When people are in retirement, they often are shocked that their tax bite isn’t as small as they expected. After all, they are no longer earning full-time salaries so their income taxes should plunge. In reality, however, one in four US retirees say that they have had to shell out several thousand dollars more in taxes each year than they had expected, according to a survey by the Nationwide Retirement Institute.
There are a number of strategies—including those that go against conventional wisdom—that will help you dramatically reduce what you owe the government in retirement. The strategies include choosing how and when to tap various taxable and tax-advantaged accounts…how and when to start taking Social Security benefits…and how to minimize the burden of taking required minimum distributions (RMDs) on tax-deferred accounts…
Drawing From Various Accounts
Retirees who need cash flow to supplement their basic savings and guaranteed income (such as Social Security benefits and/or pensions) generally draw from three types of investment accounts, each with its own tax consequences.
Conventional wisdom says that in retirement you should draw down your taxable accounts first, followed by tax-deferred accounts such as traditional IRAs and 401(k)s, then accounts such as Roth IRAs that will not face any taxes on earnings or withdrawals. This strategy is based on the assumption that your capital-gains tax rate on profits from investments in your taxable accounts is likely to be lower than your income tax rate on withdrawals from your tax-deferred accounts. In addition, this approach leaves investments in your tax-advantaged retirement accounts undisturbed so that they can grow faster than investments in a taxable account or accounts.
In certain but not all circumstances, the plan can backfire. For example, say that you retire in your 60s and rely largely on withdrawals from your taxable accounts rather than tax-deferred accounts to pay living expenses. That means you are saving money by paying taxes on those withdrawals at the capital-gains rate rather than the income tax rate. When you reach age 72 (or 70½ if you reached that age before 2020, when a new law raised the age to 72), you no longer have that option. At that point, the IRS requires that you start taking RMDs from your tax-deferred accounts, whether you need the money or not. By then, your tax-deferred accounts may have grown so large that the RMD amounts withdrawn from those accounts push you into a much higher tax bracket.
Here are two ways to tap your various accounts that can help you lower your overall taxes during the course of your retirement…
1. Reduce tax-deferred accounts early in retirement in any year when your taxable income is low. Many new retirees find themselves with a big drop in taxable income for the first few years. They have stopped getting a paycheck, but they haven’t started receiving Social Security benefits or taking RMDs. If you approach the end of the tax year and realize that you’re in a low income tax bracket, take advantage of it by withdrawing just enough money from a traditional IRA or 401(k) to stay within that tax bracket.
Example: You are a married couple filing jointly. For 2020, these couples pay a 12% rate on taxable income of $19,751 to $80,250. But for every dollar above that, up to $171,050, they pay a 22% rate. Say that this year you have $50,000 in taxable income, which would put you in the 12% bracket. Consider taking an additional $30,250 distribution from your traditional IRA even if you don’t need the money immediately. That way you pay a 12% tax rate on the distribution amount rather than risk paying a much higher rate when you withdraw that money in the future. Resource: For 2020 income tax brackets, go to TaxFoundation.org/2020-tax-brackets.
Reminder: You can withdraw investments from your IRA “in kind,” meaning that the money remains in the same investments but those investments are transferred to a taxable account.
2. Convert traditional retirement accounts to Roth retirement accounts in low-income/low-tax-bracket years. Many retirees have large traditional IRAs and 401(k) accounts but much smaller Roth accounts. That can be a disadvantage because Roths allow tax-free withdrawals. And if you plan to leave something for your heirs, they can inherit your Roth accounts and not pay any taxes on withdrawals, unlike with a traditional IRA or 401(k).
What to do: Say you are an unmarried retiree with just $10,000 in taxable income this year. For 2020, you pay a 12% tax rate on income over $9,875 up to $40,125. Consider converting $30,125 from a traditional IRA to a Roth IRA. You’ll have to pay tax on the amount you convert—but at just a 12% rate. If you had left the money in your traditional IRA, you could wind up paying a much higher rate on distributions in the future.
If you fail to keep an eye on how much taxable annual income you have when you decide to start taking Social Security benefits, you might end up having to pay taxes on your benefits. About 40% of Social Security recipients do. It’s a “stealth tax” because the higher your income rises, the more your Social Security benefits might be subject to taxes. That means you should keep various types of income low enough to avoid the two thresholds at which taxes on Social Security benefits kick in.
To figure out whether you’ll owe taxes on your Social Security benefits this year: Take one-half of your expected annual Social Security benefits. Add it to any nontaxable interest you receive plus your adjusted gross income (which includes pension payments, traditional 401(k) and IRA withdrawals, interest, dividends and income from a part-time job). This odd formula yields what the IRS calls your “provisional income.” If it’s less than $32,000 for married couples filing jointly or less than $25,000 for singles, you owe no tax on your benefits. Between $32,000 and $44,000 for couples and $25,000 and $34,000 for singles, you pay income taxes on 50% of your Social Security benefits. If it’s more than $44,000 for couples or $34,000 for singles, then up to 85% of your Social Security becomes taxable. Helpful: Use the interactive calculator at IRS.gov to calculate whether you will owe taxes on your Social Security benefits.
What to do if you think your income will trigger high taxes on your Social Security benefits…
Don’t load up your portfolio with investments that will generate much more income than you will need each year. Many retirees use lots of bonds and dividend-paying stocks and mutual funds to generate income. But that can boost your adjusted gross income enough to raise your Social Security tax. Consider including substantial amounts of investments that don’t generate much annual income such as growth-oriented stocks and funds.
Withdraw investment money in ways that won’t increase taxable income. That means withdraw first from Roth or taxable accounts rather than a traditional IRA or 401(k).
Realize that some common tax-reduction strategies don’t reduce taxable income for the purposes of the Social Security formula. These strategies include…
- Taking itemized deductions such as charitable contributions.
- Investing in municipal bonds. Even though muni bond income may not be subject to federal and/or state taxes, it’s still included in your provisional income.
- Starting Social Security benefits based on the lower-earning spouse’s earnings history and delaying benefits based on the higher-earning spouse’s history. Although this will produce less taxable income for the couple, it won’t help reduce Social Security tax. Reason: The combined income of the two spouses, not the income of each spouse, is used to determine Social Security tax.
Required Minimum Distributions
RMDs can be a growing burden for seniors. The older you get, the greater the RMDs you are required to take as a percentage of tax-deferred assets, starting at 3.65% your first year and rising to 6.76% by age 85. And those withdrawals are taxed at ordinary income tax rates. They also can trigger higher taxes on Social Security benefits, as described in the Social Security section above. In addition to the methods described above to lower the bite of RMDs, here are other smart strategies…
Avoid two distributions in the same year. Your first RMD must be taken by April 1 of the year after the year in which you turn age 72 (or age 70½ if you turned that age before 2020). However, it makes sense for many taxpayers to take that first RMD by December 31 of the year in which they turn 72 so that they don’t have to take two distributions in the following year that could result in a large tax bill and even push them into a higher tax bracket for that year.
Purchase a qualified longevity annuity contract (QLAC) to lower the size of your RMDs. How it works: You transfer a lump sum from your tax-deferred accounts to an insurance company and, in return, you receive an annual payment from the insurer for the rest of your life starting in a year you select. The payouts, which must start no later than age 85, are included in your annual taxable income. But the money you use to buy the QLAC is not included as income in RMD calculations, so it reduces the size of your RMD, lowers your taxable income and trims your tax bill.
Buy a permanent life insurance policy with the after-tax money from your RMD if you plan to leave money to your heirs and don’t need some or all of your distribution for living expenses. This policy combines a death benefit with a savings portion, allowing the policy to build a cash value, against which you can borrow funds or, in some instances, withdraw cash to meet needs such as medical expenses. After your death, your heirs inherit the policy benefit, which is not subject to income tax.