How Do You Pay Less Tax on Retirement Account Withdrawals?
As a retiree, you might be done cashing a regular paycheck. But, as far as the IRS is concerned, you probably aren't done earning income or, in most cases, paying taxes. In fact, without precise planning around how and when you start tapping into your nest egg, you could open yourself up to higher tax liabilities in retirement than you had when you were working full time.
Here's a very basic example of a retirement withdrawal strategy checklist that we use at Keen Wealth to help retirees minimize their taxes and maximize their resources for living a full and rewarding retirement.
1. Categorizing Retirement Accounts
When we first sit down with a retiree, we need to understand what kinds of accounts they have and the size of those accounts. In this example, we're going to set aside things like savings, pensions, and other benefits and focus on three types of retirement accounts:
Examples: Traditional IRA, 401(k), 403(b)
Contributions to these accounts were not subject to income or payroll taxes in the year you made them. This reduced your total taxable income for the year you contributed. However, the withdrawals you make from these accounts will be taxed based on your income tax rate at the time of withdrawal.
Examples: Roth IRA, Roth 401(k)
You made contributions to these accounts with money that was subject to payroll and income tax. Therefore, the IRS doesn't tax these dollars again as they earn ROI or once you start making withdrawals.
Examples: Standard brokerage accounts
Your brokerage accounts don't offer the same tax advantages as your retirement accounts. The money you invest has, generally, been subject to income and payroll tax, and you have to pay taxes on capital gains and income from dividends in the year you receive them.
2. Sequencing Withdrawals
Bucket 1: Taxable Accounts
In most cases, we recommend that retirees withdraw from their taxable accounts first. The capital gains you'll pay on those withdrawals are usually lower than your income tax rate. And while you're spending this money and paying lower taxes, the money in your tax-advantaged accounts will continue to grow.
Bucket 2: Tax-Deferred Accounts
Withdrawals from your 401(k) and traditional IRA are usually taxed as ordinary income. So, the longer you can put off taking money from these accounts, the lower your taxes typically will be, and the more these accounts can grow. Once you turn 73, by law, you have to start taking required minimum distributions (RMDs) every year. As discussed below, it can be advantageous to start planning ahead for RMDs.
Bucket 3: Tax-Exempt Accounts
Again, assuming you don't need to tap into your Roth IRA to pay the bills or cover an emergency, it's best to let these accounts keep growing. By taking full advantage of their tax-exempt status, you'll be maximizing their earning potential and hopefully reducing your total tax bill in retirement.
3. Reducing Tax Liability
While there are no “one-size-fits-all” solutions for minimizing tax liability, three that we often focus on at Keen Wealth are:
Roth Conversions
If your income in a given year is lower than usual, you'll potentially be in a lower tax bracket. If that’s the case, that means the tax you'll pay on a conversion from a tax-deferred account into a tax-exempt Roth IRA will also be lower than usual. That conversion will grow tax-free along with the rest of your Roth IRA and won't be subject to taxes upon withdrawal.
Remaining in Lower Tax Brackets
Tax-exempt accounts can come in handy during years when earnings are up in your other accounts. Since withdrawals from a Roth IRA are tax-exempt, you can access the cash you need without bumping yourself up into a higher tax bracket.
Managing RMDs
Again, at age 73, you are required to start taking RMDs from tax-deferred accounts like 401(k)s and traditional IRAs. Even if you don't need money from these accounts before then, making timely Roth conversions or taking smaller withdrawals can lower the size of your eventual RMDs, and the amount of tax you'll have to pay on them. This can spread out your total tax liability over several years rather than hitting you with a big tax bill starting at 73.
4. Advanced Strategies
Once we've covered the basics, my team will start digging deeper into a senior's financial situation, needs, and retirement goals. As we fine-tune withdrawal strategies and weigh potential tax implications, we'll often consider:
Delaying Social Security Benefits
Waiting until your full retirement age to claim Social Security will increase the amount of your eventual benefits. If you time those benefits to coincide with withdrawals from your retirement accounts, you might also reduce the percentage of your benefits that are subject to income tax.
Tax-Loss Harvesting
Selling certain investments at a loss can offset capital gains in other areas of your portfolio, reducing your tax bill and opening opportunities to rebalance and diversify your holdings.
Qualified Charitable Distributions
Starting at age 70 1/2, you are allowed to make qualified charitable contributions (QCDs) from a traditional IRA to an approved charity or nonprofit without paying tax on the withdrawal. And, at age 73, those QCDs count against your RMD requirements. Coordinating this strategy with the rest of your spending plan can help you achieve your giving goals while also reducing your tax liability.
5. Preparing for the Unknown
You could generally group the first four parts of this retirement withdrawal strategy checklist under the heading "Things We Know." At least annually, my team will coordinate a senior’s withdrawal strategy with anticipated spending, such as monthly expenses, Medicare premiums, and planned retirement goals, like moving, contributing to a grandkid’s college education, charitable giving, or taking a big vacation.
But what about all the things that you can’t anticipate? A slip-and-fall that drives up medical expenses. A new interest in European art that recalibrates your travel goals. Another round of changes to the government’s rules around retirement accounts. A flooded basement. An uptick in inflation.
When you have a solid financial plan, it’s almost always possible to adjust it. When you don’t, you might end up making emotional, knee-jerk reactions in the moment that could put your long-term security at risk.
Our checklist-driven process at Keen Wealth creates personalized, comprehensive financial plans that cover all your bases while also providing built-in flexibility. Let’s meet to review your retirement withdrawal strategy, your tax situation, and your goals for retirement.
About Bill
Bill Keen is a financial advisor with over 30 years of industry experience. As the founder and CEO of Keen Wealth Advisors, a registered investment advisory firm, he focuses on providing personalized retirement planning designed to help people thrive before and during their retirement years. With a passion for educating others, Bill regularly blogs about retirement planning, hosts the podcast Keen on Retirement, and has contributed to Forbes, U.S. News and World Report, Reuters, Wall Street Journal’s Market Watch, Yahoo Finance, and other publications. Based in Overland Park, Kansas, Bill and his team work with clients throughout the greater Kansas City area and across the nation. To learn more, connect with him on LinkedIn or visit www.keenwealthadvisors.com.
KWMG, LLC’s dba Keen Wealth Advisors (“company”) is an SEC Registered Investment Advisor located in Overland Park, KS. The company and its representatives may only conduct business in those states where registered or where excluded/exempt or from licensure. For registration information please contact the SEC or the state securities regulators for the states where the company is notice filed. A copy of the company ADV is available upon request. Advisory services are only offered to clients or prospective clients where the company and its representatives are properly licensed or exempt from licensure. No advice may be rendered by the company unless a client service agreement is in place. This information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy and is for illustrative purposes only. Clients and prospective clients must consider all relevant risk factors involved with each strategy, including costs or fees, and their own personal financial situations before trading.
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