor:
Short term capital gains are taxed at regular income rates, if you’ve held those investments for less than a year. Long-term capital gains, depending on your income level, are taxed at either the 0-, 15-, or 20-percent tax bracket. Of course, this could change with the tax proposals happening with the Biden administration, but that’s where they are currently.
A lot of the clients who start working with us have been investing in tax-inefficient funds. Because of this, they’re paying more than they should each year on capital gains and interest in dividends. So that’s something important to look at with your financial advisor.
To see if your Social Security benefit is taxable, add up your adjusted gross income, your non-taxable interest, and half of your benefit. Currently in 2021, if that amount is more than $34,000 as an individual, or $44,000 as a married couple, then up to 85 percent of your social security benefit may be taxed.
There are certain tax advantages that are available with annuities. They can be bought within pre-tax accounts, but then the payments usually come out as taxable income. However, annuities can also be bought in after-tax accounts, in which case only the earnings are taxed. When it comes to annuities, there are a lot of different options out there. A specialist can help you choose one that fits you or evaluate ones that you currently have, make sure that you budget right, and calculate how much you’re going to be paying in tax on those distributions.
A lot of people look at historical, cyclical patterns of tax rates. In doing that, they see that we’re on the lower end of the cycle currently. And some people think that this increase in government spending has got to be paid somehow. Taxes are really just one of two ways that the government can pay off their debt. According to these schools of thought, it seems inevitable that tax rates are going to go up soon.
But whatever you think, and whatever the future actually holds, it makes sense to map out your retirement picture. When you do this, be sure you can see expected income and withdrawals. Then plug in different tax scenarios, either taxes staying the same, going down, or going up. Making this type of map can be confusing but it’s something that real wealth managers do. They take all of your financials and your investments, your taxes, the withdrawal plan, the estate plan, and then they fit it together to come up with your ideal picture. If you’re not currently getting that with your investment advisor, then reach out to me. I’d be glad to have a conversation.