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Tax issues are an area most of us focus on once a year. However, if you are heading into retirement and you do not have a solid tax plan in place, you could be paying thousands of dollars in taxes needlessly.
Most Americans file their taxes annually using a tax preparer or a CPA. They might receive some advice about deductions, but what is being addressed is the year past and not the future. Without proper planning, your retirement savings are vulnerable, even more so if tax rates continue to rise.
Following are several strategies to protect your retirement savings and implement an effective financial plan.
Minimize the taxes on your Social Security benefits. According to Kiplinger, up to 85% of your Social Security benefits could ultimately be taxed as regular income. Most of us don't realize that tax would have to be paid, but if your combined income1 is above IRS limits, you may be required to pay taxes as high as 50-85%. A comprehensive income plan must consider the impact of taxes on your retirement income and provide solutions that include how much to pull from which account and what to do to minimize the potential tax hit.
Many of us have been placing the bulk of our retirement savings into a tax-deferred investment account. You may reduce the retirement tax bill by moving the bulk of those funds into a Roth IRA. The Roth IRA allows for tax-free growth as well as tax-free retirement income. If this works in your financial planning, you have until December 2025 to take advantage of the tax reductions put into place by the Tax Cuts & Jobs Act of 2017. If you do a Roth conversion after 2025, you are likely to pay higher taxes. The Roth IRA could also significantly lessen the tax burden on your surviving partner, as there are no required minimum distributions of an inherited Roth IRA.
Diversification is key, and a combination of investment account types allows different tax treatments. The Roth IRA is one way to offer the potential for growth while minimizing federal taxes. Brokerage accounts offer taxable growth potential. If you are eligible to take tax deductions in retirement, you will need this taxable income to take advantage of them. As said before, withdrawals from a traditional IRA or pre-tax 401(k) count as taxable income, so you could withdraw only enough to offset your eligible deductions and then draw the rest from your Roth account. If you have taxable accounts to draw from in retirement, you can draw them down and allow your traditional IRA and pre-tax 401(k) assets to continue to potentially grow tax-deferred until your required beginning date, after which time minimum distributions must be taken.
Another way to reduce your taxes in retirement is to spread your contributions among different account types, as specific investments have differing tax rules. For example, income you earn from municipal bonds is generally tax-free at the federal level and sometimes at the state and local levels as well. This bond income is tax-exempt when held directly or as a qualified distribution from a Roth account, but it is taxable when it's distributed from a retirement account. It is then regular income and taxed accordingly. Asset allocation is key to minimizing your tax burden. A good rule of thumb is to have taxable accounts holding tax efficient assets like index mutual funds, index ETFs, tax-exempt bonds and stocks. Non-taxable accounts should hold less tax-efficient assets such as actively managed funds and taxable bonds. Investing this way helps to realize all potential tax benefits while minimizing your tax liability. As with any allocation, check with your financial advisor.
Another way to limit tax exposure is with charitable giving. There are several strategies in this area that can be applied: itemizing cash donations on your return up to certain limits; gift appreciated securities, such as mutual funds, ETFs, or individual stocks, to minimize future capital gains, which can be donated through a donor-advised fund; donating $100,000 annually from your IRA directly to a qualified charity through a qualified charitable distribution (QCD) as long as certain rules are met. These rules require that you’re at least 70.5 when making the gift and that the check is payable directly to the qualified charity.
It Is important to consider tax-efficient investing when creating your investment strategy. While you may be focusing on saving and investing, have a qualified financial advisor help you with proactive tax planning. Saving money matters. However, what is key is how much of that money you keep and can use during a long retirement.
Colleen Kelleher Sorrentino, CFA is with Kelleher Investment Advisors, a New York-based investment advisor. Stacey Mankoff is with The Mankoff Company LLC, a New York-based marketing firm serving the financial industry.
1Adjusted Gross Income + Non-taxable Interest + Half of Your Social Security Benefits = Combined Income
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
