It seems everyone knows how to save money on taxes while working using retirement accounts, but many people completely mess up their tax planning when they are actually retired! All that hard work and planning for years, just to mess it up once you’re retired. There is a ton of conflicting advice about what assets to spend first, which to save for last, how much income to take and so on. This makes deciding what to do very confusing and worse, it can cost you thousands of hard earned dollars.
Thankfully, there are a couple of easy tips you can follow to really make your retirement more tax efficient. Even better, they are commonsense and easy to follow once you learn them!
I can’t even count the conflicting articles I have read about which type of account do you take your money from first in retirement? In my opinion, it’s actually quite simple. Many people are told the best idea is to spend down the non-retirement account completely, and save the retirement accounts for later. This will minimize your current taxes and even potentially make it so you don’t pay hardly any taxes. Unfortunately, even in retirement, you still have to plan for the future! There are two main problems with this strategy. Firstly, you will allow your traditional IRA to grow without touching it, making your RMD’s (Required Minimum Distributions) grow. Those will be fully taxable and could bump you up a bracket. Secondly, if you spend all your non-retirement money first, you are left with few or no choices if you want to make a big purchase. Clients often call up wanting to help their children or grandchildren with a $100k down payment or something. Once they realize they only have IRA’s left and that it will cost them $170k to make that gift, they almost always decide against it. If they have non-retirement accounts left, the answer is usually that they are willing to help out their family.
For most people, their retirement needs are quite modest. They’ve paid off their home, the kids are out of the house and it’s just a couple enjoying their retirement. They can live quite reasonably on about five to ten thousand dollars per month. Let’s assume they have social security payments of three thousand per month and no pensions. Additionally, let’s assume they have a non-retirement account, a traditional IRA, and a Roth IRA.
So what do you do? Let’s look at a couple of examples. First we’ll look at the couple who needs ten thousand per month. After social security, they need an additional seven thousand per month. We don’t want to take all of this money from retirement accounts because that would bump them up a bracket. We also already discussed why not to take it all from non-retirement accounts. The answer of course, is to do a mix. Under the current tax laws, a couple who is not itemizing can have about $100k of taxable income and still be in the 12% bracket. In this situation, we want to take advantage of that fact. For simplicity, let’s assume the three thousand from social security is fully taxable. So that’s thirty six thousand of taxable income. What we want to do is take an additional $100k-$36k=$64k from their traditional IRA. This way we are maxing out the 12% bracket. This still leaves about $1,700 per month that we need to get to ten thousand per month. That money we take from the non-retirement account. The way I look at it, $120k of income and staying in the 12% bracket is extremely generous.
In the second example, let’s say the couple only need about five thousand per month. That’s two thousand over social security. We would still recommend they take that money from their traditional IRA since it’s still cheap money. However, this puts their taxable income at only $60k. That’s leaving money on the table. There’s still $40k left in the 12% bracket that they could be using to maximize their lifetime tax savings. In this case, the answer is a Roth conversion. Why not pay 12% on the money today and never have to pay taxes on it again? In my opinion, 12% is so generous we need to take advantage of it now, before the law changes again! So this couple should take $40k and convert it from their traditional IRA into a Roth. This will lower their RMD in the future, and if they don’t spend the money, make their estate pass more tax efficiently to their heirs.
I keep talking about RMD’s, and in many cases they mess up a person’s tax situation. Particularly if they are frugal. Many people haven’t been spending this much money and then when the turn 70.5 the IRS says they have to take it out and trigger taxes on it. This can make you pay way more in taxes and even bump you up a bracket, something the frugal certainly don’t want. There is a good solution under the new tax law. The standard deduction has increased to the point that far fewer retirees will be able to itemize their taxes. This makes contributing to charities effectively non-deductible, since you don’t get additional deductions by contributing to charities if you aren’t itemizing. Thankfully, we can still make direct contributions to charities using your RMD up to certain limits. This means you can optimize your tax situation by donating straight from your IRA instead of from your pocket. For example, if you give $5,000 to a charity from your pocket, your total deduction is just the standard deduction. If instead you give it directly from the IRA, your total deduction is the standard deduction, but your income is reduced by the $5,000 you gave straight to charity. This effectively makes the charitable contribution deductible again. You do have to remember to check the correct box on your taxes or tell your accountant that you made a direct contribution. It won’t necessarily show up on your 1099.
Hopefully one of these tips will help you save some taxes and make your life a bit more tax free! Of course, this advice is generalized and not suited to every situation, but it can make some of these big questions a bit easier to answer.
Like always, if you’re facing retirement and need a second opinion learn about what makes us different, we’ll audit your entire strategy to make sure you have the right tools to make your retirement as low risk as possible and still drive in a good income.
And if you want a further dive into some of the biggest risks with retirement planning then check out our webinar or download our ebook on taking income in retirement.
