Many people — some with retirement plans already in place — have no idea what their spending will look like in retirement.
Why is this important? Because if you don’t know how much you’re planning to spend in retirement, you don’t know how much income you’ll need to cover those expenses. And if you don’t know those two key pieces of information, any retirement plan that you have isn’t worth the paper it’s printed on. It’s impossible to aim if you don’t know where the target is.
Fortunately, the answer to this question isn’t complicated at all. In fact, it’s simple if you aren’t planning any lifestyle changes in retirement. If you are, it’s a bit more challenging, but still easy to figure out with some simple math.
Beyond ensuring that your income is sufficient to meet your expenses over a potentially 35-year-long retirement, understanding your expenses and income can provide significant insight into your tax situation. By strategically managing your income and expenses during retirement, you can potentially position yourself to lower your tax bill on an ongoing basis.
How to determine your expenses
Figuring out your expenses is easy, even using back-of-the-napkin math. If you’re still working, write down your take-home pay — that is, your pay after taxes, any 401(k) contributions and any health or life insurance premiums. How much do you generally have left over at the end of the month after paying your bills? If you don’t have anything left, are you digging into savings or incurring credit card debt to fund your lifestyle?
Let’s say your take-home pay is $5,000 a month and you have $500 left over at the end of the month. That puts your current expenses at $4,500 a month. From there, you can make adjustments to your estimated future need by adding in any new expenses that you may be forced to pay out of pocket once you finally retire, like life and health insurance premiums. You’ll also need to add in any expenses that will result from lifestyle changes, such as additional vacations, a second home or helping your children or grandchildren.
If you want to be more systematic, you can track your expenses over time using a budgeting app, such as Mint, You Need a Budget (YNAB) or Clarity Money. These apps securely sync with your bank account, downloading and classifying your transactions.
Understand your sources of income
Once you’ve got a handle on your expenses, take a look at your sources of retirement income. For most people, this includes Social Security and retirement savings, though some people do have defined benefit pensions that provide lifetime income.
You’re eligible to claim Social Security when you turn 62. When you claim your benefit at 62, your benefit is reduced by 25% to 30% from the benefit you would receive at full retirement age.
- 66 for individuals born between 1943 and 1954
- Between 66 and 67 for individuals born between 1955 and 1959
- 67 for individuals born in 1960 and later
For individuals born in 1943 or later, there’s an 8% increase in your benefit every year that you wait to claim beyond full retirement age up until age 70.
You’ll see why this is so important when you dig into the following four retirement tax strategies. By employing these strategies, you may be able to position yourself to reduce your taxes in retirement, saving thousands of dollars that you can then direct toward your expenses and standard of living.
Strategy #1: Connect taxation with outflow, as well as income
When you are working, you’re taxed on your earned income. However, when you retire, you don’t have earned income. Instead, you are taxed on a combination of outflow of cash withdrawn from your retirement plans as well as the income from fixed sources like Social Security and pensions (if you have one).
Understanding this switch isn’t easy. You have to realize that the taxes paid on Social Security are calculated differently than the taxes on our earned income in our working years. Instead of using our adjusted gross income (AGI) the IRS will use “provisional income” to determine certain thresholds that tell them what amount (if any) of our Social Security benefit is taxable. Any outflows from retirement accounts like IRAs or 401(k)s directly impact provisional income. This means that not only will your IRA distribution be taxable, it may cause more of your Social Security benefit to be taxed as well. These taxes directly reduce the amount of money you have to pay your living expenses and fund your lifestyle in retirement.
This is why careful tax planning in retirement is so important. When you take the time to coordinate Social Security and retirement distributions (as we will see in Strategy #2), you may be able to avoid paying more than your fair share in taxes throughout your retirement.
Strategy #2: Spend down traditional IRAs and delay Social Security
When you turn 70½, you are required to begin withdrawing money from your traditional 401(k), 403(b), IRA or other tax-deferred account. Because you didn’t pay taxes on these contributions when you made them during your working years, you must begin to pay taxes on them now.
What you may not realize is that these withdrawals are taxed at your marginal tax rate, not at the more favorable capital gains or qualified dividends rates. Why does that matter? Because marginal tax rates are generally higher than capital gains rates.
By strategically spending your IRA assets before you turn 70½, you may be able to reduce your future required minimum distributions (RMDs). If you are able to delay filing for your Social Security benefit during this time as well, you can increase the amount of your checks in the future. When you do finally begin collecting your Social Security check and you have reached age 70½, you should have a smaller taxable distribution from your RMD as well as a higher benefit from Social Security. Since Social Security is taxed differently than IRA distributions — with the maximum taxable portion of your check being 85% — you may effectively boost your retirement income and lower your overall taxes throughout retirement.
Strategy #3: Convert traditional IRA assets into a Roth IRA
By strategically shifting assets out of your IRA before you turn 70½ through Roth IRA conversions during years in which your marginal tax bracket is low, you may reduce your RMDs and the amount of tax you pay. Even better, distributions from Roth IRAs aren’t taxed in retirement, because you pay the tax when you contribute or when converted.
One issue that holds retirees back from converting assets in a traditional IRA over to a Roth IRA is that taxes are due in the year the conversion is made. These taxes increase the more money you convert.
You have to be careful — and obtain advice from a tax professional — because Roth conversion rules can be complex. However, if you find yourself in a lower-than-normal tax bracket after you retire, it might be a good time to convert at least part of your IRA to a Roth.
Even if you convert only a small portion of your traditional IRA into a Roth, this may help you lower your tax bill in retirement, since Roth distributions aren’t taxed.
Strategy #4: Contribute to a Roth
This won’t work if you don’t have any earned income. But if you are still working full time, or even part time, you can contribute to a Roth regardless of your age.
If you are under 50, you can make a Roth contribution of up to $6,000 in 2019. If you are 50 or older, your contribution limit increases by $1,000, adding up to $7,000 total.
Not only do you not have to pay taxes on Roth distributions in retirement, Roth IRAs are also exempt from RMD rules, meaning you don’t have to withdraw the money unless you want to. This means these funds can grow over time, providing an important source of untaxed retirement income.
Roth IRAs are subject to income limits. Individuals making more than $122,000 and couples making more than $193,000 can’t contribute. However, you can contribute to a non-deductible IRA and then convert those funds into a Roth IRA.
A final word
Between RMDs and taxes on Social Security, taxes can be a wake-up call in retirement. By proactively planning before and during retirement, you can potentially minimize your taxes and have more money to pay your bills and enjoy your retirement.
Joel Hardin is a Senior Partner and a co-founding member of City Center Financial LLC. Joel is an Accredited Portfolio Management Advisor℠ (APMA®) as well as a National Social Security Advisor Certificate Holder (NSSA®). Joel brings an analytical and principled approach to portfolio management, income and Social Security planning, tax-mitigation strategies and retirement planning. Joel focuses his knowledge and skills toward helping his clients successfully navigating their retirement.
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