The Easy-to-Miss Way to Have Enough Money for Retirement
Be tax smart to maximize your savings in retirement. Here are four ways to reduce your taxes once you retire and keep more of the money you worked so hard to save.
We spend so much time and effort obsessing over how to generate enough money to have enough money for retirement. We work hard, save diligently and invest strategically, all in the hopes that eventually our nest eggs will be big enough to support the lifestyle we want once we quit working.
Amid all that striving and working, many people forget to employ some simple strategies that could make a huge impact on how much money they keep in their pockets that they can then add to their retirement savings. What are they?
Taking steps to lower taxes after you retire. Here are a few ways you can do just that.
Know How to File for Social Security in a Way That Reduces Taxes
Most people pay into Social Security for their entire working careers via FICA taxes. If you paid in, then you can expect a payout in the form of Social Security retirement benefits. (Don’t know how much money you can expect? Look up your estimated benefits or benefits payments here.) You have a lot of choice in regards to when you can file for Social Security and start claiming benefits.
The earliest you can file is at age 62. If you do so, you’ll get a reduced benefit. If you wait until your full retirement age (which ranges from 65 for those born in 1937 and earlier, on up to 67 for those born in 1960 and later), then you’ll get your full benefit. And if you can wait until you’re 70 to begin filing, your benefit will increase by 8% every year you delay after your full retirement age until the benefit caps out at 70.
Filing as early as possible is a mistake for most people. If you can, the best strategy to use is one where you delay Social Security benefits for as long as you can. While you delay taking your benefits, you can cover your gap years (which is what we call the time between whenever you retire and when you reach the age of 70) in many ways.
Some options for paying for your living expenses and other needs and wants during those years include using:
- Cash from a savings account
- Investments in a taxable account
- Roth IRA money
- Your pension
- Passive income from a rental property, business or another source
If you can lean on any of these methods of funding your lifestyle to provide income before age 70, go for it — and delay filing for your Social Security retirement benefits. This will give you a couple important advantages.
The first is that you’ll get more money from Social Security, as mentioned above, at a rate of what is essentially an 8% return per year. That’s a pretty fantastic guaranteed rate of return that you won’t find anywhere else. In addition, you also reduce your taxable income in your gap years.
Social Security benefit payments are partially taxable, so by postponing your benefit payments you also postpone taxes while decreasing your income. Because income tax rates are progressive, this sets you up to pay significantly less in taxes — and you can build on that advantage by then using tax-efficient partial Roth conversions.
Avoid the Tax Hit from Required Minimum Distributions with a Partial Roth Conversion
In your gap years while you wait to take your Social Security benefit, you can do something called a partial Roth conversion. You might also hear this referred to as a Roth conversion ladder.
A partial Roth conversion allows you to take some money from a traditional IRA account and put that it into a Roth account. You’ll pay taxes on the money you take out of the traditional IRA at the time you make the withdrawal. This might not sound so great at first. Isn’t the point to lower your taxes?
Yes, paying less in taxes is the goal — and this strategy might allow you to pay less in taxes overall because you pay them when you do the partial conversion instead of waiting until 70. The idea is that during those gap years, you’re in a lower tax bracket and so your income rate will be lower than it will be in the future.
Plus, at age 70½, you must take RMDs. These are required minimum distributions, which could trigger much higher taxes in retirement. The partial Roth conversion means paying small amounts of taxes each year during your gap years, which reduces your future tax burden.
Manage Taxes from an Employer Pension
If you have a pension, it’s important that you utilize your partial Roth conversion option before those pension benefits begin. Payments from a monthly pension benefit are subject to income taxes, just like your Social Security benefits payments. That income from your pension can dramatically impact how much money you risk parting with when your tax bill comes due.
How can you work your pension without losing a chunk of your retirement nest egg to Uncle Sam? We’ll make a few assumptions for this example so you can see how this would work with some realistic numbers.
Say you plan to retire at 60. You have a traditional IRA account worth $1 million, and you can expect to receive $2,500 per month in Social Security benefits starting at age 67 — but you plan to wait until age 70 to file, which will increase your benefit to $3,100 per month. When you retire, you rely on cash savings and the money in a taxable brokerage account to pay your living expenses between the ages of 60 and 65, when your pension kicks in.
Meanwhile, during those years, you make use of partial Roth conversions, taking some of your money from that traditional IRA and contributing it to a Roth. You pay taxes on that money, but because you haven’t filed for benefits or started using your pension, your taxable income is very low — meaning you’re operating from a lower tax bracket and paying less in taxes than you might in a few years when you start earning income from your benefits.
Your pension will kick in at 65, which will increase your taxable income. Then at 70, you’ll receive your Social Security benefits, which also kick your taxable income up and will land you with a higher tax bill — but you’ve already completed your Roth conversions while paying the bare minimum in taxes, which helps you save money!
Give Back Through Your RMDs
One other strategy you can use to lower taxes after you retire is one that can help you and others: making charitable contributions. You can do this at any time, but to save on taxes, you need to think through how you make your donation.
The best way might be waiting until you’re 70 and forced to take RMDs from accounts like your IRA — and then simply turning that RMD into a Qualified Charitable Donation (QCD). This works because you’ll likely be in a higher tax bracket (and facing higher tax rates after age 70, compared to the tax bracket you probably fall into during your gap years). Making a charitable contribution while you’re in a higher tax bracket means you save more on taxes.
Not to mention, waiting until 70 — rather than, say, donating as soon as you retire at age 60 — gives the money in your IRA another full decade to stay invested and continue earning compounding returns. Not only does that leave you with more money for your own retirement, but it might put you in the position of being able to give more, too, if that’s important to you.
Make Use of Your ‘Gap Years’ to Lower Taxes in Retirement
These strategies only work if you plan ahead for them. You need to think about your gap years, or that time between when you retire and when things like pensions and Social Security payments will come into play, if you want to take advantage of ways to lower your taxes in retirement.
About the Author
Founder and CEO, Define Financial
Taylor Schulte, CFP®, is founder and CEO of Define Financial, a fee-only wealth management firm in San Diego. In addition, Schulte hosts The Stay Wealthy Retirement Podcast, teaching people how to reduce taxes, invest smarter, and make work optional. He has been recognized as a top 40 Under 40 adviser by InvestmentNews and one of the top 100 most influential advisers by Investopedia.