If your working years were spent as an employee, your taxes on wages were pretty straightforward. You worked and contributed to employer-based benefits, and the net was reported to you on a W-2 form, which you used to plug into your 1040 tax form. There is not much wiggle room for reporting that income and paying the associated taxes.
The good and the bad of retirement income planning is that you have all the control. If you exercise that control wisely, the good is that you’ll pay less in taxes during retirement than you expected. The bad is the possibility that you will not use your control as you should and will ultimately pay more taxes. The main factors are when you pull your money out, how your money is invested, and how you navigate transitions.
Below, each component will be explained to give you ideas to apply to your own situation. As always, there is a difference between education and application. Speak to a financial planner before flipping the switch on any of these ideas.
Timing is everything
Every week, I buy a bag of coffee. I always look for those charming blue sale tags. Recently, there was a sale for the ages: La Colombe, typically $13 per bag, was on sale for $6. Here’s how I view this: every bag I buy saves my future self $7. I bought five bags because it was the most I could comfortably carry, and I went home satisfied that I had racked up future savings of $35. Your tax liability won’t come with blue tags, but it will fluctuate throughout your life based on your taxable income.
Typically, the best sale during retirement is the gap between retirement and when you claim Social Security. It would help if you lived off cash or taxable investment accounts during this period, which will keep your taxable income lower and allow you to move money from pre-tax accounts into Roth IRAs. You will pay the taxes today at the lower rate and avoid a higher rate when your Social Security and required minimum distributions (RMDs) start.
Figuring out whether or not this works for you, take a comparison between your current marginal tax rate and your future marginal tax rate. Some planners and tax professionals will run this projection for you.
Oversimplifying the concept:
Suppose you are in the 12% marginal rate bracket today and expect to be in the 24% marginal rate bracket tomorrow. In that case, every dollar you convert to a Roth IRA saves you 12 cents. The catch: you can move a limited amount before you jump from 12% to 22%. This amount is called your “headroom.”
On Giving Tuesday, your alma mater makes one final plea for you to commit to a small monthly gift. The easiest thing to do is click the link and enter your bank account or credit card info. But cash is usually the worst charitable giving vehicle. When retired clients are giving to charity, here is a rule of thumb as to where the money should come from:
- IRA first: If you are at least 70½, this is often the most efficient way to give. A gift directly from an IRA to any charity is a qualified charitable distribution or QCD. This is first on the list because it reduces your gross income, whereas most charitable giving reduces taxable income. Gross income, not taxable, dictates your Medicare Part B and Part D premiums. You don’t want to overpay for Medicare.
- Appreciated stock next: a client wanted to give a large gift to his alma mater for his 50th reunion. We looked at the investment position within his taxable account with the largest unrealized gain. Instead of giving cash, we transferred shares directly to the university. By doing this, he avoided the capital gains tax he would have paid when he eventually sold that stock. The actual donation is reported on Schedule A if you itemize it like a cash donation would be reported.
- Cash last: Cash donations will not reduce your taxable income or help you avoid capital gains tax. However, it’s easiest.
Navigate Transitions Wisely
We frequently encounter retirement transitions such as relocation, divorce, and death. All three come with tax consequences, but today, we will focus on relocation and death.
- Relocation: Selling your primary residence comes with substantial tax advantages if it has been your residence for two of the last five years. This will allow you to exclude $250,000, or $500,000 per married couple, from your gains. The biggest mistake people make is converting the primary home into a rental when they relocate and missing out on fulfilling the residency requirement.
- Death: When you die with capital assets, there is a step-up in cost basis. This means you can avoid all or part of the gains that occurred during the decedent’s lifetime. If you hold a joint account with a spouse and that person dies, half of that account will step up and avoid capital gains tax. If the decedent were the sole owner, the entire account would be free of capital gains taxes. Not everyone with a joint account should be re-titling to an individual account, but this is worth considering if there is a solid reason to believe that one of the individuals will die first.
Tax planning is not optional for retirees concerned about Uncle Sam living off their nest egg. Even if you are past the magic window between retirement and Social Security, there is still time to maximize what you keep in retirement.