Tax planning doesn’t end with retirement. In fact, tax planning can be equally, if not more important, during retirement. That’s because, without additional employment income, taxes can unduly reduce your income and your nest egg if you aren’t strategic.
We’ll review both what general tax planning looks like, and what you can consider in tax planning. First, though, let’s review how different kinds of retirement income are taxed.
How Income is Taxed
The three primary kinds of income in retirement are ordinary income, long-term capital gains, and Social Security benefits.
Ordinary Income
Ordinary income covers most of the kinds of income you might receive in retirement. Ordinary income is taxed at marginal rates ranging from 10% to 37%, depending on how much income you receive in a given year.1,2 It can include:
- Income from employment or self-employment
- Distributions from traditional retirement accounts such as an IRA or 401(k)
- Annuity payments*
- Short-term capital gains
- Taxable portion of Social Security benefits (more on that soon)
- Pension payments
- Ordinary dividends
- HSA withdrawals for non-qualified expenses
- Roth conversions
*Annuity payments from an annuity purchased with after-tax money (non-qualified annuities) will be partially taxable; qualified annuities held inside of an IRA or other tax-deferred retirement plan will be taxed in accordance with tax rules for distributions from this type of account.
Long-Term Capital Gains
Long-term capital gains are taxed at 0%, 15%, or 20%; these rates are often more favorable than ordinary income tax rates. Long-term capital gains refer to gains on assets sold after being held for at least one year. For those whose income exceeds a certain level, an extra 3.8% is added on to income taxed at long-term capital gains rates. This is called the net investment income tax (NIIT).
Long-term capital gains can come from:
- The sale of investments such as stocks, mutual funds or ETFs
- Gains on the sale of real estate
- Gains from the sale of a business
Additionally, qualified dividends are also taxed at long-term capital gains rates.
Social Security Benefits
Your Social Security benefits are not taxable by themselves, but they can be added to your taxable income based upon your filing status and combined income.
Single filers:
- If your combined income (defined as adjusted gross income, plus nontaxable interest income, plus ½ of your Social Security benefits) is between $25,000 and $34,000, then you may have to pay taxes on up to 50% of your benefit.
- If your combined income is over $34,000, then you may have to pay taxes on up to 85% of your benefit.
Joint filers:
- If your combined income between you and your spouse is between $35,000 and $44,000, then you may have to pay taxes on up to 50% of your benefit.
- If your combined income between you and your spouse is over $44,000, then you may have to pay taxes on up to 85% of your benefit.
For those who file as married and separate, you will likely be required to pay taxes on your benefits.
Retirement Tax Planning
Retirement tax planning is an ongoing, dynamic process, not just a one-time task. Ideally, you’re looking both at short-term tax planning (what’s happening in the next year or so) and long-term planning (how you’ll handle future events).
Annual Planning
We believe you should review your retirement income strategy every year, especially in the years before required minimum distributions (RMDs) start.
Start by reviewing what money is coming in versus your expenses that year. Make sure you include all income sources, including Social Security, employment or self-employment income, investment income, and RMDs, among others. What taxes are you likely going to need to pay on that income?
If your expenses exceed your income, you’ll want to review your options, including taxable accounts, retirement accounts such as IRAs and 401(k), and other sources. Decide which accounts you’ll tap for additional income based on your anticipated tax situation for the year. For example, if you are in an otherwise low income year, perhaps this is a good year to tap into a tax-deferred retirement account and pay taxes on the withdrawals.
Longer-Term Planning
As you’re doing your annual tax planning, factor in some of the longer-term considerations to further minimize your overall retirement taxes.
- Will you need all of the money from your RMDs to cover your expenses? If not, think about steps like charitable contributions or Roth conversions to reduce the future tax hit from your RMDs.
- Is your mix of investment accounts between taxable, tax-deferred, and Roth accounts optimal based on your needs? If not, make adjustments over time with tactics like a Roth conversion or withdrawing more or less from certain accounts. Don’t worry that you need to do everything all at once; this is a multi-year tax and investment planning exercise.
- How can you position your assets in the most tax efficient ways for your heirs? This can be more relevant if you're widowed or single. For example, converting a traditional IRA to a Roth can allow you to pass on your IRA tax-free to non-spousal beneficiaries. In essence, you’re paying the tax for these beneficiaries by doing the conversion.
Things to Consider
Every person’s situation will be unique. Here are some things to consider as you look at your particular situation.
Using Lower-Income Years
For many retirees, especially those in the “gap” years after they’ve retired but before they claim Social Security, there may be years when their income is lower than in normal years.
One option might be taking withdrawals from a traditional retirement account, like an IRA or 401(k). While you will pay taxes on these withdrawals, you’ll pay taxes at a lower rate than in years where your income is higher.
Tapping traditional retirement accounts during lower-income years also allows you to reduce the amount of RMDs you’ll have to withdraw in the future.
Tapping your taxable investment accounts can also be a good option during lower-income years. If your income is especially low, you might find yourself in the 0% or 15% tax brackets for long-term capital gains — which might be a good opportunity to sell shares that have grown substantially and take advantage of that low tax bracket.
RMDs
RMDs are a major taxable event for many retirees. For those with substantial amounts in a retirement account like a traditional IRA, these amounts can be substantial and could significantly add to your tax liability.
The additional taxable income from RMDs could make a portion of your Social Security benefits subject to taxes and/or push you into a higher income tax bracket. This income might also put you in a situation where you’ll be incurring the Medicare IRMAA (income-related monthly adjustment amount) surcharge on your premiums in future years.
QLACs
Qualified longevity annuity contracts (QLACs) are deferred annuities that can be purchased inside a retirement plan like an IRA or a 401(k). Money used to purchase a QLAC is excluded from RMD calculations until you annuitize or otherwise take distributions of this money, which can be deferred as long as to age 85.
These lower RMD amounts will result in lower RMD taxes during these years. QLACs also allow you to defer the money in the contract until later in retirement as a hedge in case an extra pool of money is needed later.
QCDs
Qualified charitable distributions (QCDs) are distributions from a traditional IRA that are directed to a qualified charitable organization. Once you reach age 70 ½, you can distribute up to $100,000 annually from a traditional IRA using QCDs. This amount is adjusted for inflation each year.
QCDs are not taxed, and they serve to reduce the amount of the traditional IRA that is subject to future RMDs. Once you reach the age where RMDs are required, QCDs can be used to satisfy some or all of your RMD requirements. QCDs are a very tax-efficient way to contribute to charity, especially if you cannot itemize deductions on your tax return.
Roth Account Distributions
Qualified distributions from a Roth IRA, Roth 401(k), or other type of Roth account are tax-free. In order to be considered as a qualified distribution, certain requirements including age and holding period requirements must be met.
State Taxes
States vary in terms of how retirement income is taxed. There are several states with no state income tax at all. In other cases, there are states that don’t tax retirement income, such as income from a retirement plan distribution or Social Security.
Be sure to fully understand the extent to which your retirement income will be taxed in your state. If you are considering relocating once you retire, you should check into how retirement income will be taxed at the state level in the state you are considering.
Roth conversions
Converting money from your traditional retirement account into a Roth is another way to potentially save taxes in retirement over the long term, since qualified distributions from a Roth account are tax-free.
Another benefit is that the money you convert into your Roth IRA will no longer be subject to RMDs. This can save taxes once you reach your RMD required beginning date. If a Roth conversion makes sense for you, timing it during lower-income years will probably make the most sense.
Still Working Exemption
If you’re still working at age 73, you may be able to delay taking RMDs on the money in your employer’s 401(k), if they have adopted the clause in their 401(k) that allows for this. RMDs pertaining to money in this plan are delayed until you are no longer employed by this company.
RMDs from other retirement accounts must still be taken as normal. This includes traditional IRAs, traditional 401(k)s, 403(b)s, and 457 plans. And of course, once you leave the employer whose plan offers this exemption, you must start taking your RMDs from that plan as well.
Retirement Tax Planning is Ongoing
Tax planning in retirement is not “one and done”. You'll need to plan annually, because your income can vary, the tax rules can change, and RMDs change depending on your age.
For investors who have a mix of taxable and retirement accounts, a big part of the process is deciding how much to withdraw from each type of account. The tax impact arising from distributions from each type of account will be an important factor to consider.
Making solid, informed retirement income planning decisions that include the impact of taxes can go a long way towards ensuring that you don’t outlive your retirement nest egg.
Working with a knowledgeable financial advisor and a tax professional can be very beneficial in helping you reach the right balance between retirement tax concerns and a strategy that allows you to maximize your income in retirement.
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