As we face a “likely" climate where taxes are going to be higher, I wanted to share a couple of optimal planning ideas to avoid - what I call “Tax Torpedoes”. What is a tax torpedo? It’s when your effective rate on certain portions of your income is higher than the statutory tax rate (in essence, the legal tax rate for each bracket of total income).
While every strategy will not be applicable to you, there is at least one idea that regardless of where you are in life, should be considered to potentially reduce your taxes and increase net income.
1. Increase Contributions to Roth IRA Accounts.
At any age (since they removed the age 70 ½ ceiling), Roth IRA contributions and conversions are an optimal tool to potentially reduce future taxes. By paying taxes at a “reasonable” rate up front, you can enjoy tax free growth on earnings for distributions down the road.
Blending those eventual tax-free distributions with other forms of retirement income such as social security can help potentially avoid the tax torpedo of dragging more social security income into the tax picture as well as decreasing the chance that you will have to pay higher Medicare surcharges or pay surcharges at all.
A second advantage is when you may need cash unexpectedly. For many, this is an automatic tax increase if their only source of funds are typically their old 401k’s which are now IRA’s. By having a healthy reserve of tax free funds, you can address that surprise expense without increasing your tax burden on potentially multiple forms of income.
Lastly, just remember that in order for the distributions to be tax free, you must be at least age 59 ½ and have held the account for a minimum of 5 years.
2. Use Pre-Tax Investments Earlier in Retirement to Reduce Required Minimum Distributions (RMD’s) at age 72.
Having multiple sources of retirement income is a good thing! Not only owning a Roth IRA, but a taxable brokerage account which may offer more attractive capital gains rates as well. Often people only draw from such accounts early on to avoid paying taxes on IRA assets, while allowing those funds to continue growing tax deferred. While that is not necessarily a bad thing, you may not be approaching each year's tax story as efficiently as you can. By pulling out just enough funds from your traditional/rollover IRA at a reasonable tax rate now, you are in effect reducing what your required minimum distribution will be down the road, thus lowering your overall tax obligation.
Also, and as important, it could change your decision on when to start taking social security which may also reduce overall taxes, as well as maximize your lifetime benefits and the benefits of your spouse.
3. Consider Delaying Social Security Benefits.
I ended the last point with Social Security. Let's make this a tax torpedo all of its own. For many of you, your lifestyle decisions alone will automatically determine if 85% of your Social Security benefits will be taxable. That is certainly not the case for all of you. If you have done the heavy lifting pre-retirement and have enough assets with various tax treatments as income sources, holding off from starting Social Security until age 70 should not be exceedingly difficult (however, there are more than tax implications that must be considered when choosing the best Social Security start date for you).
The ability to withdraw money from IRA assets without worrying about dragging Social Security into the tax picture can be huge. This will allow you to not only reduce those traditional IRA balances prior to requirement minimum distribution (RMD) years, but also reduce your overall tax structure potentially by not dragging another income source into the equation. Second, the combination of Social Security income with other taxable income for some could result in being subject to a marginal tax rate as high as 49.95 percent!
4. Rollover Pre-Tax IRA’s into Roth IRA’s.
This last tax torpedo is certainly not a general statement for everyone. This strategy must be done correctly as well as very carefully. There are several questions that you have to ask yourself before you start a strategy of Roth conversions. First and foremost, will converting a portion or all my IRA assets necessarily change my tax picture down the line? For some of you, you may feel based on your distributions now, that any tax increase in the future may not necessarily affect your tax bracket. The other question you must ask yourself is how much money do I want to convert? Besides the obvious issue of maximizing what you can convert at reasonable tax rates, will you even spend all of this IRA money over your lifetime or your spouse’s lifetime? On some occasions, a tax deferred is a tax not paid. Even so, part of your strategy may be to pay taxes on behalf of your children. As most IRA's that are inherited now must be liquidated in 10 years, many retirees are trying not to leave a tax burden on their children.
In closing, everyone's tax strategy in retirement is going to be a little different based on your personal situation and the types of assets that you hold. There are multiple considerations in determining the best approach for you. Keeping more of the nest egg requires all retirees to not only take into account all of the types of assets they own, but also, how they are taxed and what current Federal tax and IRA law offers. Depending on how you choose to live in retirement, you may not want to bear the burden of, or have an interest in, figuring out the most efficient strategy for you, each and every year. I encourage everyone to use a trained and accomplished Certified Financial Planner that is not only an expert in tax planning but also an expert on IRA law, rules and regulations. Not understanding the rules will chip away at the longevity of your nest egg and likely cost you tens of thousands, if not more, over your lifetime.
Roy Larsen is a Certified Financial Planner™ practitioner and Fee Only Wealth Manager who resides outside of Atlanta, Georgia.
Roy's Financial Blog contains articles on the multiple and complex issues of living successfully in Retirement. There are additional resources on our educational website, www.successfulretirementinstitute.com.