To this day, I have yet to meet someone who likes paying taxes, however like Benjamin Franklin put it, “the only thing certain in this world is death and taxes”. Taxes in retirement is usually one of the biggest topics that I get asked about from individuals who are thinking about retiring in the near future. For the longest time most of the clients we come across have been saving in their 401K or IRA for decades and have accumulated a large sum of money in a qualified retirement plan in other words a plan that all of the dollars have not been taxed yet. So, when retirement is right around the corner and I get the question, how can I avoid taxes in retirement, it would be like trying to run a marathon this upcoming weekend without training. unfortunately, it's hard to do a lot about upcoming tax in retirement if you haven't been planning for it for years prior to actually retiring. So, what can you do about taxes in retirement? Today we're going to discuss how to plan for taxes in retirement well in advance and what you should be doing if you are years away from retirement and we're going to talk about withdrawal sequencing so how do you withdraw money from your savings to keep your tax rate low as possible.
What can you do if you are years away from retirement to start planning for taxes in retirement?
One strategy to consider is adjusting your 401K contributions from a traditional 401K into a Roth 401K if that's offered by your plan administrator. Roth 401Ks came about in 2006 and have become more and more prevalent in different 401K plans. The benefit of a Roth 401K is that you can actually contribute more money to a Roth 401K then you can to a Roth IRA and for high income earners, there is no income limit on contributions. A Roth 401K has the exact same contribution limits as a traditional 401K the biggest difference in the two is that money that is contributed to a Traditional IRA is not taxed when you put it in and is taxed when you withdraw the money later on in retirement whereas in a Roth 401K the funds that you contribute to the Roth 401K are taxed when you put them in however all of the gains as well as any withdrawals you take in retirement are tax free. Another benefit of having a Roth 401K is that there are no required minimum distribution requirements at 72 like there is in a traditional 401K. RMDs exist in traditional retirement accounts because Uncle Sam is going to want his cut of those untaxed assets at some point. However, in a Roth 401K just like a Roth IRA the money has already been taxed and there's never a time where you have to take money out of that because it's no benefit to Uncle Sam because they are not receiving any taxes from that distribution. Deciding between a traditional or a Roth 401K is often a decision about when to pay taxes. One question you might want to consider is determining if you're going to have higher lower income in retirement than you are today. the goal is to pay your taxes when in the lowest possible tax bracket. So, if you are expecting a higher income in retirement. It may be better to pay the taxes now if you are in a lower tax bracket than you eventually will be. On the other hand, if you are in a higher tax bracket today than you will be in retirement, lowering your taxable income today by contributing to a traditional 401K will allow you to pay taxes when you withdrawal the money at a lower tax bracket.
Another thing you want to consider is whether or not you already have some assets in a Roth 401K or Roth IRA or if all of your money is in a qualified account like a Traditional IRA or 401K. If your current portfolio is entirely or nearly all qualified retirement assets, it may make sense to contribute to a Roth 401(k). Having a diversity of types of accounts with your retirement savings will allow you to diversify your income sources in retirement, which can be helpful from a tax perspective. Roth 401(k)s give you access to untaxed income in retirement, and you could even eliminate the RMD requirements by converting to a Roth IRA. A major advantage of Roth 401K accounts is for higher earners that are usually phased out of Roth IRI contributions, now it is possible to make backdoor contributions to a Roth IRA, However, the Roth 401K is a simple way for high income earners to save into Roth assets.
Another common concern that I often run across is for individuals with large balances in qualified accounts like a 401k or IRA and planning for eventual RMDs that will occur. For example, a 60-year-old toady with a $2,000,000 qualified account balance has 12 years for those assets to continue to grow and compound. Let’s assume that the $2,000,000 turns into 4 million by the time they are 72 and RMDs begin. That first RMD will be over $150,000 and can eventually get into the 2 and 3 hundred-thousand-dollar range if not more depending on investment growth rates.
What are some things you can do to reduce your eventual RMD amount if you have a large sum in qualified accounts?
One thing you can consider is a Roth conversion at some point. A Roth conversion refers to taking all or part of the balance of an existing traditional IRA and moving it into a Roth IRA. Converting to a Roth IRA may ultimately help you save money on income taxes. For instance, if you expect your income level to be lower in a particular year but increase again in later years, you can initiate a Roth conversion to capitalize on the lower income tax year and then let that money grow tax-free in your Roth IRA account. So how much should you convert and when should you do it? Two things may determine how much you can afford to convert from a traditional to a Roth IRA in a given year: the effect on your tax rate and the means for paying the taxes on the conversion amount. Because the conversion amount is added to your taxable income, it could potentially bump up your tax bracket. To stay within the same tax bracket, the most you could convert is the difference between your current tax bracket’s highest end and your pre-conversion taxable income. Strategically planning Roth conversions could help you reduce your future RMD amount. Another benefit is that people who inherit your Roth IRA will have to take RMDs, however they will be tax free as long as the account has been open for at least 5 years.
So now that we've looked at a few options for planning ahead for taxes in retirement I want to touch on withdraw sequencing which determining which accounts to withdrawal from first in retirement to help mitigate taxes.
Now there isn't A1 size fits all answer to withdraw sequencing and that's because it's going to depend on factors like an individual's age and their tax rate when taking the withdrawals in fact it's usually a pretty good idea to pull money from multiple accounts during retirement whether it's tax deferred traditional IRAs or 401ks or Roth accounts or taxable brokerage accounts. While it is usually a pretty good idea to pull from all of these types of accounts the overarching goal to keep in mind when developing your withdraw strategy should be to preserve the tax savings benefit of your tax-sheltered investments for as long as you possibly can. Let’s assume that a retiree has both taxable and tax advantage assets it's usually best to hold on to the account the tax advantaged assets for as long as possible while spending down less tax-efficient assets. So, where should you start?
If you're older than 72 the first thing you want to start with are your required minimum distributions or RMD's. it is important to never miss a RMD as the penalty is equivalent to half of the amount that should have been taken. Now if you're not required to take RMD's or you've taken your RMD and you still need retirement funds the first thing you want to do is turn to your taxable assets and start by selling assets with the highest cost basis first and then move onto assets where the cost basis is lower. A few things to consider here is that selling taxable assets is not always a straightforward answer depending on your assets in your estate and your goals to leave a legacy to your heirs, keeping assets with a low-cost basis in your estate to pass down to your heirs could avoid capital gains tax all together. After you utilized your RMD's, you will then move on to your taxable assets and then tap into your traditional retirement savings while saving your Roth IRA assets for last. What’s helpful about planning your withdrawal sequence ahead of time is that it allows you to structure the investments in each of the accounts based on when you will draw from them. Similar to the bucket strategy we discussed in our retirement needs episode that you can check out here.
keep in mind withdrawal sequencing guidelines are just that their guidelines there may be reasons why tapping into your Roth accounts makes sense if you're finding yourself in a year with higher taxes or if there's a year where you have a lot of taxable deductions maybe it might make sense to tap into your traditional tax deferred accounts rather than taking money out of your taxable accounts it is important in retirement to be flexible and that's why we believe retirement planning is an ongoing process it's not like setting up a will or a trust that you only review every few years. reviewing your retirement plan on an ongoing basis will help make sure that you're forecasting and planning for things that might change in your financial situation so that you can make the most efficient use of your retirement assets. As always, our firm is happy to help you plan for a tax efficient retirement by putting together a comprehensive analysis of your retirement.
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