While we all must pay our fair share of taxes, being tax efficient simply means not making simple mistakes that can cause you to pay an unnecessary amount.
Tax planning is important no matter what stage of life you're in, but the reality is that much more tax planning can be done after the paychecks have stopped than during your working years. Here are some simple rules and actionable steps you can take in retirement to keep your income taxes as low as possible, year in and year out.
Look at How Your Income Sources are Taxed
The first step of any retirement plan is to establish an after-tax income goal for yourself each month. Each person's budget is unique, so we always start there. Retirement is the first time in our entire lives we choose where we pull our income from. We have different sources from which we could pull money, such as traditional IRAs, Roth IRAs, Social Security, dividends or interest, etc. Each of these sources is taxed differently, some more favorably than others. The first, and most commonly used, strategy to being tax efficient in retirement is to simply understand what combinations of sources to pull income from that will result in the least tax amount.
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Before we go any further, let's quickly understand how these sources are taxed. Most pensions (if you're lucky enough to still have one) are taxable as ordinary income. Money you pull out of traditional 401(k)s and IRAs is also taxed as ordinary income. Roth IRAs (after meeting a couple basic rules, including being at least age 59½) are 100% tax free when you pull money out. When it comes to the non-retirement accounts, you can spend your own money completely tax free. When you invest those funds, the taxation differs, which we'll get to in just a bit.
Rather Pay 12% in Taxes or 22%?
Let's look at a simplified example (but please keep in mind it's not quite this easy; these are just examples to illustrate broader points):
A 65-year-old couple is looking for $7,000 a month in after-tax income to meet their retirement goals, or $84,000 for the year. Let's say they have $500,000 in traditional IRAs and $200,000 in non-retirement accounts sitting in cash.
Looking at the 2018 tax brackets, let's focus on married filing jointly: After $77,400, they go from paying 12% on taxable income to 22% on taxable income. This means they should stop pulling from their IRAs once their taxable income reaches $77,400 for the year. It would be much more beneficial to take the final $7,000 they need for the year from the non-retirement account, which is not taxable income. By properly using the after-tax money, they saved those IRA dollars from getting taxed at a 10% higher rate.
Conversely, people often spend way too much of their non-retirement money early in retirement and miss out on low tax brackets for their IRA income. In the example above, in theory it would be good for the couple to spend $77,400 from their IRAs this year; chances are that money will never be taxed at a rate lower than 12% again. If they spent all their after-tax money right away, then when they pull from the IRAs in future years, it could be at a higher rate.
It's the proper mix of each, year in and year out, that allows you to be efficient this year and throughout retirement.
Social Security is trickier. First, there is a calculation called "provisional income" in which you first take half of the Social Security benefits you receive, and then you add up everything else (except your after-tax savings, Roth IRA income and cash value life insurance, when structured properly). If you have a low provisional income, none of your Social Security is taxed at all. As your provisional income gets higher, as much as 85% of your Social Security benefits could show up on your return as taxable income.
Rather Pay $137 in Taxes or $10,270?
Let's look at another example. These clients have a taxable pension of $21,180. They get a combined $38,412 a year in Social Security benefits. They have hundreds of thousands of dollars in both IRAs and non-retirement accounts and are looking to spend an additional $50,000 this year.
Case 1
They simply pull $50,000 from their non-retirement cash. You won't find this anywhere on a tax return because it isn't taxable. If you look at their Social Security dollars, IRS income limits mean that only $4,193 of the actual $38,412 they received was taxable. Although they took about $110,000 of actual income, only $25,373 turned out to be taxable because of the way they blended their accounts. After taking their new increased standard deduction of $24,000, they will only pay $137 of federal tax now!
Case 2
They pull the $50,000 from their IRAs, making their taxable income now $50,000 higher. In addition, because this also caused their provisional income to be higher, now 85% of their Social Security benefits, or $32,650, is taxable. This time, they will pay $10,857 in federal tax. As you can see, pulling the $50,000 out of the IRA caused an additional $10,720 in tax.
Therein lies the biggest message of this whole article.
- Step 1: Make an after-tax income goal for yourself.
- Step 2: Add any income sources already coming in, such as Social Security or pensions. This will tell you how much additional income you will need to pull from your accounts.
- Step 3: Simply run mock tax returns, looking at different combinations of sources of income to see what blend will cause the least amount of tax.
The Bottom Line
If you pay less in taxes every single year, then those dollars get to stay in your investment accounts and keep earning a compounded rate of return year over year. Sometimes saving just 5% a year in effective taxes can add hundreds of thousands of dollars to your net worth over a 25- or 30-year retirement.
As I mentioned, different investments also have different tax features in your non-retirement accounts. Interest from corporate bonds, CDs or annuities is also taxed as ordinary income—as well as "ordinary dividends" and short-term capital gains from stocks. "Qualified dividends" and long-term capital gains get preferential treatment and are taxed at lower rates than your marginal tax bracket.
This means it's important to know how you structure your investments when choosing between a taxable bond and a tax-free one, as well as whether to trigger capital gains in a given year and, if so, how much.
Kevin Derby contributed to this article.
