When you’re depending on your savings to do the heavy lifting in retirement, you need to wring out as much income as you can from every dollar of savings. However, if most of your savings are in tax-deferred accounts, you’ll end up sharing your windfall with Uncle Sam in the form of taxes on your retirement distributions.
Those taxes cut into your income by anywhere from 10% to 37%, depending on your tax bracket, where you live and your investment strategies. That means that the $500,000 that you have saved, is actually not $500,000 — rather, you must discount it by how much you’ll owe the federal, state and local governments each and every year that you take retirement distributions.
Early in your retirement, this isn’t a big issue, because you don’t have to take distributions from your tax-deferred accounts unless you want to. That changes when the IRS requires you to begin taking required minimum distributions (RMDs) based on your life expectancy and tax-deferred account balances. RMDs used to kick in at age 70.5, but the recent passage of the SECURE act has now raised that to age 72 for everyone born on July 1, 1949, or later. The age remains at 70.5 for everyone born before that.
Fortunately, there are strategies that enable you to create tax diversification in your retirement savings accounts. These strategies are best employed as early as possible — decades, or at least years, before you retire. However, even if you are only a few years away from required minimum distributions, there’s still time to mitigate your retirement tax bill.
The new retirement reality
After toiling at a factory for 35 years, my dad retired at age 55 when his employer closed the factory and headed to the land of cheaper labor. He was a man of simple means and had no issues taking an early retirement because his defined benefit pension and Social Security would support him until the day he died.
That is how retirement worked for millions of Americans. But we now have moved into an age of the New Retirement. The defined benefit pensions of yesterday are as elusive and rare as the Northern Hairy Nosed Wombat. The New Retirement now consists of a self-funded pension, of sorts, known as the 401(k) or 403(b).
While these vehicles allow you to save for retirement and, in many cases, receive a company match, they are also tax deferred. That means you receive a tax deduction when you contribute, but you have to pay taxes when the money is withdrawn at retirement.
For example, let’s say you went to a mortgage broker and asked for $400,000 to buy a new home. The broker agreed, with the condition that upon the last payment, you would owe the interest at the rate he decided to set then. Would you take that loan? My gut says not a chance.
But that is exactly the situation you are in when you used tax-deferred accounts to save for retirement. Because you then must take money out to pay retirement expenses and pay whatever the current tax rates are at that time.
Creating tax diversification
Tax diversification is the practice of saving for retirement through a variety of retirement vehicles with different tax treatments. Instead of putting all your eggs in one basket, you spread your savings out among types of accounts to minimize your tax bill as much as possible.
Some types of accounts you can use to accomplish this are:
- Traditional 401(k), 403(b) or IRA: You get a tax deduction when you contribute but have to pay taxes when you withdraw the money in retirement. The government requires you to take required minimum distributions at age 72 (or age 70.5 for those born before July 1, 1949).
- Roth 401(k), 403(b) or IRA: You do NOT get a tax deduction when you contribute, but funds grow tax free, qualified withdrawals are tax free and there are no required minimum distributions.
- Taxable savings or brokerage account: You pay tax on any dividends or interest yearly and on capital gains when you sell.
With this information in mind, here are five strategies for achieving tax diversification, maximizing your retirement income and minimizing your future tax obligations.
Strategy #1: Contribute to a Roth IRA or 401(k)
If you’ve got earned income and are within government limits for Roth IRA contributions, the biggest favor you can do your future retired self is to make Roth IRA contributions. Maximum Roth IRA contributions are $6,000 for 2019, unless you are 50 or older, in which case you can contribute $7,000. Your ability to meet those maximum contributions, however, can phase out dependent upon your income level. You have until April 15, 2020, to make a contribution for 2019.
Roth Contribution Limits 2019
|Header Cell - Column 0||Married Filing Jointly Modified Adjusted Gross Income||Single + Head of Household Modified Adjusted Gross Income|
|Partial contribution||>$193,000 but <$203,000||>$122,000 but <$137,000|
Note: For 2020, the maximum amount you can contribute to a Roth IRA remains the same, but the income phase-out levels rise a bit. For the particulars, see 401(k), 403(b), TSP Contribution Limits Climb in 2020.
Strategy #2: Make a Non-Deductible IRA Contribution
If you make too much money to contribute to a Roth, you can still make a non-deductible contribution to your traditional IRA. The catch is that you need to maintain records of your non-deductible IRA contributions so that you will know what amounts you don’t have to pay taxes on when you withdraw money in retirement.
Unless you convert that money to a Roth IRA as soon as it hits your traditional IRA account. This is known as a “back-door” Roth contribution and is completely within the IRS rules.
Strategy #3: Convert traditional IRA savings to a Roth IRA
When you convert money from a traditional IRA to a Roth IRA, you must pay taxes on the amount you can convert. Why? Because you received a tax deduction when you made that original contribution.
Converting savings to a Roth gets the tax bill out of the way now that you would otherwise pay later in retirement. At that point, tax brackets may be higher. Also, it means the money in the Roth can grow tax-free throughout your retirement, because there are no required minimum distributions.
One way to mitigate the pain of making a large tax payment to convert your savings is to convert smaller amounts over a longer period. When you ladder your conversions in this way, it’s easier to stay in your current tax bracket rather than moving into a higher bracket where you would have to pay more taxes.
You may not want to convert if you need an income solely from your retirement account. It may not make sense because it may take too long to see the benefit of paying the tax early.
Strategy #4: Begin taking distributions in your 60s
While you don't have to begin traditional retirement account withdrawals until after age 72 (or 70½ if you were born before July 1, 1949), taking smaller distributions beginning during your 60s spreads the tax bill over more years.
This strategy can also help you stay in a lower tax bracket and reduce your lifetime tax bill. Withdrawals from tax-deferred accounts are taxed at ordinary income rates, rather than more favorable capital gains tax rates. Spreading the tax bill out over time helps you avoid a situation in which you would be hit with a large tax bill once your income has ceased in retirement.
Strategy #5: Contribute to taxable accounts
If you’ve got money to contribute to savings beyond what you are already saving in your 401(k) and Roth IRA, taxable accounts are a great idea. You can invest in virtually any type of investment, such as Individual Brokerage Accounts, Municipal Bonds or even High Yield Money Market accounts, and you don’t have to worry about required minimum distributions. There is also no maximum contribution limit. With taxable accounts, you are only taxed on the gains portion of the account. With that in mind, when these taxable investment accounts pay out qualified dividends, such as those that come from most stock and mutual fund accounts, you typically pay at a lower tax rate.
A final word
Ultimately, we know there is no way to avoid taxes altogether, but we need to use the proper strategies to mitigate the tax burdens we are sure to face during retirement.
There is no one-size-fits-all solution. Financial advisers throughout history have preached diversification when it comes to their investments. Diversification has proven to be a sort of safety net for your investments.
It only makes sense that in the age of the New Retirement, we need to be equally diversified when it comes to the tax implications on our retirement accounts. Mitigating taxes today as well as in retirement requires a well-balanced approach.
Mark Anglin is a financial adviser at Bales Financial Group (opens in new tab) in Cumming, Ga. He is also a licensed insurance agent who can offer life, home, auto and commercial business lines of insurance services. As a college graduate and a veteran of the United States Army, Mark is passionate about serving his community by offering his business services as well volunteering his time to coach basketball to youth athletes.
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