Tax planning is all about tax efficiency, making sure the various pieces of your financial plan work together in the most tax-efficient way. Tax planning is especially important in retirement; if you can keep your tax liability as low as possible in your golden years, you can keep more of your hard-earned money in your pocket.
An important thing to note about tax planning is that it’s not something to do one time and forget about. This is an ongoing process and should be part of your comprehensive retirement plan.
Skip RMDs in 2020
The CARES Act was signed into law at the end of March to provide relief to people and businesses impacted by the coronavirus pandemic. While there was a lot of attention given to the $1,200 stimulus checks many Americans received, there hasn’t been a lot of talk about other aspects of the law that impact retirees specifically.
Required minimum distributions have been suspended for 2020, meaning retirees who own a qualified account, like an IRA or 401(k), and beneficiaries taking distributions from an account do not have to withdraw money this year. This includes anyone who turned 70½ in 2019 and would have had to take their first RMD by April 1, 2020. The CARES Act gives those people relief from their 2019 and 2020 RMDs. The two biggest benefits to skipping your RMDs this year are keeping that money in your account to grow and avoiding the taxes that are due when you withdraw money and count it as earned income.
If you’ve already taken your RMDs but don’t need the money, you can put that money back into your account to avoid counting it as income this year. Keep in mind, you only have a 60-day window to do it; the money must be put back into the account by Aug. 31, 2020. If you’ve taken all or part of your RMD for 2020 and want to understand your options, talk with your financial adviser before the August deadline.
Max Out Retirement Contributions
Beyond the immediate tax benefits of maxing out your retirement contributions, saving money early and often is an important part of increasing your retirement security. You can contribute up to $19,500 in your 401(k) in 2020 and up to $6,000 in your IRA. Those 50 and older can add an extra $6,500 to their 401(k) and an additional $1,000 to an IRA.
How much you contribute to your retirement accounts during your working years — and the types of accounts you contribute to — will impact how much you pay in taxes both now and in retirement. Contributing to a traditional 401(k) or IRA reduces your taxable income for the year. The money you put into these accounts grows tax deferred until you withdraw it in retirement.
The SECURE Act, which took effect on Jan. 1, allows you to continue putting money into your IRA at any age as long as you are still working. In the past, you could not contribute to an IRA after age 70½. The new rule gives you a valuable tax benefit now and helps you save more for retirement. Depending on whether a Roth IRA will benefit you in retirement, this new rule also gives you more time to convert your traditional IRA to a Roth IRA while you’re still working.
Convert to a Roth
Speaking of Roth IRAs, there is a great opportunity right now to convert your tax-deferred accounts, like traditional IRAs and 401(k)s, to tax-free accounts, like a Roth IRA. The balance in your traditional IRA or 401(k) account might be down due to the volatility we’ve experienced this year; combine that with our historically low tax rates and the taxes you’ll pay on the conversion now could be lower than in the future. You’ll owe the IRS when converting money from a traditional IRA to a Roth IRA, but you will withdraw that money tax free from your Roth in retirement. I have never heard anyone complain about tax-free retirement income!
Roth IRAs play an important role when it comes to tax diversification. A mix of tax-deferred, tax-free and taxable accounts (like your brokerage and savings accounts) will help you better control your tax liability in retirement; you gain more flexibility over how much money you withdraw and from which account.
If you’re curious about whether or not a Roth conversion could benefit you, talk with your tax professional and financial adviser about your options.