Step 3 of 4: Perform Multi-Year Tax Planning to Minimize Taxes in Retirement
By Scott Snider, CFP®, RICP® and Michelle Ash, MSFS, CFP®
KEY TAKEAWAYS
Multi-year tax planning starts with reviewing your overall income picture over your lifetime to look for any periods of time when you’re likely to be in a lower tax bracket.
The goal is to figure out which accounts to make withdrawals from and when based on what your income situation looks like at various periods of time.
The timing of when you receive income from social security, pensions, and IRA distributions will affect how much income taxes you will pay over your lifetime.
Delaying social security benefits, how you manage your investment income, leveraging tax-deferred accounts, Roth conversions, planning for required minimum distributions (RMDs), and proper use of tax deductions are effective strategies to consider when mapping out your multi-year tax planning.
This article is entry #4 in our Retirement Income Series and is Step 3 of a 4-step withdrawal planning process that we employ – performing multi-year tax planning to minimize taxes in retirement. To recap, the 4-steps to YOUR retirement income plan are:
Begin with the end in mind: what's your ultimate nest egg goal?
Understand different withdrawal methods that tell you how much money you can take out.
Perform multi-year tax planning to minimize taxes in retirement.
Get to know YOUR retirement building blocks and when and how to use them for maximum effect.
Before you learn more about Step 3, we recommend reading Step 1 and Step 2 if you haven't already.
To effectively perform multi-year tax planning strategies, you need to start by looking at your overall income picture over your lifetime. Every single year is accounted for. Doing it this way creates a timeline that allows you to evaluate the bigger picture and identify where specific planning strategies along that timeline may help reduce your overall tax burden. Through this process, the goal is to determine which accounts to withdraw from and when based on your income and expense situation during various segments of time.
Taking it a step further, some of the main components that affect how your retirement income will project over time are:
The timing of when you take social security and pension income.
The timing of when you begin taking distributions from taxable accounts versus tax-free accounts.
The timing of when the IRS requires you to take distributions from pre-tax accounts.
WITHDRAWAL PLANNING TIMELINE
To help visualize how the retirement timeline is mapped out, the following examples below illustrate two common scenarios:
To understand the big picture, let's dive into what's happening in both projections in the above graphs. We will assign names to each chart so that it's easier to follow along. The graph to the left is for Joe Sample, and the diagram to the right is for Bob and Cindy Jones.
Starting with the graph to the left, we see that Joe Sample receives a steady income throughout his retirement. At the same time, Joe's expenses remain elevated above his income for the entirety as well. This gap in spending and income means that Joe will need a modest level of portfolio withdrawals each year to supplement his lifestyle.
The second graph to the right shows that Bob and Cindy Jones' fixed income is much lower during the first few years of retirement because they delayed receiving their social security income and didn't need to pull income from their pre-tax IRAs. Also, during this brief period, expenses are higher than income, so Bob and Cindy must use their bank account savings and other tax-efficient investments to cover their shortfall. Notice that once their social security and required minimum distributions (RMDs) kick in, their income remains higher than their living expenses for the rest of their lives.
Unfortunately for Bob and Cindy, their taxes will increasingly become more expensive as they grow older. Instead, they would benefit by mapping out a timeline of cash flows. In doing so, they would recognize that withdrawing from pre-tax accounts sooner would spread their tax liability over their lifetime, reducing their lifetime tax liability.
TAX STRATEGIES FOR RETIREMENT
Now that you understand how to plot out your plan, let's examine six specific tax planning strategies that can help you minimize your tax liability during retirement.
1) Delaying Social Security Benefits
When you retire in your early-to-mid 60s, you have a decision to make about social security and when to take it. Delaying your social security benefits until your full retirement age (or as late as age 70) creates a window of time when you will need to live on other assets to get by. In such instances, consider drawing from tax-favored accounts like Roth IRAs and taxable investments to keep your taxable income lower for that stretch of time.
Qualified distributions from your Roth IRA are tax-free, so if you have enough Roth money, you can enjoy your go-go years of retirement without paying any taxes. If leaving a significant legacy isn't important, you may consider such a withdrawal strategy, as there are other potential financial benefits, like reducing your ACA health insurance premiums until you are eligible for Medicare.
Also, suppose you have a taxable account, such as a brokerage or high-yield savings account. In that case, you can rely upon those assets to generate interest, dividends, and capital gains income. The benefit of living on long-term capital gains and qualified dividends is that they are taxed at a preferential rate of 15% for most retirees. In some cases, the taxable rate on capital gains income can be 0% or 20%, depending on how your income is structured that year.
2) Managing Investment Income
Another way to reduce the taxable income generated from your after-tax investment accounts is by shifting some of those dollars into municipal bonds and annuities. The interest generated from municipal bonds is generally federally tax-exempt for fixed-income investors. They are also usually exempt from state income taxes if the bond issuer is in the investor's home state. These types of bonds are especially attractive to retirees in a high tax bracket.
Annuities are another vehicle that allows retirees to tax-defer the growth of their after-tax savings (non-qualified money). In other words, when capital gains, dividends, and interest are earned within the annuity account, no taxes are due until the annuitant receives income. Also, because most annuities don’t force income distributions until age 90, the owner has the option of deferring taxes for a majority of their lifetime. The earnings come out first and are taxed as ordinary income upon distribution. After all earnings are exhausted, the principal is withdrawn without incurring taxes since that money was already taxed.
3) Tax-Advantaged Retirement Accounts
If you fall into the semi-retired category, you may be earning consulting income as a 1099 contractor. In this case, consider deferring part of your earnings into retirement accounts such as a solo 401(k), SEP IRA, SIMPLE IRA, pension, or cash balance plan. Understanding which type of retirement plan is applicable to meet your needs is beyond the scope of this article; however, the benefit of putting money away into a pre-tax retirement plan is that you reduce your taxable income. For example, defined contribution plans such as a solo 401(k) allow you to tax-defer as much as $66,000/year ($73,500/year if older than 50).
4) Roth Conversions
For a more in-depth understanding of Roth conversions, we have an entire library of articles found here – Roth Strategies. The basic premise of a Roth conversion strategy is that by shifting dollars from your traditional pre-tax IRA to your tax-free Roth IRA, you are paying taxes now with the expectation that you (or your heirs) will benefit from saving money on paying taxes over the long term
Therefore, the ideal timeframe to consider Roth conversions is when your income is lower relative to other segments mapped out along your retirement timeline. In addition, it makes sense to evaluate Roth conversions when you have a sizable traditional IRA subject to significant RMDs. More on that is detailed below in point #5.
5) Planning for Required Minimum Distributions (RMDs)
Suppose you are a retiree who only needs the income from your IRA once the IRS says that distributions are required. In that case, you might be setting yourself up for disappointment when you turn 73 - the age at which the IRS currently requires mandatory distributions. Say you have $3M saved in a traditional IRA; your RMD when you turn 73 would be $113,207. Add that to your social security income and income generated from investments, and it's possible you suddenly jumped into a higher tax bracket. A way to plan around this is to smooth out your distributions from your traditional IRA leading up to RMDs or perform Roth conversions several years before you turn 73. To learn more about RMDs, we cover this subject in more detail in the following article – Managing your Required Minimum Distributions (RMDs) in Retirement.
6) Tax Deductions
With the standard deduction set at $27,700 (+1,500 for each spouse above 65) in 2023, itemizing your deductions has become a challenge for the average retiree. Especially if your house is paid off and you no longer get the mortgage interest deduction. However, an effective way to occasionally increase your deductions above the standard deduction is bunching your itemized deductions. The simplest way to think about this strategy is to effectively pay two years' worth of deductions in a single tax year so that you can hurdle over the standard deduction. Then the following year, when your itemized deductions are lower, you use the standard deduction.
PERFORMING MULTI-YEAR TAX PLANNING
In order to minimize lifetime taxes, you must understand the tax strategies available to you and how they can be incorporated into your cash flows from one year to the next. In other words, coordinating your withdrawal planning is an ongoing process that requires a lifetime projection of your retirement so that you can adequately identify which accounts to make withdrawals from and when.
From there, revisit your plan annually to:
Account for life changes.
Update your account values due to market forces.
Adjust for other tax changes.
Otherwise, you're likely paying too much in taxes.
Next, we will cover Step 4 of the 4-step Planning Process to YOUR Retirement Income Plan, where you will get to know your retirement building blocks and when and how to use them for maximum effect.
IMPORTANT DISCLOSURE INFORMATION
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