By Tom Rasmussen, CFP®
Although tax planning is critical during your earning and working years, it is just as, if not more, important as you approach and begin living in retirement. We have more people retiring now than we ever have before, making information on retirement tax strategies even more crucial for more people.
As you transition into your retirement, your income becomes much more predictable and consistent. Because of that, it is essential not only to know your tax situation but to plan for it as well. We will cover a few strategies that you can implement and points to keep in mind. This list is not comprehensive but includes some of the most common strategies you need to keep an eye on.
What is a Roth conversion? A Roth conversion is the transfer of qualified or pre-tax assets [traditional IRA or 401(k)] to a Roth IRA. Although a conversion is a taxable event, when done properly it will ultimately save you quite a bit of money in taxes paid during retirement.
Roth conversions have become such a popular financial planning tool in recent years because most retirees’ savings are tied up in pre-tax accounts, which are taxed as the money is withdrawn.
One of the main benefits of doing Roth conversions is being able to control how much is left in your pre-tax accounts and ultimately how much your required minimum distributions (RMDs) will be once you reach RMD age, which was recently increased to the year you turn 72 as part of the SECURE Act. Roth IRAs are not subject to RMDs.
Once your RMDs start, there is not much that you can do to control your retirement income. The RMD is calculated by taking the prior year’s ending retirement account balance and dividing it by a life expectancy factor (this can be found on IRS.gov). Therefore, the lower your traditional IRA balance, the lower your RMDs are, giving you more control over your tax situation.
The ideal time to begin Roth conversions is between the time that you retire—for example, let us say 65—and when RMDs begin at age 72. That gives you six years to do Roth conversions in this example. Your tax situation will determine the amount that you convert. The goal is to max out your current tax bracket without causing you to leap into the next bracket.
As an example, if your taxable income is $100,000, you are left with approximately $50,000 that you can convert to your Roth IRA without being pushed into the 24% tax bracket. This strategy would convert $300,000 to your Roth IRA ($50K/year for six years), not including market growth.
The funds in your Roth IRA will never be taxed again, as contributions are taxed as they’re contributed or converted to the Roth IRA.
Although one of the only tools you have available to you when trying to control your Social Security income is when you take it, it is still important to be aware of the tax consequences.
By the time you retire, you should already have a pretty good idea of when you will take your Social Security and how much the benefit will be. Up to 85% of your Social Security benefits can be taxable. This is not to say that your Social Security will be taxed 85%, but that 85% of the amount you receive will be subject to income taxes.
The taxation of Social Security is based on your “provisional income.” Provisional income is calculated by taking your modified adjusted gross income (MAGI) and adding any tax-free interest and 50% of your Social Security income.
For example, as a joint filer, if your MAGI was $50,000, you received $10,000 in tax-free interest, and half of your SS income was $15,000, then your provisional income will be $75,000 and 85% of your SS income will be subject to taxes.
Please refer to the table below for the provisional income limits and taxation:
If you are a tax filer who normally itemizes rather than taking the standard deduction, charitable gifting can be an effective tool if you feel inclined to do so.
There are a lot of ways to go about this, but several of the more common ones are laid out below. There are restrictions and limitations to the amount you can itemize. Please see IRS.gov or speak with your financial advisor to determine what those are.
You can gift money directly to your favorite charity or church. This is typically the most beneficial move, as it allows for a direct deduction of the cash that was contributed.
If you are in a position where you do not need your RMD to live on, you can do what is called a qualified charitable distribution (QCD). You direct your RMD for that year to go directly to a charity or church, and the money never shows as taxable income to you.
Although you do not get the deduction, you also do not have to claim those funds on your tax return. Depending on where your IRA is held, you will most likely just need to fill out a simple form to do this.
You can also contribute money to a donor-advised fund. A donor-advised fund allows you to contribute money now and later direct the funds toward the charity that you would like.
You can also set up a DAF directly with the charity of your choosing and later direct how those funds are used within the charity.
As you can see, it is incredibly important to know what strategies you might use to help plan for and control your tax situation in retirement. Effective tax planning is one of the most important strategies when it comes to your financial plan and something that you do not want to leave to chance. It requires thought, calculations, and efficient planning.
Schedule a complimentary meeting with a wealth advisor to discuss your personal situation.