Strategies to Reduce Taxes in Retirement
How to invest tax efficiently in the higher tax environment with the looming tax changes
The debate about tax policy and infrastructure spending continues to heat up in Washington. President Biden is close to getting his spending bill passed in Congress and as a result, changes are coming to the tax code. We are heading into a higher tax environment and the importance of being tax efficient with your investing and retirement withdrawals is more important than ever. It’s estimated that taxes may need to double in the next decade to pay for the looming federal deficit. The way you handle your investments and withdrawals can potentially save you or cost you a lot of money depending on what you do.
As you know, withdrawals coming from a traditional IRA will be taxed as ordinary income rates. With the tax rates poised to increase, this means more of your IRA distributions will be taxed. Keep in mind that at age 72 you are required to withdraw a certain amount from your traditional IRA whether you need it or not. This is called your required minimum distribution or RMD. The amount that you must withdraw increases every year that you age. We see some of our clients being forced to take out more from their IRA than they even need in order to live the lifestyle they want. With those larger “forced” distributions, the IRS is essentially making you pay more taxes with each successive year. Roth IRA’s, on the other hand, allow you to take distributions tax free. So long as you are over the age of 59.5 and made your first Roth IRA contribution at least five years ago, you can make tax-free withdrawals. Additionally, the Roth IRA is not subject to RMDs at age 72. Interestingly enough, if you leave money in a Roth 401(k) it will be subject to RMDs at the age of 72. This is one of the many reasons that we typically recommend rolling your old 401(k) over to an IRA when you leave your employer (in addition you get a much better selection of investments, more control and lower cost on your investment vehicles). For a great article on that click here.
The challenge that many of you face is that you make too much money to be able to contribute to a Roth IRA. For single filers the income limitations are $125k-$140k and for married filers it’s $198k-$208k.
For all the details on contribution limits click here.
The challenge for many high-income earners is how do you get money into a Roth IRA, especially if you earn too much to be able to contribute. One strategy that we love is the backdoor Roth IRA strategy. At this point in time we don’t know for certain whether the backdoor Roth IRA strategy will survive the coming changes to the tax code. We will apprise you as soon as this becomes clear. Another effective strategy to get money into Roth IRA’s and effectively lower your tax bill in retirement is the Mega Backdoor Roth IRA strategy. This enables you to make after tax contributions to your 401(k) at work and then convert the after-tax portion to a Roth 401(k) to enjoy all the growth in a tax-free manner. Like the Backdoor Roth IRA strategy, we don’t know for sure whether this will survive and we will update you as soon as the law is passed. Even if the ability to do a Mega Backdoor Roth IRA contribution goes away you can still partially take advantage of it. If your company allows you to make an after-tax contribution to your 401(k) you can roll the after-tax contribution amount to your Roth IRA once you leave the employer. The gains on that investment amount can be rolled into a Traditional IRA. For example, those under age 50 can contribute up to $58,000 to a 401(k) in 2021, if your employer allows that. This figure would include pretax, Roth, after-tax and employer contributions. For individuals 50 or older, the limit is $64,500. Contributing after-tax to a 401(k) after you have maxed out your pretax contributions lets you benefit from additional tax deferral on earnings from dividends, capital gains and interest of your investments.
Under current law, some 401(k) plans allow for in-service conversions which then enables your gains to grow in a tax-free manner. We recommend you take advantage of the in-service conversion option if it’s available. Again, it’s unclear whether this will survive.
Another strategy you can consider is shifting some of your pre-tax dollars from your traditional IRA to your Roth IRA. This is known as Roth conversions. Keep in mind, every dollar you convert will be taxed as ordinary income rates, so you want to do this when your income is lower.
Roth Conversions During the gap years?
We like to refer to the years between when you retire and when RMD’s begin as your “gap years.” This is a period of time when your income goes down and you may find yourself in a much lower tax bracket than you were in during your peak income earning years just prior to retirement. The gap years provide a wonderful opportunity to convert some of your pre-tax dollars from a traditional IRA to a Roth IRA and pay taxes at a much lower rate. For 2021, a couple who is married filing jointly is in the 12% tax bracket all the way up to adjusted gross income of $81,050. Single filers remain in the 12% tax bracket all the up to $40,525. If there are years where you find yourself in the 12% bracket, we highly recommend you consider converting as much as you can and paying Federal taxes at 12%. You may look back in 10 years and wish you were in such a low bracket.
Additionally, you may want to consider delaying your Social Security benefit as long as you can. Under the current rules, you can delay your Social Security benefit all the way to age 70. While you can take your benefit as early as age 62, it is significantly reduced. Furthermore, if you plan to work between age 62 and your full retirement age, the IRS will withhold $1 for every $2 you earn above $19,560 for 2022. Delaying your Social Security benefit keeps your income lower and can result in you being in a lower tax bracket while you are converting your IRA.
If your goal is to take full advantage of the “gap years” and convert as much as you can from your traditional IRA to your Roth IRA you should build up your cash reserves prior to retiring so you can live on this during the first few years of retirement, delaying Social Security until 70 and converting while you are in this lower tax bracket.
When it comes to investing, exchange traded funds, or ETFs, have grown in popularity over the years. In addition to being able to buy and sell them for no cost, ETFs are more tax efficient than their mutual fund cousins. Generally, holding an ETF in a taxable account will generate less taxable incomes than if you held a similarly structured mutual fund in the same account. For the most part, ETF managers are able to manage the secondary market transactions in a manner that minimizes the chances of significant capital gains distributions. It’s rare for an index ETF to pay out a capital gain, when this does occur it’s usually due to some unforeseen circumstance. This is in contrast with mutual funds. When a mutual fund manager realizes a gain, the owners of mutual funds are responsible to pay taxes on the gains in their taxable account. As we move into the higher tax environment it is going to highlight the positive benefits of tax efficient investing in ETFs.
Making Qualified Charitable Distributions to keep your tax bill lower. Doing well by doing good.
Overall, you should be thinking about all aspects of your investment strategy in order to minimize your tax bill in the higher tax environment. Doing Roth conversions during the gap years, making after tax contributions to your 401(k) for future rollovers to your Roth IRA, using ETFs instead of mutual funds in your taxable accounts are all ways to keep your tax bill lower in retirement. But if you are not in a position to take advantage of these strategies and are facing large RMDs there is something else you can do. If you are charitably inclined, you can take a qualified charitable distribution from your IRA and make a gift directly to a qualified charity. The qualified charitable distribution (QCD) rule eliminates the taxes on the distributions used to make charitable contributions. Note the annual limit on QCDs is $100,000, even if this exceeds the amount of your RMD. QCDs are allowed at age 70 ½ and can be done even if your RMDs will not commence until age 72.
The importance of being savvy during the years prior to retirement and during retirement is key to keeping the tax bill lower in retirement. If you have questions on ways to lower your taxes in retirement, please give our office a call and we can help you out.