Where there is income, there will be tax. So, it’s no surprise that building a successful retirement income plan will have a lot to do with how much tax you will pay on your account withdrawals.
In all honesty, planning for the “money-out” phase of retirement is often more complicated than the “money in” phase. That’s why it’s often likened to climbing Mt. Everest—because 80% of injuries occur not on the way up, but on the way down.
So how do you limit your tax liability to improve your odds of retirement success? Here are a few considerations to get you started.
First, understand how your retirement income will be taxed.
It is much easier to shield your money from taxes during your retirement plan’s accumulation phase than in the distribution phase. That’s because, as you start receiving income in retirement, the IRS can come at you in ways you may not have considered. An income source on the left will affect the tax treatment on the right and could affect your Medicare and Social Security in the background. Like we said, there are a ton of moving parts.
What this means is that what you see on the surface, as far as your retirement account balances and your projected cash flow from these accounts, may be different from what you actually get. So many retirees are blindsided with lower-than-expected cash flows because they weren’t prepared for how their income would be taxed.
- Ordinary income taxes on withdrawals.
The money accumulated in your 401(k) or IRA is worth less than the amount stated on your account statement. That’s because, after all the years of tax-deferred accumulation in those accounts, the IRS is waiting in the wings to get its share. That happens as soon as you start taking distributions, which are taxed as ordinary income.
So, if you have accumulated $500,000 in your 401(k) or IRA, here is what it would be worth after taxes:
$325,000 if you’re in the 35% tax bracket
$315,000 if you’re in the 37% tax bracket
Understanding where you stand on an after-tax basis is crucial in planning your distributions, so they have the most negligible impact on your tax bracket. It also puts you in a position to consider strategies that can help mitigate the impact of taxes.
- Requirement minimum distributions: If you think you can avoid taxes by not taking distributions, the IRS forces you to take withdrawals starting at age 73 through the required minimum distribution (RMD) rules, whether you need the income or not. This can have the effect of pushing you into a higher tax bracket, increasing your tax liability. However, with that understanding, you can explore strategies to mitigate its impact.
- Social Security “tax torpedo”: Not only are withdrawals from tax-deferred accounts fully taxable, but they can also trigger the Social Security “tax torpedo,” which exposes as much as 85% of your Social Security benefits to ordinary income taxes.
Then, choose strategies for controlling taxes in retirement.
Knowing what they know now in terms of retirement income taxation, many retirees would probably have chosen a different strategy that included allocating more of their retirement contributions among post-tax accounts that generate tax-favored capital gains or a Roth IRA for its tax-free withdrawals (which are is not considered provisional income included in the Social Security tax calculation).
However, retirees knocking on retirement’s door still have an opportunity to develop an income strategy that can effectively minimize their taxes and stretch their assets further into the future.
Tax-Efficient Withdrawal Strategies: An essential strategy for reducing taxes on retirement account withdrawals is implementing a tax-efficient withdrawal strategy. This involves withdrawing funds from taxable accounts before tax-deferred accounts, which can help reduce tax liabilities with a more favorable capital gains tax. It’s essential to work with a financial advisor to determine the best approach for your situation.
Consider a Roth IRA conversion: While contributions to a Roth IRA are not tax-deductible as with traditional IRAs, withdrawals are tax-free. A Roth’s tax-free income in retirement can lower your overall taxes in several ways, not only increasing your cash flow but also extending your retirement capital further into the future.
- The tax-free income will not push you into a higher tax bracket, as would taxable withdrawals from a tax-deferred qualified retirement plan.
- The tax-free income will not count towards the stealth Social Security tax torpedo on excess earnings.
- There is no required minimum distribution rule for a Roth IRA, enabling you to keep growing your retirement capital tax-free.
The tax code allows individuals who otherwise don’t qualify for a Roth IRA to fund a traditional IRA or 401(k) plan and then convert it to a Roth. There is no income limit or limit on how much or how many times you convert.
When you do convert, it triggers a tax on the conversion amount because it is treated as a taxable distribution. For example, if you transfer $10,000 from a tax-deferred qualified retirement account to a Roth, that amount is added to your adjusted gross income (AGI) and taxed at your federal tax rate.
If you have $100,000 in a traditional IRA, it can be converted all at once. However, considering the tax implications, it may be better to convert portions of it over several years.
Qualified Charitable Deduction to Offset RMDs: A Qualified Charitable Deduction is a direct, tax-free transfer of funds from your IRA to a qualified charitable organization. To be eligible, you must be at least 73 and ready to take your first RMD. It’s a direct transfer, so the check must be payable to the charitable organization by December 31 to qualify. If married, you and your spouse can each transfer up to $100,000 tax-free from your IRA each year, even if it exceeds your RMD.
The QCD is unavailable for 401(k) plans, SEPs, or SIMPLE IRAs. However, if you roll any of those plans into an IRA, it becomes QCD eligible.
These strategies have tax implications, and everyone’s tax situation is different. You should always consult a qualified professional tax advisor to discuss your specific tax situation and how these tax reduction strategies apply to your situation.
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At Platt Wealth Management, we like to encourage our clients to dream, plan, and do. Don’t let an underdeveloped tax strategy get in the way of “doing” all you’ve dreamed and planned for.
If you’re in need of a financial guide to help you make your way through the “money in” and/or “money out” stages, we would love to see if we’re a good fit. Simply schedule your complimentary phone consultation to discuss your opportunities.
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