Retirement requires many adjustments. Your allocation to stocks and bonds, your tolerance for risk, the management of your time -- all might need adjustment in retirement. Tax planning is another area that needs attention.
Nationwide Retirement Institute's recent survey found 70% of recent retirees are only "somewhat knowledgeable" or "not at all knowledgeable" about tax planning in retirement.
In your working years, often the only major tax strategy to consider is maximizing contributions to your retirement plan at work, thereby decreasing your taxable income. In retirement, there are more choices about where to pull income from and when, and those decisions can have important tax consequences.
Here are the top six tax strategies every retiree needs in retirement:
Be proactive: Tax strategy happens all year.
You need to get your financial adviser and tax professional on the same page about your income plan in retirement. That means giving them the information they need before the end of the year and as your income needs change throughout the year. Waiting until April 15 to start working on your tax strategy may be too late to tax optimize your retirement income plan.
Understand how Social Security is taxed.
Whether your Social Security is taxable depends on your "provisional income." If your provisional income is less than $25,000 (for singles) or $32,000 (for married filing jointly), your Social Security is not taxable. Although that income level sounds small, it's after deductions. Also, only half your Social Security income is counted in the calculation. Furthermore, certain income sources might not count toward the calculation. It can include income from Roth IRAs, municipal bond income and some annuity income. People with provisional incomes above those levels could be subject to taxes on up to 50% or even 85% of their benefits. Once you see where you fall on the Social Security tax spectrum, there are some steps you can consider to improve your position. Read 5 Ways to Avoid Taxes on Social Security Benefits.
Realize that cash is king, and your trust account is not far behind.
Keeping your taxable income low will help you save money on taxes. Having a withdrawal strategy that includes using your available cash can tax optimize your overall income picture. Also, consider your nonqualified accounts, joint account or trust accounts as income sources in retirement. Specifically, look at holdings with little appreciation that could be liquidated over time with little tax consequence.
Convert traditional IRAs to a Roth when it makes sense.
Traditional IRA and 401(k) contributions reduce your taxable income. This can lower your tax bill when your taxes are often at their highest. Withdrawals from IRAs and 401(k)s are, however, fully taxable. It's important to think through how and when to take those withdrawals in the most tax-efficient manner.
A Roth IRA does not offer a tax deduction when you make an investment or do a conversion, but it does offer tax-free growth and tax-free income in retirement. Converting from an IRA to a Roth is a taxable event, but it positions that asset to grow tax free and be withdrawn tax free down the road.
When does it make sense to do a Roth conversion? Talk to your tax adviser every December and ask how much a conversion might cost. Converting slowly over time often makes the most sense. Converting too much at one time can put you in a higher tax bracket and be costly. A slow, long-term Roth conversion strategy can mean more long-term wealth and a more tax-efficient plan.
Manage your investments based on their tax classification.
If your investments in your Roth and your traditional IRA and your trust account are all in the same kinds of funds, you or your adviser could be doing something wrong.
- Your Roth should be the most aggressive asset in your portfolio because it grows tax free, you can pull money out tax-free in retirement and you can give it to whomever you want tax free.
- Your traditional IRA can be more actively managed because you can buy or sell positions with no tax consequence until you make a withdrawal.
- Your joint or trust account is better for more buy and hold positions -- long term investments -- because they get a step up in cost basis when you or your spouse passes away. A step up in cost basis means the remaining spouse can sell the individual position like a stock or an ETF and pay no taxes.
Be charitably tax smart.
If you give consistently to your church or charity, make sure you note the tax benefits of those gifts. If you are still working and are in a higher tax bracket, consider pre‐funding some of your charitable gifts to get the most out of those tax deductions in years you might need the deduction.
Consider a family foundation or your own donor advised fund to pre‐fund charitable gifts in the years you need the deductions. In retirement, when you may be in in a lower tax bracket, you might not have the same level of tax savings by making tax-deductible gifts.
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