How to Pay Less Taxes In Retirement
A tax-efficient withdrawal strategy in retirement can help you minimize the amount of taxes you pay on your retirement income and potentially increase the success of your Financial Plan.
Working with an advisor who specializes in Retirement Planning that also conducts detailed tax planning is a key consideration when interviewing a potential fit for your needs.
Some of the best tax-efficient withdrawal strategies that you may consider include:
Roth IRA conversions
If you have a traditional IRA or a 401(k), you may be able to convert some or all of these pre-tax funds to a Roth IRA. Once these assets are moved to a Roth IRAs, qualifying withdrawals in retirement become tax-free.
There are several considerations to make when considering a Roth conversion however:
Tax Rates: A Roth conversion benefit those most who expect to be in a higher tax bracket in the future. Often times, during a career many save exclusively on a pre-tax basis. This often becomes problematic. Having too much of your assets that are pre-tax going into retirement can produce sizeable RMDs later in life, driving your tax brackets into a much higher rate than desirable.
Conversion amount: Consider the effect a conversion would have on both current and future tax liability as well as ‘hidden’ taxes. A conversion may allow you to pay less in taxes down the road, but has other ancillary benefits like paying less for Medicare premiums or reduced taxation of Social Security benefits.
Cash on Hand: For a Roth conversion to be most beneficial, it’s best to pay the resulting tax liability from assets outside the Roth. Planning to have cash on hand or funds set aside in a brokerage account are great ways to handle this.
Portfolio composition: Consider the mix of pre-tax and after-tax assets. Having a good mix of assets across tax location allows you much greater flexibility of controlling your taxable income each year.
Estate planning: Roth conversions can impact the amount of taxes your heirs pay on the assets they inherit. When inheriting pre-tax dollars, most non-spouse heirs only have 10 years to distribute the assets from a traditional IRA. This is often during their highest earnings years. Leaving a Roth to heirs allows you to pass along your assets completely tax free.
Tax-Efficient Withdrawal Order
Tax-efficient withdrawal order refers to the order in which an investor withdraws assets from different types of investment accounts during retirement to minimize taxes. The goal is to minimize the tax liability associated with withdrawals by taking advantage of the different tax treatments for different types of accounts.
The general order for tax-efficient withdrawals is as follows:
Taxable accounts: Withdraw assets from taxable accounts first, as these accounts produce taxable income that cannot be deferred.
Tax-deferred accounts (e.g. IRA): Withdraw assets from tax-deferred accounts next, as these accounts are not taxed as they grow, but only upon withdrawals are they taxed as ordinary income.
Tax-free accounts (e.g. Roth IRA, HSA): Withdraw assets from tax-free accounts last, as these withdrawals grow completely tax free and are not taxed upon withdrawal.
It's important to keep in mind that this is a general guideline and the most tax-efficient withdrawal order will depend on an individual's specific circumstances, including your marginal tax bracket, expected future tax rate, and other financial goals.
Tax-loss harvesting
This strategy involves selling investments that have decreased in value to offset any capital gains produced from other investments. This can help reduce your overall tax liability.
If the losses exceed gains for the year, you are even able to use up to $3,000 of the unused losses to offset ordinary income. The goal is to reduce the overall tax bill by taking advantage of losses in the portfolio to offset taxable gains.
Be aware of wash sale rules when doing so however. The wash sale rule is a tax law that disallows a tax deduction for losses on the sale of a security if an identical or substantially identical security is bought within 30 days before or after the sale.
It's important to consult a financial planner that offers tax planning to help you understand how these strategies may affect your unique tax situation and retirement plan.
