If you’re like most recent retirees, you’ve likely built the majority of your nest egg by taking advantage of your employer 401(k) or a similar tax-deferred retirement plan over the years. It’s a savvy move, given that contributions are made automatically each pay period before they’re taxed, and you typically receive some form of matching contribution from your employer.
While your 401(k), 403(b), or traditional IRA provides a major tax benefit while you’re still saving, you’ll still need to pay tax on that money when you begin taking it out. For many retirees, the amount of tax they are expected to pay in their retirement years can come as an unwelcome surprise.
Thankfully, with thoughtful planning and some good foresight, there are ways that you can mitigate the taxes that you pay, and give yourself more control over when and how you ultimately pay them. While we all have to pay taxes, you shouldn’t pay more than you need to.
The Challenge: RMDs and Federal Benefits
Required Minimum Distributions (often referred to as RMDs) are the amounts of money you’re required to withdraw from your retirement accounts each year, beginning at age 72. When you contribute to a pre-tax retirement account while working, you’re electing to instead pay the tax on that money when you take it out at a later point in time. Once you reach age 72 (previously age 70.5 until the SECURE Act went into effect earlier this year), the IRS requires that you begin taking money out. Since every dollar that you distribute is treated as taxable income, this can result in a hefty tax bill for those that have saved a lot in a 401(k) or traditional IRA.
For example, let’s consider a married couple who both turn 72 the same year. They saved diligently throughout their working years, building a combined balance of tax-deferred assets of around $2 million. Based on the IRS’s Required Minimum Distribution Worksheet, in a normal year* once they reach RMD age, they’d be required to take out almost $80,000 from their assets in just the first year alone.
By taking excess distributions, their adjusted gross income will increase, which can lead to higher Medicare premiums and more of their Social Security benefits becoming taxable.
In addition, taxes and fees on federal benefits can also take a toll. Up to 85% of your Social Security benefits may be taxable. And you could be charged Medicare premium surcharges if you make beyond a certain amount.
*The IRS has suspended required minimum distributions for 2020 as part of the CARES Act in response to the COVID-19 pandemic.
The Solution: The Tax Planning Window
So how can you plan ahead to avoid paying income tax at a higher rate than you need to on your retirement account distributions? For many, the opportunity often presents itself in the years immediately following your retirement in what’s commonly referred to as the “retirement tax planning window.”
This period of time often presents itself in the years after you stop working and before you’ve elected to take your Social Security benefits or are required to take minimum distributions. During this period, you’ll likely find yourself in a lower tax bracket than when you were working, providing a significant opportunity from a tax perspective.
This is where I often suggest taking some of your traditional tax-deferred retirement savings and moving it to a Roth IRA instead, also known as a Roth conversion. When you convert money to a Roth IRA, you pay tax on the money upfront and create a new source of tax-free retirement income.
By electing to pay some taxes now while in a lower tax bracket, you’re essentially hedging against potential higher tax rates in the future when you’re required to. If your goal is to pay the least amount of taxes over the course of your lifetime, there’s a good chance you’ll be saving money in the long run by paying some of that tax now.
While you can’t entirely avoid paying taxes in retirement, you can control how much of your money you keep by taking control now and planning ahead. If the majority of your savings are held within retirement accounts, it’s critical that you have a tax-efficient strategy around how and when you take money from your accounts when you’re no longer working.
Need help with establishing a plan for how to reduce the taxes you pay in retirement? Schedule a 30-minute call with me to chat about your situation and determine if I’m the right fit to help you out.
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Brett Koeppel is a fee-only Buffalo financial advisor, CERTIFIED FINANCIAL PLANNERTM , and the Founder/President of Eudaimonia Wealth. Eudaimonia Wealth is a fee-only, fiduciary, Buffalo financial planner and wealth management firm dedicated to helping families prepare for and transition into retirement by providing independent, objective financial planning and investment management advice.