Create a Bucket List
This is not the kind of bucket list that includes scaling mountains and writing a novel. Instead, you should estimate your cash flow needs in retirement and take inventory of your income sources, segregating them into one of three “buckets”:
• Taxable — such as mutual funds, brokerage accounts and rental property income;
• Tax-deferred — including traditional IRAs and 401(k) plans; and
• Nontaxable — for example, Roth IRAs and Roth 401(k)s.
As you withdraw funds during retirement, carefully select from these buckets to maximize tax efficiency. Some people tap their nontaxable and taxable buckets first to avoid paying taxes on withdrawals from tax-deferred accounts. But this approach can backfire by triggering hefty required minimum distributions (RMDs) once you reach age 72 (see number three).
To avoid this result, consider withdrawing tax-deferred funds until you reach the upper end of the 12% tax bracket ($81,050 for joint filers in 2021). This strategy generates modest current taxes while drawing down your tax-deferred accounts to minimize future RMDs. The next funding tier might come from brokerage accounts, which typically generate long-term capital gains taxed federally at between 15% and 23.8%. To maximize tax-free growth, withdrawals from nontaxable accounts should be delayed as long as possible.
Under current federal law, you are required to begin distributions from traditional IRAs and employer-sponsored retirement accounts when you reach age 72. The RMD for a given year is calculated by dividing your account balance by the “distribution period.” Generally, this means your life expectancy under the government’s Uniform Lifetime Table. But if your spouse is more than ten years younger than you, the distribution period is your joint and survivor life expectancy.
Because RMDs usually consist of ordinary income, they can generate significant taxes. But if you retire before age 70, you can use the period between retirement and the onset of Social Security benefits and RMDs (when you will likely be in a lower tax bracket). By taking distributions from traditional IRAs or 401(k)s during that time in amounts that will not push you into a higher bracket, you can minimize taxes on those distributions and lower future RMDs.
Other strategies involve:
You may be able to defer RMDs from your 401(k) plan. Some plans permit participants to postpone RMDs so long as they continue working (even part-time) for the company that sponsors the plan.
Qualified Charitable Distributions (QCDs)
If you are charitably inclined, and at least age 72, you can kill two birds with one stone: A QCD allows you to transfer up to $100,000 per year tax-free directly from a traditional IRA to a qualified charity. There are several potential benefits: You can satisfy your charitable goals, reduce your IRA balance without tax consequences, and if you are age 72 or older, QCDs can be applied toward some or all of your annual RMDs.
Another effective strategy is to execute a Roth IRA conversion, recognizing current taxable income while you are in a lower tax bracket. Roth IRAs are not subject to RMDs. (See “Sidebar: A Window of Opportunity.”)
Related Read: How to Plan for a Tax-Efficient Retirement
Consider making contributions to a Roth 401(k) plan if it is offered by your employer. The most tax-efficient strategy is to contribute in the earlier years of your career assuming your salary will be at the lower end which means you will be in the lower tax bracket. In future years, when your salary is at the higher end and you will be in the higher tax bracket, switch to contribute to a regular 401(k) plan. If you missed this strategy and have been contributing to a 401(k) plan for the last 10-20 years, consider switching now to contribute to Roth 401(k) in order to grow the nontaxable bucket instead of the tax-deferred bucket.
Get the timing right
Minimizing taxes in retirement is a delicate balancing act, requiring careful timing of distributions from various income sources. Work with a financial professional to develop a plan that addresses your goals and considers your situation — ideally before you retire.
Sidebar: A window of opportunity
If you have significant balances in one or more traditional IRAs, the window between retirement and age 70 or 72 can be an ideal time to convert some or all of these into Roth IRAs. Most, or all of the amounts converted, will be taxable as ordinary income. But completing the conversion while you are in a lower tax bracket will keep taxes to a minimum.
To ensure that the conversion itself does not push you into a higher tax bracket, you may need to do it in annual phases. For example, you could convert a portion of your IRA balance each year. Once the process is complete, you will essentially have converted taxable assets into nontaxable assets and reduced, or even eliminated, the need for future RMDs.
For more information, contact Jacqueline Janczewski at email@example.com or 312.670.7444. Visit ORBA.com to learn more about our Wealth Management Services.