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Make the most of your money and minimize taxes in retirement

Make the most of your money and minimize taxes in retirement

Many people look forward to retirement as a time to let go of the day-to-day worries that they had to deal with during their working lives. But even in retirement, Uncle Sam demands his due. Taxes remain a constant and, for retirees who don’t plan carefully, they can take a serious bite out of retirement savings. Yet with some thoughtful financial planning, you can minimize your tax burden, leaving more of your savings available to make your retirement comfortable and rewarding.


Do

Do effectively time withdrawals from retirement accounts

One of the most powerful ways to keep your taxes manageable in retirement is to be deliberate about when and how you withdraw money from your various retirement savings accounts. You may have savings in accounts that are fully taxable, tax-deferred, or tax-free. Conventional wisdom suggests that you withdraw funds first from taxable accounts, as such accounts will usually contain assets subject to capital gains tax rates, which are relatively low for most taxpayers.

Tax-deferred accounts come next. Withdrawals from these accounts are taxed at your ordinary income tax rate, except for any after-tax contributions, which are not taxed a second time. Since distributions from tax-deferred accounts are treated as ordinary income, it can ultimately be more expensive to spend money from an IRA than from a taxable account, since dividends and long-term capital gains in taxable accounts are taxed at favorable rates compared to ordinary income taxes.

Tax-free accounts are generally last in line, allowing them to grow over time. Tax-free accounts are also usually the right choice for large emergency expenses, like major home repairs or medical bills, as taking money from tax-deferred accounts for these needs might push you into a higher tax bracket.

By holding assets in a mix of accounts, retirees can consider the tax consequences each year. If it’s a low income year, they may want to pull some money from their traditional IRA to benefit from that year’s low tax bracket. If it’s a high-income year and investments in a taxable account have a lot of appreciation, it may make sense to spend from a tax-free Roth IRA account. 

Do be aware of the Social Security “tax torpedo”

Social Security benefits are taxed based on your other income, which is generally the sum of your adjusted gross income, nontaxable interest, and half of your Social Security benefits. As your income rises, the proportion of your benefit that is taxable does, too. But the way Social Security’s taxability is calculated creates an even bigger tax hazard—often called the “tax torpedo.” Retirees who collect Social Security benefits early often need to supplement them with withdrawals from an IRA or other retirement account. But if income in early retirement exceeds relatively modest levels, there is a steep increase in marginal tax rates. If you do take your Social Security benefit relatively early, it is important to allow for the ripple effect that the benefit’s taxation could have on your overall tax rate.

Do understand your capital gains tax liability

As mentioned above, capital gains taxes are relatively low compared to income taxes. But it is still important to understand what sort of capital gains taxes to expect to pay on your various investments. Capital gains are assessed in two categories: short-term and long-term. Short-term capital assets are those you hold for less than a year before selling, and they are taxed at higher rates than long-term assets. Your taxable accounts are ideal for assets subject to capital gains tax, saving tax sheltered accounts for assets taxed at ordinary income tax rates when possible.

It is also important to remember that if you sell an investment at a loss, the loss can offset your capital gains; if your loss is greater than your gains, you can also deduct against other income, up to $3,000 per year. Any loss over that amount carries forward into the future. Annual, disciplined selling to harvest such losses is especially important in down-market years. You should also buy “replacement funds” that have similar market exposure as the funds you sold at a loss. This practice will ensure you participate in any market recovery.

Do plan for the new ACA taxes

Beginning with the 2013 tax year, a new Medicare surtax applies to taxpayers who have net investment income (NII) and whose modified adjusted gross income (MAGI) exceeds a certain threshold ($250,000 for married taxpayers). This new surtax will essentially raise the marginal income tax rate for affected taxpayers and is entirely separate from the regular income tax and alternative minimum tax. A large part of wealthy retirees’ income often comes from investments, so this new tax may significantly impact them.

There are two main approaches to minimize the impact of the surtax. The first is to reduce your net investment income and the second is to reduce your MAGI. There are a variety of tactics you could adopt to accomplish these goals:

 

  • Invest more heavily in municipal bonds
  • Invest in tax-deferred annuities
  • Use life insurance with cash value build-up
  • Carefully plan the timing of estate or trust distributions
  • Convert a traditional IRA to a Roth IRA
  • Plan with Charitable Remainder Trusts and/or Charitable Lead Trusts

Also note that the law defines “net investment income” quite specifically. Retirees should understand what sorts of income count toward the threshold and attempt to structure their portfolios so that they can minimize the impact of this tax. 

Do thoroughly plan with a tax expert

Tax planning should have two components. First, it is important to create a long-term plan that governs decisions including how much you should withdraw each year and from which accounts. A long-term plan will also include considerations such as taxes you might pay on your savings while you’re still working or places to allocate various investments in order to minimize your taxable income.

Annual tax-bracket planning can help you to uncover various opportunities that arise because of circumstances that change from year to year. Such planning will allow you to strategically realize capital losses, take advantage of high numbers of itemized deductions, and keep an eye on legislative changes that could affect your plans.

Both long-term and year-to-year tax planning will help you keep your tax burden as low as possible, and neither should be neglected. For many retirees, such plans may be more complicated than they feel comfortable handling alone. You should never hesitate to seek qualified help from a tax expert or financial planner when handling such planning decisions. 


Don't

Do not forget about state taxes

In addition to federal income taxes, state income taxes can take a substantial chunk of your retirement savings without planning. Be sure to factor the income taxes levied by your state, as well as property taxes, into your planning. Some people consider moving to a state with low or no income taxes when they retire. This strategy can be effective, though you should be certain to take the necessary steps to establish domicile in your new state in order to avoid your former home state’s claims on your income.

Moving isn’t the only solution, however, and you should not move simply for tax purposes if you have no desire to leave your home. Another alternative is to consider investing in state-specific municipal bond funds, which can bring tax benefits to offset state-level taxes. The first and most important step is to plan for and understand how state and local taxes will affect your retirement nest egg.

Do not neglect to diversify by tax treatment

Putting all your eggs in one basket is almost never a good idea when investing, and retirement accounts are no exception. While you are still working, saving in a variety of taxable, tax-deferred and tax-free accounts will give you many more options when planning how and when to withdraw those savings. Most investors will want to keep securities that will receive capital gains treatment in taxable accounts and leave other investments in tax-free accounts, such as Roth IRAs, to grow over time. Diversifying early gives you more options as to which accounts to withdraw asset from later and will allow you to better manage your income tax burden in retirement.

Do not invest accounts independently of each other

You should manage all your investment accounts as part of your overall portfolio. This will help you manage risk most effectively. For example, while the tax treatment of the account may help you decide which investments should go where, don’t let the relative sizes of the accounts determine your asset allocation (the balance of asset types you hold in your overall portfolio). If you have $100,000 in a Roth IRA and $175,000 in a taxable account, it does not mean that you should necessarily hold $100,000 in cash or bonds and $175,000 in stocks. Determine your asset allocation first, and then look at how best to implement that overall strategy across all your accounts.

Depending on your personal risk tolerance, retirement timeline, and a variety of other factors, your ideal asset allocation will vary. But once you know your target, you will be able to use your various accounts to best effect. You will generally want to keep your highest current income-producing assets in tax-deferred accounts. You may also want to consider keeping any international investments in taxable accounts, so that you can take advantage of the foreign tax credit. An effective investment plan will consider your entire financial picture, not just one account at a time.

Do not forget special rules for company stock

If you hold stock from your employer in a 401(k), it is important to remember that a special rule allows you to pay the lower capital gains rate on the growth of that stock. To take advantage of this rule, you must take it out as an “in-kind distribution.” Basically, you will need to move the stock directly to a brokerage account, rather than selling it and reinvesting the profits as you would with most 401(k) assets. Rolling the stock into an IRA also forfeits this benefit. While it’s wise to avoid overly concentrating a position in any one company, keep this company stock advantage in mind if it applies to your situation.

Do not neglect your required minimum distributions (RMDs)

Certain kinds of retirement savings accounts, including traditional IRAs and 401(k)s, have required minimum distributions (RMDs) each year after the account holder reaches age 70.5, regardless of whether the saver needs the money or not. If you fail to withdraw your full RMD for the year, you will be subject to a hefty excise tax, equal to 50 percent of the amount by which you fell short. You should account for RMDs in your overall withdrawal strategy in order to avoid having to pay the underpayment penalty. If drawing your full RMD results in drawing down more money than you want or need, remember that you can always reinvest the assets in a taxable account.


Summary
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Taxes can be one of the largest items in a retiree’s budget. However, taxpayers can use a combination of annual and long-term planning in order to keep their tax bills to a minimum and to maximize the amount of savings available for other wants and needs. For those who have not yet retired, diversifying their retirement accounts’ tax treatment and understanding the way their future tax treatment will be calculated can give savers a running start on a retirement where a smaller portion of their savings are earmarked for Uncle Sam. For most people, taxes will never go away entirely. But with attention and planning, they can become a much smaller worry.


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Anthony D. Criscuolo, CFP®Client Service Manager/Portfolio Manager

Anthony D. Criscuolo, CFP®, has extensive experience in Palisades Hudson’s estate planning, tax, investment management and accounting practices. Anthony provides a wide range of services to his clients, including asset allocation and investment ...

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