An excerpt from Wealth Redefined, by Bob Reby, CFP®
While it is possible to minimize your taxes no matter what stage of life you are in, there is no doubt that tax minimization will be easier in your retirement years – if you plan!
How Tax Planning Saves Money for Retirees
Let’s take a look at John and Sarah, a recently retired couple who have always worked hard, earned a good salary, and paid very high tax rates. When John and Sarah were working, they had limited ways to lower their tax bill. They wrote off their mortgage interest, took credit for their charitable contributions, and contributed to health savings accounts, but they still ended up with a hefty tax bill year after year.
Now that John and Sarah are retired, they can use strategic withdrawals from retirement and non-retirement accounts to lower their tax rates and keep more of the money they worked so hard to earn all those years. Examples of retirement accounts are Traditional IRA or a 401(k) accounts where you can contribute tax-free up to a certain annual limit, and see your investments grow tax-free until it’s time to withdraw.
John and Sarah need to withdraw approximately $50,000 a year to supplement their Social Security income and maintain their pre-retirement lifestyle. Since they have a portfolio of $1.5 million, they figure they can safely withdraw that amount, but they also want to keep their tax rate as low as possible.
Fortunately, John has $120,000 in a Roth IRA and Sarah’s Roth is worth $135,000. By tapping those funds first, John and Sarah can realize up to $36,000 in tax-free income in the coming year, and they will need to generate only $14,000 more from their taxable accounts. That should keep their tax bracket low, far lower than when they were still working.
Planning for Future Tax Years
Keep in mind that I don’t always recommend tapping into non-retirement accounts first before taking required minimum distributions (RMDs) from retirement accounts. Many advisors do recommend this, with the logic being that you should delay paying taxes for as long as possible. Withdrawals from a Roth IRA are tax-free and withdrawals from non-retirement investment accounts are taxed at the capital gains rate, which is generally less than the rate on ordinary income.
The reason I deviate from some of my colleagues is that when you’re left with nothing but retirement accounts and your withdrawals are taxed as ordinary income, any time you must make a large withdrawal for an emergency or a large purchase, you risk moving up into a higher income tax bracket. If you needed to make a $30,000 repair on your home, for example, you might have to withdraw approximately $50,000 to cover the taxes. This is because the $30,000 would be taxed in the 40% range or higher (Federal plus State)—and you’d have to pay taxes on the money you withdraw to cover the taxes!
If you retain funds in a Roth, there is no tax hit. If the funds are in a non-retirement account, the tax hit is often less severe when you have to make that big withdrawal because you’re only paying long-term capital gains taxes instead of taxes on ordinary income. (The tax rates on long-term capital gains are significantly less for most income brackets.)
Complimentary Tax Planning Chapter
Tax planning is a core component of financial planning. Taxes are most households’ largest expense. Reducing this expense may dramatically improve your cashflow, enhance your financial security, and increase the probability that you’ll be able to achieve all of your goals.
Discover additional strategies to reduce your income taxes both now and in the future by downloading a complimentary tax planning chapter from Wealth Redefined: Charting the Way to Personal and Financial Freedom.
