tax planning

5 Tips to Minimize Your Taxes in Retirement

Don’t pay more than you have to. It all starts with a thorough understanding of the basics of how retirement income is taxed.

The July 15 extended tax filing deadline just passed. While it might seem early, now is the right time for you to rethink the impact of taxes when planning for your retirement.

We all know that the sooner you begin saving for retirement, the more you will benefit from the power of compounding. And the sooner you prepare for the impact of taxes in retirement, the more likely you’ll be to generate more income for more years.

More than a third of current retirees (35%) did not consider how taxes would affect their retirement income when planning for retirement, according to the Nationwide Retirement Institute’s Tax-Efficient Retirement Income Study. And many express regrets. Roughly one-third wish they had better prepared for paying taxes in retirement — and roughly one-fourth believe they’ve paid several thousand more than they expected.

The Ground Rules

To minimize taxes in retirement, and generate more retirement income, it’s important to know the tax treatment of your different income sources in retirement. How those sources interact will help determine the right sequence for drawing down accounts.

You should also keep in mind the SECURE Act, which took effect on Jan. 1, 2020, and has changed many rules around qualified retirement accounts, including contributions and withdrawals.

Finally, remember that taxes are not static, and could go up or down in the years ahead. As the retirement safety net remains under threat, while the country’s deficit continues to grow, it’s a good idea to be prepared for rising taxes and to think in terms of tax-efficient retirement planning.

Whether you’re already retired, or still in the planning process, here are five tips to ensure you don’t end up paying higher taxes in retirement:

Tip #1: Know the Benefits of Tax Diversification

Tax diversification is important to control how much you pay in taxes — and when those taxes are paid. In the same way that you diversify investments across different asset classes, you can also diversify across different types of taxation. This also gives you flexibility should tax laws change. Tax diversification starts by knowing the differences between tax-deferred, tax-free and taxable accounts:

  • Tax-deferred vehicles allow you to delay paying taxes on investment gains, and potentially accumulate more over time through tax-deferred compounded growth. Some tax-deferred vehicles allow you to contribute pretax dollars, reducing your current tax bill to keep more of what you earn. Your withdrawals in retirement will be taxed at ordinary income rates — but in many cases your income and tax rate in retirement will be lower.
  • Tax-free vehicles are funded with after-tax dollars. So, you will pay taxes when you contribute, but your investment will benefit from years of tax-free compounded growth. And withdrawals in retirement are also tax-free.
  • Taxable accounts include brokerage accounts. If you sell your investments, you’ll pay taxes on the gains. Investments held for less than a year will typically be taxed at the higher rate for short-term capital gains, while investments held for more than a year will be taxed at the lower rate for long-term capital gains. You also may incur taxable income on certain types of investments (e.g. dividends/distributions inside mutual funds) even if the asset is not sold. Other assets may be tax-exempt, such as municipal bonds.

Tip #2: Understand Asset Location

Not all investments have the same tax impact. Some are more tax-efficient than others, depending on whether they are taxed at lower long-term capital gains rates or at higher rates for short-term capital gains and ordinary income. Asset location is a proven strategy to help minimize the impact of taxes and help you potentially increase returns without increasing risk. The tax savings can be substantial, especially if you’re in a higher tax bracket:

  • What should go in taxable accounts: Locate tax-efficient investments such as index funds, ETFs, buy-and-hold stocks and tax-exempt municipal bonds — in taxable accounts.
  • What should go in tax-free accounts: Locate tax-inefficient investments — such as fixed income, REITS, commodities, liquid alternatives and other actively managed strategies — in tax-deferred or tax-free accounts, to preserve gains without the drag of taxes.
  • What to do with other assets: After maxing out qualified plans and other tax-advantaged retirement savings plans (discussed below), consider low-cost investment-only variable annuities (IOVAs) for more tax-deferral. 

Tip #3: Know the Differences Between Retirement Savings Accounts

There are a range of different retirement savings accounts and qualified plans that provide tax advantages for long-term savers. They vary in several ways, including contribution limits and the tax treatment of contributions and withdrawals. The SECURE Act now allows you to make contributions to these accounts after age 70½, as long as you meet certain requirements. In certain cases, you’ll need to consider the impact of required minimum distributions (discussed in the next section). Some of the most popular tax-advantaged accounts include:

  • 401(k)s are tax-deferred employer-sponsored plans. You contribute pretax dollars, and your employer may match a portion. Your withdrawals will be taxed as ordinary income. You can invest up to $19,500 in 2020, with a $6,500 catch-up contribution if you’re 50 or older by the end of the tax year. (For more, see How Much Can You Contribute to a 401(k) for 2020?)
  • Roth 401(k)s are tax-free employer-sponsored plans. Contribution limits are the same as traditional 401(k)s, but you fund a Roth 401(k) with after-tax dollars, so your withdrawals are tax-free and penalty-free, as long as you've had the account for five years and are at least 59½. What’s more, there are no income limits on Roth 401(k)s, unlike Roth IRAs, making this an attractive option if you’re a high earner. (For more, see How Much Can You Contribute to a Roth 401(k) for 2020?)
  • IRAs, or individual retirement accounts, are tax-deferred and withdrawals in retirement are taxed as ordinary income. You can contribute pretax income of up to $6,000 in 2020, with a catch-up contribution of $1,000 for those 50 and older. Contributions may be tax-deductible, but the amount of your deduction may be reduced or eliminated if you or your spouse is covered by a workplace retirement plan.  (For more, see How Much Can You Contribute to a Traditional IRA for 2020?)
  • Roth IRAs are tax-free, allowing you to contribute after-tax income now, with tax-free withdrawals in retirement. However, if you’re a high earner, your contribution levels are likely to be reduced or completely eliminated based on income limits imposed by the IRS. In addition, your contributions are not tax-deductible. (For more, see How Much Can You Contribute to a Roth IRA for 2020?)

Tip #4: Understand Required Minimum Distributions (RMDs)

If you have a 401(k) or a traditional IRA (and certain other qualified plans, such as a 403(b), 457(b) or SEP IRA), you’ll need to begin taking required minimum distributions (RMDs) every year after you reach a certain age.

Under the SECURE Act, if you turn 70½ in 2020 or later, you can now wait to take your first RMD by April 1 of the year after you reach 72. But for those who turned 70½ in 2019 or earlier, you will continue to follow previous rules, which required you to take your first RMD by April 1 of the year after you reached 70½.

Additionally, under the CARES Act, all RMDs have been suspended for 2020. If you have any retirement savings accounts subject to RMDs, including 401(k)s, 403(b)s and IRAs, this waiver applies in 2020, regardless of your age.

RMDs can be complex, leading to unpleasant surprises when they’re not handled correctly, such as a spike in taxable income and a higher tax bracket. You should also keep in mind the 50% penalty you’ll pay on any portion of the required amount that you don’t withdraw by the deadline.

It’s important to develop a plan. To help you manage RMDs, advice from a financial professional can help you save thousands in taxes and penalties.

Tip #5: Consider Roth Conversions

Once you’re in retirement, your tax liabilities could begin to increase, for reasons such as delayed Social Security payments or large RMDs. If so, a Roth conversion could help you generate more tax-free income in retirement and lead to a lower tax rate in the future. Another advantage is that there are no RMDs from a Roth IRA during the lifetime of the original owner.

Be aware that a Roth conversion is a taxable event. But by paying taxes when you do the conversion, you will pay no federal income taxes on any future withdrawals, as long as they are taken after you've had the account for five years and are at least 59½. 

Because of the tax impact, the timing of your conversion is important. If possible, choose a time when your taxable income is lower than a typical year, or if you have accounts that have lost value. You may also want to consider Roth conversions in smaller amounts over a number of years, to spread the tax impact and avoid creeping into a higher tax bracket. Due to the nuances of Roth conversions, you should consult with a financial professional.

Act Now for More Tax-Efficient Retirement Income in the Future

There is no better time than now to get started on your plan for tax-efficient retirement income. Start with a holistic long-term financial plan, incorporating a variety of solutions to grow and protect your investments.

Knowing the tax treatment of your different income sources in retirement, and understanding how those sources will interact when making withdrawals, is your next step. Those who prioritize tax diversification will be in a better position than those who do not. There are many other decisions — from choosing the right sequence of withdrawals, to managing RMDs and Roth conversions — that will help you to minimize taxes and generate more income in retirement.

Have you spoken with an adviser or financial professional? A skilled financial professional can help you establish a holistic plan that fits with your goals at any stage of your financial life, including a strategy for more tax-efficient retirement income. They can also help you manage the complexities, as market conditions — and tax laws — continue to change.  Consult a financial professional today to learn more about how you can minimize taxes and optimize your investments to fit your retirement income needs. 

Neither Nationwide nor its representatives give legal or tax advice.  Please consult with your attorney or tax advisor for answers to your specific tax questions.

About the Author

Craig Hawley

Head of Nationwide's Annuity Distribution, Nationwide

Craig Hawley is a seasoned executive with more than 20 years in the financial services industry. As Head of Nationwide's Annuity Distribution, Mr. Hawley has helped build the company into a recognized innovator of financial products and services for RIAs, fee-based advisers and the clients they serve. Previously, Mr. Hawley served more than a decade as General Counsel and Secretary at Jefferson National. Mr. Hawley holds a J.D. and B.S. in Business Management from The University of Louisville.

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