Careful tax planning in retirement in essential. In this article, we’re offering several strategies that may help reduce your overall tax burden.
If you’ve planned carefully, you may be lucky enough to have multiple sources of income in retirement. For example, retirement savings accounts and other investments, Social Security, and possibly even a pension plan may generate income for you to cover expenses and maintain your lifestyle once you stop working.
For high earners, your living expenses in retirement are often much lower than your taxable income prior to retiring. Consequently, many retirees see their taxable income plummet in the early years of retirement. Yet due to required minimum distributions (RMDs), retirees tend to see their taxable income spike after turning 72. That’s why we often refer to the time between your retirement date and your first RMD as your “gap years.”
Indeed, this spike in taxable income later in life can push you into a higher tax bracket. It can also cause your Medicare premiums to increase. To help minimize these effects, tax planning in retirement is critical—particularly during your gap years.
What Is an RMD?
To keep people from using retirement accounts to avoid paying taxes, the IRS requires individuals to begin taking minimum distributions from their employer-sponsored retirement accounts and traditional IRAs once they reach a certain age. As of 2020, required minimum distributions (RMDs) kick in at age 72.
Your annual RMD is calculated based on your account balance and life expectancy. In other words, the more you have saved, the higher your RMD will be.
You can withdraw more than your RMD amount in any given year but be prepared for the potential tax consequences. On the other hand, the IRS imposes a penalty of up to 50% if you fail to take your RMD before the deadline.
Both scenarios can be costly. Fortunately, careful tax planning in retirement can help you manage your RMDs to avoid high taxes and other penalties.
The Cost of High Income in Retirement
In 2022, the United States has seven federal tax brackets—10%, 12%, 22%, 24%, 32%, 35% and 37%. Your bracket depends on your taxable income and filing status. Therefore, a meaningful increase in taxable income can push you into a higher tax bracket, all else equal.
For retirees, higher taxes can eat away at your retirement savings over time. This increases the risk that you’ll outlive your financial resources. Unfortunately, a higher tax bracket can also cause other expenses to rise—yet another reason why tax planning in retirement matters.
For example, if the Social Security Administration considers you to be a “higher income beneficiary,” you’ll pay higher premiums for Part B (the health insurance portion of Medicare) and Medicare prescription drug coverage. Currently, single taxpayers with modified adjusted gross income (MAGI) above $91,000 and joint taxpayers with MAGI above $182,000 must pay higher premiums. If you only have Part B or prescription drug coverage, you’ll pay an income-related monthly adjustment amount on the benefit you have.
Furthermore, those who pay higher Medicare premiums aren’t covered by the “hold harmless” provision. This rule protects your Social Security benefit payment from declining due to an increase in the Medicare Part B premium.
At the same time, your income can affect your long-term capital gains tax rate. In 2022, the long-term capital gains rate is 0%, 15%, or 20% depending on your taxable income. If you’re married filing jointly and your taxable income is less than $83,350, your long-term capital gains rate is 0%. (Single filers can earn up to $41,675 and have a 0% rate.) However, if your taxable income exceeds these thresholds, your long-term capital gains tax rate jumps to 15%.
5 Tax Planning Strategies to Reduce Your Overall Tax Burden in Retirement
By now, the potential consequences of a spike in taxable income in your retirement years should be obvious. Therefore, it’s important to manage your income from Social Security, investments, and traditional IRAs and 401(k)s, especially once you begin taking RMDs.
Indeed, RMDs can push you into an unfavorable tax bracket if you don’t prepare accordingly. The good news is there are several strategies that can accelerate income in years when you fall into a lower tax bracket. Ultimately, these tax planning strategies—when implemented successfully—can lower your overall tax burden in retirement.
Strategy #1: Roth Conversion
The IRS allows individuals to convert a traditional IRA to a Roth IRA via a Roth conversion. A Roth IRA conversion shifts your tax liability to the present. As a result, you avoid paying taxes on withdrawals in the future. In addition, Roth IRAs don’t require minimum distributions.
With a Roth conversion, you pay taxes on the amount you convert at your current ordinary income tax rate. Then, any withdrawals you make in retirement will be tax-free if you’re over age 59 ½ and satisfy the five-year rule. And since Roth IRAs don’t have RMDs, you can leave your funds to grow tax-free until you need them.
A Roth IRA conversion can be a powerful tax planning strategy, but it doesn’t make sense for everyone. You should consider the advantages and drawbacks before converting your IRA to a Roth.
Strategy #2: Accelerate IRA Withdrawals
Another tax planning strategy to consider is taking distributions from your traditional IRAs before you reach age 72. This strategy may make sense if your income during your gap years is low, and a withdrawal won’t push you into an unfavorable tax bracket.
One of the benefits of accelerating your withdrawals is that it removes assets from your traditional IRA today. By doing so, it also reduces your RMDs—and subsequently, your future tax liability.
Strategy #3: Realize Long-Term Capital Gains
As mentioned previously, the long-term capital gains tax rate is currently 0% for married couples filing jointly with taxable income less than $83,350. As such, your gap years may be an opportune time to realize long-term capital gains and reset the cost basis on your highly appreciated investments.
It’s important to note that long-term capital gains are added to your taxable income to determine your federal income tax bracket. In other words, if you’re married with a joint income of $80,000, you can’t cash out $250,000 worth of appreciated stock tax-free. In the absence of other strategies that reduce your taxable income, you could only sell $3,350 to take advantage of the 0% tax rate.
Strategy #4: Avoid Net Investment Income Tax (NIIT)
High income taxpayers may be subject to net investment income tax (NIIT). If your modified adjusted gross income exceeds a certain amount, you must pay an additional 3.8% tax on investment income. NIIT is imposed on interest, dividends, and capital gains from various investments, including stocks, bonds, rental real estate, and business interests.
Fortunately, you may be able to avoid NIIT through careful tax planning in retirement. First, be sure to review your income throughout the year from various sources. If your projections indicate that you may be subject to NIIT, consider ways to lower your taxable income. Alternatively, you can simply limit your income from investments to avoid paying the extra 3.8% tax.
Strategy #5: Donate Your RMD to Charity
Lastly, your income during your gap years may be more than enough for you to live on in retirement. If so, you can donate your RMD to charity—a tax planning strategy called a qualified charitable distribution (QCD). A QCD allows IRA owners to transfer up to $100,000 directly to charity each year.
QCDs can satisfy all or part of your RMD each year, depending on your income needs. You can also donate more than your RMD amount up to the $100,000 limit. And since QCDs are non-taxable, they don’t increase your taxable income like RMDs do.
It’s important to note that the IRS considers the first dollars out of an IRA to be your RMD until you meet your requirement. If you take advantage of this tax planning strategy, be sure to make the QCD before making any other withdrawals from your account.
Bottom Line: Tax Planning in Retirement Is an Ongoing and Necessary Process
In many ways, tax planning in retirement—and especially during your gap years—can be more complex than in the years leading up to retirement. The many potential challenges underscore the importance of having a detailed retirement plan that anticipates changes to your income and relevant tax laws.
It’s also worth noting that Congress is currently working on new legislation that, among other provisions, would raise the RMD age. If passed, this change would likely extend your gap years, giving you more time to plan for taxes in retirement.
One of the easiest ways to stay on top of these changes and plan for your financial future is to work with a trusted financial advisor like Milestone Asset Management Group. Our in-house team of financial planners and CPAs can help you proactively make the best money decisions for your retirement. To speak with a member of our team and see if we’re a good fit, please schedule a call.