Remember back to when you received your first paycheck. You were so excited. You knew how much you were earning per hour and how many hours you worked, and you couldn’t wait to go out and splurge on something you’ve been dying to get. You were handed your paycheck envelope and tore into it with great anticipation and … wait a minute … that’s not even close to what you expected.
This was your first hard lesson about taxes – the government wants a piece of what you earn at work.
Unfortunately, stopping work in retirement doesn’t mean the taxes stop too. But making a plan now to mitigate risks like rising taxes can help prevent unfortunate surprises while you’re trying to enjoy your golden years.
Thinking through how your retirement savings and income will be taxed – and creating a tax-efficient withdrawal strategy to minimize the effect of taxation – can help you have a better idea of how much money will end up in your pocket instead of Uncle Sam’s. Of course, there is some uncertainty – taxes change. Rates could go up or down in the years ahead.
In the most recent Quarterly Market Perceptions Study from Allianz Life, 64% of respondents said they worry that their income will not keep pace with tax increases. And taxes, along with other factors, are leading 61% of respondents to say that they are worried that their current financial strategy will not provide the lifestyle they would like to have in retirement.
The good news is, current tax laws provide options to help that reduce taxable income, such as tax credits, increased standard deductions and pre-tax or after-tax retirement plans.
It will come as no surprise that not all tax provisions will lower your taxes. The deduction limits on state and local income tax (only up to $10,000 per tax return is deductible), increased taxes for Medicare on high earners, and varying rates on long-term capital gains could result in a higher tax bill. So you’ll want to work closely with your financial professional, as well as a tax advisor, as you navigate your approach to reducing taxes on your retirement income.
No matter what, you want to have a tax-efficient strategy. Here are a few strategies to consider that can mitigate some of the effect of taxes during retirement.
1. Consider Roth IRA conversions
A common way that many save money for retirement is to put money aside in an employer-sponsored plan or an IRA. These retirement savings vehicles let you invest pre-tax dollars and, hopefully, enjoy tax-deferred growth over time. The trade-off, though, is that taxes will be due when you start withdrawing that money to fund your retirement.
Pre-tax money in a retirement plan or IRA can be converted into a Roth IRA. Through the conversion, income tax will be paid now, instead of later when the money is withdrawn.
Converting your tax-deferred assets into a Roth IRA now could provide you with some flexibility later that could help to reduce the taxes paid during retirement. That means more money for enjoying that well-deserved retirement or for passing along to beneficiaries.
For example, let’s say your marginal tax rate at the time of conversion is 12%. Later, either by changes in tax law or increases in total income, this withdrawal would be taxable at 24% marginal tax rate. A Roth IRA conversion could net you 15.8% more after-tax income.
The benefit of the conversion, providing you follow the rules regarding Roth IRA withdrawals and the proper waiting periods, is there won’t be any taxes paid on earnings for owners or account beneficiaries. A Roth IRA conversion could convert an entire IRA all at once or can be spread out over a number of years. For some people, it makes sense to perform conversions over multiple tax years to avoid being bumped up into a higher tax bracket.
Like any retirement or tax strategy, it doesn’t work out the same way for everyone. Converting an employer-sponsored plan or IRA into a Roth IRA is a taxable event that can have wide-ranging effects. Unintended consequences could include increased taxes on Social Security benefits or higher Part B and D Medicare premiums. The conversion could result in needing additional tax withholding or estimated tax payments. You’ll need to decide whether the taxes would be paid out of the funds being converted or from another, perhaps after-tax, account. It could also mean that you lose certain tax deductions or credits or protection from cost-of-living adjustment increases for Medicare.
Consult with a qualified tax adviser for help making decisions regarding whether to convert a traditional IRA to a Roth. You should be aware there were some provisions in proposed tax bills in 2021 that would limit Roth conversions and prevent nondeductible IRA contributions from being converted. These proposals may come up again – your adviser should keep you updated. Roth conversions need to be completed by Dec. 31, and you can no longer change your mind later and switch a Roth conversion back to a traditional IRA.
2. Explore charitable giving options
For the philanthropic-minded, charitable giving can help reduce the tax burden and preserve wealth as well as allow for leaving a legacy.
A charitable trust is often used by people with sizable assets, but there are other charitable giving strategies people with more modest assets could consider, including qualified charitable distributions and donor-advised funds.
A qualified charitable distribution (QCD) can be used to make charitable gifts using funds from a traditional or, in some cases, a Roth IRA. QCDs will not increase your adjusted gross income. When you withdraw funds from an IRA and then give them to charity yourself, the withdrawal is taxed as income and your adjusted gross income increases.
With a QCD, the withdrawal is made from the IRA, and the IRA provider issues the check payable to the charity directly. Even though it may satisfy all or a part of the IRA owner’s required minimum distribution (RMD), it is not considered income and does not have to be recognized by the IRA owner. A QCD can be used by IRA owners who are over the age of 70½ with a limit of $100,000 per year per individual.
The way QCDs affect your state taxes will differ in states with an income tax structure that does not tax IRA distributions while allowing a deduction for charitable contributions. Since the withdrawal is not recognized as income, a QCD could still benefit individuals who want to donate their RMD and could not use the donation as a federal tax deduction due to the increased standardized deduction.
The other strategy — donor-advised fund — will separate the actual gift from its tax benefits. The tax benefits from a donor-advised fund can be used now and the gift can be sent to the charity later. This could be used to make a large charitable gift without having to make the entire gift at one time.
A donor-advised fund allows for accumulating charitable gifts while at an elevated tax bracket that will be distributed later while in a lower tax bracket. So you can gain the larger tax deductions while in a higher marginal bracket. The fund may also help to avoid long-term capital gains taxes.
3. Using a health savings account for accumulation
Health savings accounts (HSAs) have unique characteristics that can help in retirement. Yes, there are tax benefits to take advantage of, but the bottom line is that your health care expenses will increase as you age. An HSA can help cover those expenses while offering tax advantages.
The accounts, which are available to people who are enrolled in high-deductible health plans, allow pre-tax contributions, tax-free earnings potential and income-tax-free distributions for qualified medical expenses. What’s more, unused balances in an HSA are available and portable – not a “use it or lose it” scenario.
Keep in mind that once someone is enrolled in Social Security or when they apply for Medicare at age 65, they are no longer eligible for HSA contributions.
Not everyone eligible to contribute to an HSA can wait to use it. People with limited cash flow who are struggling to save for retirement would be better off using an HSA for current medical expenses and saving retirement money in a 401(k), 403(b), traditional IRA or Roth IRA.
Among the various risks that people may face in retirement, taxes are inevitable — and no one wants a surprise tax bill that can suck the fun out of retirement. These strategies, and others, could help you mitigate tax risks in retirement. The first step is to find a financial and a tax adviser who will help you start planning now to create a tax-efficient strategy to reduce your tax burden later.
This content is for general educational purposes only. It is not, however, intended to provide fiduciary, tax or legal advice and cannot be used to avoid tax penalties or to promote, market or recommend any tax plan or arrangement. Please note that Allianz Life Insurance Company of North America, its affiliated companies, and their representatives and employees do not give fiduciary, tax or legal advice. Clients are encouraged to consult their tax adviser or attorney.
Kelly LaVigne is vice president of advanced markets for Allianz Life Insurance Co., where he is responsible for the development of programs that assist financial professionals in serving clients with retirement, estate planning and tax-related strategies.
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