Reducing Your Taxes In Retirement
Many things change dramatically when you retire, not the least of which is your tax situation. Retirees face a unique set of challenges and opportunities that many CPA’s (and Financial Advisors) simply don’t address. One of the most significant changes in retirement is the ability to manage taxable income. By strategically taking distributions from various retirement accounts and making informed tax decisions with after-tax investments, retirees can significantly impact their taxable income. Of course, managing taxable income often involves shifting taxable income from one year to another, which brings up the second big change in retirement tax planning: the need to think and plan long term. There are choices that you can make now that may not end up hurting you until 10 years down the road when it is too late for a course correction. Let’s discuss each of these issues, in turn, to show how they can apply to retirees.
Managing your income
One of the best ways to save money on taxes in retirement is through something called ‘bracket management’. The basic idea behind bracket management is to fill up the 10% and 15% tax brackets and avoid bumping into the 25%, 28%, 33%, 35%, and 39.6% brackets. If you were an employee during your working years, then there were relatively few opportunities to manage your taxable income. But during retirement, you can impact your taxable income by deciding where to draw for your income needs. For example, consider the situation of a retiree with a $1M IRA a $200,000 ROTH IRA, and $50,000 savings account. Pulling money out of the IRA generates taxable income while pulling money out of the ROTH IRA and savings account does not. By doing a tax estimate up front, this retiree could potentially save thousands in taxes by drawing from the IRA while in the lower brackets, and then from the ROTH IRA and savings account once those lower brackets have been filled.
Retirees with all or a significant portion of their assets in IRA’s may have a long-term problem with tax brackets. Required minimum distributions from beginning at age 70.5 require retirees to begin distributing a minimum amount from the IRA’s every year, and these minimum requirements increase with age. Required minimum distributions may force retirees out of the lower income tax brackets and into the higher brackets – whether the money is needed or not! You can avoid this trap by taking a long-term view of your tax planning. If you will be in a higher tax bracket in 10 or 15 years, it may pay to strategically convert some of your IRA to a ROTH IRA. For example, consider a 60-year-old married retired couple that is living on around $80,000 per year, and own a large IRA. For the first 10 years of retirement, their taxable income is low as they are comfortably within the 15% federal tax bracket. Once required minimum distributions start, however, they will be forced to distribute and pay taxes on a percentage of their IRA, dramatically increasing their taxable income, and causing them to pay much higher taxes.
This retiree could save thousands in taxes by filling up the 15% bracket with annual ROTH IRA Conversions during his 60’s, smoothing the income, reducing the impact of Required Minimum Distributions, and dramatically reducing taxable income in later years.
Does it matter?
The important thing to remember is that taxes matter. While often ignored, by CPA’s and Advisors, a thoughtful, long-term strategy about how and when you access your various retirement accounts could save you thousands of dollars in retirement. Of course, everyone’s situation is different. If you would like to learn more, or if you would like to discuss your situation. Please contact us any time.