A lot of things change in retirement, and your taxes are one of them. But they don't have to be so painful. As part of Morningstar's Tax Relief Week, I outlined six tips to help reduce tax bills in retirement.
Tip 1: Diversify Your Assets by Tax Treatment
The first tip has to do with something you should start before retirement that can be a big help in retirement--building tax diversification in your portfolio.
That simply means that you want to hold assets in different types of accounts that will receive different tax treatment upon withdrawal. Many people come into retirement with a lot of their nest eggs in traditional IRAs and 401(k)s. Unfortunately when it comes time to take that money out, all of it is taxed at your ordinary income tax rate.
For a lot of people, it makes sense to have all three types of accounts represented in your portfolio when you enter retirement. That means Roth accounts, which will be tax-free upon withdrawal; tax-deferred accounts (traditional IRAs and 401(k)s), which are pretty inevitable for most of us who are saving for retirement; and finally, some taxable accounts, where you will be able to get ordinary capital gains treatment on your withdrawals if you buy and hold securities.
Once you reach retirement, having tax diversification can be quite valuable. Morningstar.com readers spend a lot of time strategizing about where they go for income on a year-to-year basis. They say they can manage their tax bill by pulling just enough from this account and that account to keep themselves in the lowest possible tax bracket.
Some of the tax-prep software will help you with this, but you can also consult a tax advisor for guidance if you are not sure where to pull money for living expenses in order to manage your tax bracket.
But again, the key is having those different pools available when you do reach retirement, so it is important to plan for that.
Tip 2: Consider a Roth Conversion--Even in Retirement
Some folks in retirement might think it's too late or they're too old to convert their assets to a Roth account. It's not necessarily true. The key profile for whom a conversion might make sense even after retirement is that person who is not going to need at least part of his or her traditional IRA during retirement. If you are an individual whose main goal is to pass money to heirs, you might consider converting it.
When your heirs do inherit that money, it will be free of income tax. They may owe estate tax on your whole estate, but the money they receive from you through a Roth will not be taxable.
Tip 3: Get Savvy With RMDs
The third tip involves required minimum distributions, known as RMDs. Starting at age 70 1/2, these withdrawals are required from certain types of accounts in retirement, such as 401(k)s and traditional IRAs. Of course, you need to take them, but you can be savvy about it.
First of all, check with your investment provider to see if they will let you automate your RMDs, so you won't be liable for that big penalty you'll have to pay if you'd otherwise have forgotten to take an RMD.
Another key point is, don't let your RMDs take you off your portfolio plan. I often talk to people who say their RMD is going to take them way over their 4% or 5% target withdrawal rate. But there is nothing saying you have to spend that RMD. You can actually reinvest it in a taxable account, or if your spouse has some earned income, you can think about reinvesting it in a Roth account.
Finally, think about being strategic with your RMDs and pulling your money from those accounts that you would want to rebalance anyway. That can be a great way to combine RMD season with any rebalancing that you might do to get your portfolio's allocations back into alignment.
Tip 4: Mind State Taxes, Too
State taxes can vary and may add up to quite a lot in some states. People who are in higher income tax brackets might want to think about state-specific municipal bond funds, where they can earn a double tax benefit. Sometimes you can also earn a local tax benefit.
Another thing to keep in mind is that property taxes can be a big percentage of many retirees' household expenses. You may be able to take advantage of freezes or perhaps longtime property owners' exemptions. Check with your municipality to see what sort of programs they have established to help seniors stay in their homes.
Finally it's important for people who are engaged in estate planning to remember the bite of state taxes. Right now at the federal level, we have very generous exclusion amounts of about $5 million per individual and $10 million for married couples. But in many states, those exclusion amounts are much, much lower. You can die with a much smaller estate and still have it be subject to state estate taxes.
Some of the mechanisms--such as trusts--that might not seem necessary when you are planning for federal estate taxes might in fact be quite beneficial at the state tax level.
Tip 5: Bundle and Time Your Deductions
For retirees who have paid off their mortgage, it might not pay off to itemize their deductions every year. There may be years in which taking the standard deduction is more beneficial. But in some years, it might make sense to itemize, provided you can bunch deductions together. For example, if you have medical or dental procedures that are voluntary, you can defer them and group them into a single year. That way, you can deduct them on your tax return.
Tip 6: Avoid the 'Tax Torpedo'
The so-called "tax torpedo" can hit when your Social Security becomes increasingly taxable as your income from a few different sources exceeds certain thresholds.
To calculate what's called provisional income, you look at half of your Social Security benefit, as well as tax-free income, and portfolio income. That amount together counts as what's called "provisional income." If you are over certain thresholds, a portion of your Social Security benefits will be taxable.
People who have provisional income over, say, $50,000, really don't need to worry about this, because 85% of their Social Security benefit will be taxable no matter what. But people who are below that level may be able to manage their income, particularly from their portfolio, to ensure that they don't hit the higher thresholds.
One reason it's called a torpedo is that you see a big jump up in the amount of Social Security income that is taxable once you hit a certain threshold. It jumps from 50% of your benefit up to 85%. So, you will really want to manage your bands if you are in that neighborhood of provisional income.