Saving for retirement often helps lower your taxes because many kinds of contributions are tax deductible. But what happens when you want to turn your retirement savings into income? Are you stuck paying high taxes when you’re most focused on preserving what you’ve saved?
Many folks share your concerns about losing a significant portion of your retirement nest egg to income taxes or experiencing unwelcome unexpected tax surprises. The data backs up the concerns, as well. Studies have shown that poor tax and wealth planning can cost you as much as 3% return per year from your assets.
While a lack of planning can be costly, there are actionable strategies and solutions to help you navigate the complexities of tax planning and help ensure you make the most of your retirement income.
You need a plan, not just a portfolio
It’s crucial to go beyond just portfolio management and work out a financial plan strategy. Think of retirement like taking a road trip. Building a portfolio is like putting gas in the car, but you could waste gallons of valuable fuel but taking wrong turns along the way. You need a roadmap to help prevent these wrong turns, making the most of your full gas tank.
A comprehensive financial plan, or financial roadmap, can add years of life to your investment portfolio by mapping out your goals, showing you how much spending is sustainable, and identifying ways to reduce taxes. Let’s take a look at a few strategies that have a significant impact on reducing the tax burden you might experience year to year. Learn more about the difference between a portfolio and a plan.
Mind your income sourcing
Many retirees accidentally jump into a higher tax bracket. You can avoid this by paying close attention to how you source your retirement income. Different sources, such as social security, pensions, real estate, retirement funds, and general portfolio funds, come with varying tax consequences. For example, you pay higher income tax rates on your traditional 401(k) pay, lower capital gains rates on most brokerage investments, and no tax at all on Roth account earnings. Understanding your expected tax bracket for the year allows you to strategically plan and optimize your income sources accordingly. For more on how to optimize your income sources, including an example where this cuts income tax by two-thirds, see The Four Quadrants of Retirement Income.
Hold high tax investments in low tax accounts
Vanguard’s research shows that holding each investment in a tax efficient account can add up to 0.6% per year in return to your bottom line. What does this mean practically? In retirement, stable income becomes more important, so it can be beneficial to own bonds and dividend-paying stocks. But you’re paying tax on this income whether you spend it or not. Consider holding these investments in tax-deferred retirement accounts, which can allow them to reinvest and grow while you’re not spending them. On the other hand, you can keep low tax rate investments like growth stocks, which don’t pay much income, in your brokerage portfolio limit taxes to lower capital gains tax rates.
Take advantage of lower tax rates with Roth conversions
Use historically lower tax rates or years with abnormally low income to your benefit by converting pre-tax retirement accounts to a tax-free Roth. By converting funds to a Roth IRA, you pay taxes at current rates today and enjoy tax-free growth for the rest of your life (and your beneficiary’s life, if you leave it as an inheritance). You’ll also reduce future required minimum distributions (RMDs) because Roth accounts are exempt from this requirement.
Leverage high medical costs deductions
No one wants high medical expenses, but if you or your spouse are facing medical costs exceeding 7.5% of your adjusted gross income, you can take advantage of the opportunity with Roth conversions. The deduction created by these medical expenses can be used to offset the tax impact of the Roth conversions, allowing you to possibly create more tax-free dollars for your future to help manage your tax bill, as we discuss in Turn Long-Term Care Expenses into Tax-Free Income.
Give smartly
Do you plan to give to charity in retirement? Consider the following strategies to reduce taxes and increase the impact of your charitable dollars.
Give highly appreciate stock to a Donor Advised Fund (DAF)
Selling highly appreciated stock to give to charity? You can eliminate the capital gain tax you’d pay when you sell these shares by using a Donor Advised Fund. By funding the DAF with assets with embedded long term capital gains, you can sell the stock tax free and create tax savings of up to 23.8%. Additionally, you get the charitable income tax deduction for the amount, resulting in significant federal income tax savings of up to 37%. This approach allows you to increase your charitable impact by over 20% using the same dollars!
Give RMDs you don’t need with Qualified Charitable Distribution (QCDs)
If you are age 70½ or older, you can donate up to $100,000 per year to charity directly from your individual retirement accounts (IRAs) through a Qualified Charitable Distribution. This is an effective tool as it is not subject to itemizing taxes and charitable deduction limits, making it a 100% tax free distribution. Additionally, a QCD can fulfill your required minimum distribution (RMD) amount as well. This method allows you to support causes you care about while optimizing your tax situation.
Taxes are a major concern for most retirees. However, understanding and implementing these strategies can help ensure you don’t pay more taxes than necessary. Reach out to learn more about how we can help you make a plan, reduce taxes in retirement, and safeguard your wealth for generations to come.
Converting an employer plan account or Traditional IRA to a Roth IRA is a taxable event. Increased taxable income from the Roth IRA conversion may have several consequences including but not limited to, a need for additional tax withholding or estimated tax payments, the loss of certain tax deductions and credits, and higher taxes on Social Security benefits and higher Medicare premiums. Be sure to consult with a qualified tax advisor before making any decisions regarding your IRA. This information is for general tax guidance. The application and impact of tax laws can vary widely based on the specific facts involved. This information should not be used as a substitute for consultation with professional accounting, tax, legal or other competent advisers. Before making any decision or taking any action, you should consult with a qualified professional. Tax services are not offered by Alterra Advisors or Lion Street Financial, LLC.
Grant Monson
CFP®, CLU®, ChFC®
Partner, Financial Advisor
About the Author
Grant grew up on a working wheat farm in eastern Washington. Today, he credits his family – who still manage the farm – for preparing him to build a business serving others. His vision to lead Alterra is built on relentless dedication to the success of his clients and the team – his extended family.
Grant’s dad says that he hasn’t worked a day in his life because “it isn’t work when you love what you are doing.” When combined with his mom’s view that “helping others should be part of every day”, Grant’s view of financial planning comes into focus. Alterra Advisors is very much a reflection of Monson family values.
Grant earned a bachelor’s degree in business and a master’s in economics at Washington State University. He launched his own financial advising practice over a decade ago, an entrepreneurial quest has become one of the most impactful things in Grant’s life. He loves coordinating the complex financial lives of business owners, bringing a depth of understanding that is rooted in his family’s own experience.
The “Alterra” name was coined by joining the Latin roots “alter”, the origin of the word “altruism” with “terra” meaning earth or land. This name reflects the company philosophy of “clients before profits” and providing firmly grounded advice.