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05.24.19

How to Plan for a Tax-Efficient Retirement
Justin L. Sylvan

People today are living longer than ever. These longer life expectancies mean that your retirement savings may have to stretch for more years than you anticipated. Effective tax planning strategies will ensure that your retirement goals are met.

Review Your Income Sources

The first step is to estimate your cash needs in retirement and evaluate your various income sources. Most taxpayers have a combination of taxable assets (mutual funds, brokerage accounts), tax-deferred assets (IRAs, 401(k) plans) and nontaxable assets (Roth IRAs, Roth 401(k) plans). It is also important to consider Social Security and pensions. Generally, you can begin receiving Social Security benefits at any time from age 62 to age 70. The longer you wait, the larger the benefits, although the ideal time to start taking social security depends on a variety of factors, including your retirement plans, life expectancy, other income sources and marital status. To get an initial idea of your estimated Social Security benefits, you can create an account at www.ssa.gov.

Taxpayers will want to consider their other income sources when contemplating taking social security. As your income increases, more of your social security earnings are subject to income tax. For example, if you are married filing jointly, and you and your spouse have combined income of over $44,000, up to 85% of your Social Security benefits are taxable. Combined income is generally made up of your adjusted gross income (AGI), plus any tax-exempt bond interest, plus half of your Social Security benefits.

Remember RMDs

Another important factor is required minimum distributions (RMDs). When you reach age 70-½, you are required to begin taking distributions from traditional (but not Roth) IRAs and employer-sponsored retirement plans, regardless of whether you need the money. It is possible to delay RMDs from an employer-sponsored plan, however, if you continue to work and meet certain other requirements.

Generally, the amount of your RMD is the account balance as of the end of the preceding year divided by your life expectancy, or, if your spouse is more than ten years younger, your joint and survivor life expectancy. Note: You may be able to minimize the impact of RMDs by making qualified charitable distributions from your IRA (see “The Gift That Gives Back” below).

Planning Before Age 70

Once you hit your 70s, you will have to start taking RMDs, as well as Social Security. This can trigger substantial taxes. But you can soften the blow with some planning during the early years of your retirement (assuming you retire before age 70).

Leaving assets in the traditional IRA accounts and employer-sponsored plans maximizes tax-deferred growth. Therefore, many taxpayers avoid taking distributions from these retirement plans. But this strategy also increases the size of your RMDs, which can create tax issues down the road. In the early years of retirement, you will likely be in a lower tax bracket, so it might make sense to accept some taxable distributions at that time.

One option is to take advantage of your lower tax bracket by converting a traditional IRA to a Roth IRA, either all at once or gradually over several years. You will owe taxes on the amount converted, but you will then enjoy tax-free growth and tax-free withdrawals from the Roth account, which will lower your taxes down the road.

Bucket Challenge

Most retirees have their retirement savings allocated among three “buckets” of assets: taxable, tax-deferred and nontaxable. You should develop a plan for withdrawing these funds during retirement in the most tax-efficient manner.

Suppose, for example, that you are married filing jointly and your retirement savings are held in a traditional IRA, a Roth IRA and a brokerage account. Each year, you might withdraw funds from your traditional IRA until your taxable income reaches $78,950, the top of the 12% bracket (in 2019 for married filing jointly). Income above that level is taxed at 22% or more. This approach keeps current taxes low while reducing the amount of RMDs in the future.

Next, you might draw from your brokerage account, which will likely trigger long-term capital gains taxes at a 15% rate (assuming your modified adjusted gross income does not exceed certain thresholds, where the additional 3.8% net investment income tax, or the higher 20% capital gains rate, kicks in). You will want to leave the Roth IRA untouched for as long as possible, to maximize tax-free growth.

Start Now

It takes time to coordinate various income sources and map out an effective strategy for withdrawing retirement savings. To ensure that your plan is tax efficient, start working with your advisors as early as possible.

Sidebar: The gift that gives back

If you plan to make charitable gifts during retirement and are at least age 70-½, qualified charitable distributions (QCDs) from a traditional IRA may be the most tax-efficient strategy. A QCD allows you to transfer up to $100,000 per year tax-free directly from an IRA to a qualified public charity and to apply it toward your RMDs.

A QCD bypasses your income, enabling you to reduce your taxes even if you do not itemize deductions. And because it is excluded from your adjusted gross income, it will not increase taxes on your Social Security benefits. Far fewer taxpayers itemize deductions under current law, so this strategy is gaining in popularity.

For more information, contact Justin Sylvan at jsylvan@orba.com or 312.670.7444. Visit ORBA.com to learn more about our Wealth Management Services.

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