Tax-Smart Retirement Income Planning: Strategies for a Worry-Free Retirement
Author: Long Tran, CFP®, Principal Wealth Advisor
Congratulations — you've made it to retirement! After years of saving and investing, it's time to enjoy your hard work. However, the transition from accumulation to distribution can be a challenging one, especially when it comes to managing your tax liability.
As a retiree, you likely have multiple income streams, each with its own tax implications. Making the right decisions about which accounts to tap and when can have a significant impact on your overall tax burden and the longevity of your retirement savings.
Here’s what you need to know about tax-efficient retirement distribution planning, including various income streams available to retirees, the importance of tax diversification, and key factors to consider when creating your distribution strategy.
Understanding your retirement income streams and their tax implications
As a retiree, you likely have a patchwork of income sources, each with its own unique tax treatment. Let's take a closer look at some of the most common retirement income streams and how they're taxed.
Social Security benefits
Social Security forms the foundation of retirement income for many Americans, but did you know that up to 85% of your benefits may be subject to federal income tax?
The taxable portion of your benefits depends on your "combined income," which is your adjusted gross income + nontaxable interest + half of your Social Security benefits. If your combined income exceeds a certain threshold, a portion of your benefits will be taxed. Combined income thresholds are as follows:
- Below $25,000 for individuals and $32,000 for married couples filing jointly: No income tax
- Between $25,000-$34,000 for individuals and $32,000-$44,000 for married couples filing jointly: Up to 50% of your benefits may be taxed
- Above $34,000 for individuals and $44,000 for married couples filing jointly: Up to 85% of your benefits may be taxed
Traditional IRAs and 401(k)s
Contributions to traditional IRAs and 401(k)s are made with pre-tax dollars, which means you received a tax break in the year you made the contribution.
However, this also means that withdrawals from these accounts are taxed as ordinary income in retirement. This can be a significant tax liability, especially if you have a large portion of your savings in these types of accounts.
Pensions
Most pensions are funded with pre-tax dollars and are therefore taxed as ordinary income in retirement. However, some pensions, particularly those funded with after-tax contributions, may offer a tax-free component. It's important to understand how your specific pension is taxed to plan for your retirement income.
Roth IRAs and Roth 401(k)s
Contributions to Roth accounts are made with after-tax dollars, meaning you don't receive a tax break in the year of the contribution. However, the big advantage of Roth accounts is that qualified withdrawals (those taken after age 59½ and after the account has been open for at least five years) are completely tax-free. This makes Roth accounts a powerful tool for tax diversification in retirement.
Taxable investment accounts
Investments held in taxable brokerage accounts are subject to capital gains taxes when sold. The tax rate depends on your income level and how long you've held the investment. Long-term capital gains (on investments held for more than a year) are taxed at preferential rates of 0%, 15%, or 20%, while short-term capital gains are taxed as ordinary income. Qualified dividends are also taxed at the lower capital gains rates.
Understanding the tax implications of each of these income streams is essential for creating a tax-efficient retirement distribution strategy. By knowing which accounts to tap and in what order, you can minimize your tax liability and stretch your retirement savings further.
The power of tax diversification in retirement
Many high-income earners diligently max out their pre-tax retirement accounts like traditional 401(k)s and IRAs during their working years. While this strategy can provide a significant tax break in the short term, it can also lead to a tax-heavy retirement if all of your savings are in tax-deferred accounts.
Every dollar you withdraw from a traditional IRA or 401(k) in retirement will be taxed as ordinary income. If you have a significant portion of your savings in these accounts, you could be pushed into a higher tax bracket and face a hefty tax bill each year.
This is where tax diversification comes into play. By strategically allocating your retirement savings across accounts with different tax treatments (tax-deferred, Roth, and taxable), you can gain more control over your tax liability in retirement.
For example, you might choose to withdraw from your taxable accounts first, allowing your tax-deferred and Roth accounts to continue growing. Or, you might use tax-free Roth withdrawals to fill up your lower tax brackets while pulling just enough from your tax-deferred accounts to avoid jumping into a higher bracket.
The key is to have options and flexibility. By diversifying your savings across account types, you can be strategic about which accounts you tap and when potentially lowering your overall tax burden in retirement.
Key factors to consider in your retirement distribution strategy
Creating a tax-efficient retirement distribution strategy is a complex process that requires careful consideration. Here are some key elements to keep in mind.
Current vs. future tax rates
One of the main factors to consider when deciding which accounts to tap first is your current tax rate compared to your expected future tax rate. If you anticipate being in a lower tax bracket in retirement than you are now, it may make sense to withdraw from your tax-deferred accounts first, allowing your Roth and taxable accounts to continue growing tax-free rates.
If you expect tax rates to increase in the future, it may be more advantageous to use your Roth and taxable accounts first, saving your tax-deferred accounts for later in retirement when your income (and tax bracket) may be lower.
Required minimum distributions (RMDs)
Starting at age 72 (or 73 if you reached age 72 after Dec. 31, 2022), you must begin taking required minimum distributions (RMDs) from your traditional IRAs and 401(k)s. These mandatory withdrawals are calculated based on your account balance and life expectancy and are taxed as ordinary income.
RMDs can significantly impact your tax situation in retirement, potentially pushing you into a higher tax bracket or increasing your Medicare premiums. It's important to factor RMDs into your distribution strategy and consider tactics like Roth conversions to minimize their impact.
Estate planning goals
If leaving a financial legacy is a priority for you, it's crucial to consider the tax implications for your heirs. Roth accounts can be particularly powerful for estate planning, as they are not subject to RMDs during the owner's lifetime and can provide tax-free income to your beneficiaries.
Traditional IRAs and 401(k)s, on the other hand, are subject to RMDs and will be taxed as ordinary income when withdrawn by your heirs. By strategically converting a portion of your tax-deferred savings to Roth accounts, you can reduce the tax burden for your beneficiaries and maximize the wealth you pass on.
Medicare premiums
Many retirees are surprised to learn that their income in retirement can impact their Medicare premiums. If your modified adjusted gross income (MAGI) exceeds certain thresholds, you may be subject to the Income-Related Monthly Adjustment Amount (IRMAA), which can significantly increase your Medicare Part B and Part D premiums.
For example, in 2024, if your MAGI exceeds $103,000 (for singles) or $206,000 (for married couples filing jointly), you'll pay up to $81 more per month for Part B, on top of your standard premium. The IRMAA increases start at $12.90 per month and increases with your income level.
To avoid these extra costs, it's important to be mindful of how your retirement income sources impact your MAGI. Strategies like Roth conversions, charitable giving, and tax-loss harvesting can help keep your income below the IRMAA thresholds and minimize your Medicare costs.
State-specific tax considerations for retirees
While federal taxes often get the most attention, it's important not to overlook the impact of state taxes on your retirement income. Some states are more retiree-friendly than others, offering tax breaks and incentives that can significantly reduce your tax burden.
Here are some state-specific tax considerations to keep in mind.
State income tax on retirement income
Some states, like Florida, Nevada, and Texas, have no state income tax at all, making them popular destinations for retirees. Others, like Pennsylvania and Mississippi, exempt certain types of retirement income (like pensions and IRA withdrawals) from state taxes.
It's important to research the specific tax laws in your state (or any state you're considering for retirement) to understand how your income will be taxed. Some states also have reciprocal tax agreements, meaning that if you live in one state but work in another, you may only owe income tax to your state of residence.
Estate and inheritance taxes
While the federal estate tax exemption is quite high ($13.61 million per individual in 2024), some states have their own estate or inheritance taxes with much lower thresholds. For example, Massachusetts has an estate tax exemption of $2 million, while Oregon has an estate tax exemption of just $1 million.
If you plan to leave a significant legacy to your heirs, it's crucial to understand the estate and inheritance tax laws in your state and take steps to minimize your tax liability. This may involve strategies like gifting during your lifetime, establishing trusts, or relocating to a more tax-friendly state.
Property taxes
Property taxes can be a significant expense for retirees, especially those on a fixed income. However, some states offer property tax exemptions or credits for seniors that can help ease this burden.
For example, in Texas, homeowners over age 65 can claim a $10,000 homestead exemption on top of the standard $25,000 exemption. And in Florida, seniors may be eligible for an additional $50,000 homestead exemption if they meet certain income and residency requirements.
Be sure to research the property tax laws in your state and take advantage of any exemptions or credits available to you as a retiree.
Maximizing your deductions in retirement
The 2017 Tax Cuts and Jobs Act nearly doubled the standard deduction, making it less advantageous for many retirees to itemize their deductions. However, if you have significant deductions in certain categories, itemizing may still be the way to go.
Here are some common deductions that can be particularly valuable for retirees.
Medical expenses
As we age, medical expenses often become a larger portion of our budget. If you find yourself with high out-of-pocket healthcare costs, you may be able to deduct a portion of these expenses on your tax return.
For 2024, you can deduct medical expenses that exceed 7.5% of your adjusted gross income (AGI). This includes expenses like health insurance premiums, long-term care premiums, prescription drugs, and dental care. Keep in mind that you can only deduct medical expenses for yourself, your spouse, and your dependents.
If you're self-employed, you may also be able to deduct your health insurance premiums on your tax return, even if you don't itemize. It may be a good idea to work with a tax professional to understand the best ways to your medical expense deductions.
Charitable contributions
Giving back to your community not only feels good but can also provide a valuable tax deduction. If you itemize your deductions, you can deduct cash donations to qualified charitable organizations, as well as the fair market value of donated property.
If you're over age 70½, you can also take advantage of qualified charitable distributions (QCDs) from your IRA. With a QCD, you can transfer up to $105,000 per year (or $210,000 for married couples) directly from your IRA to a qualified charity, satisfying your RMD and reducing your taxable income. This can be particularly valuable if you don't need your RMD for living expenses and want to avoid being pushed into a higher tax bracket.
Mortgage interest
While many retirees aim to pay off their mortgage before leaving the workforce, others choose to keep a mortgage for various reasons (like freeing up cash for investments or taking advantage of low interest rates). If you itemize your deductions, you can deduct the interest on up to $750,000 of qualified residence loans ($375,000 if married filing separately). This typically includes your primary home or a second home.
Keep in mind that the mortgage interest deduction is only valuable if it, along with your other deductions, exceeds the standard deduction ($14,600 for singles and $29,200 for married couples filing jointly in 2024). Be sure to run the numbers and consult with a professional to figure out if itemizing makes sense for your situation.
Putting it all together: Creating your retirement distribution plan
With so many factors to consider, creating a tax-efficient retirement distribution strategy can feel overwhelming. However, by taking a systematic approach and working with a financial advisor, you can develop a plan that minimizes your tax liability and maximizes your retirement income.
Here are some key steps to follow:
- Inventory your retirement income sources and their tax situation. This includes Social Security, pensions, traditional IRAs and 401(k)s, Roth accounts, and taxable investment accounts.
- Project your retirement income needs and estimate your tax bracket. Consider factors like your desired lifestyle, healthcare costs, and any major purchases or travel plans.
- Develop a withdrawal strategy. This may involve a combination of drawing from taxable accounts first, followed by tax-deferred and Roth accounts, or using Roth conversions to manage your tax liability.
- Incorporate state-specific tax planning, taking advantage of any tax breaks or exemptions available to retirees in your state.
- Maximize your deductions by keeping accurate records and working with an accountant to identify any opportunities to itemize.
- Review and adjust your plan regularly, taking into account changes in tax laws, your personal circumstances, and market conditions.
Remember, retirement income planning is not a one-time event but an ongoing process that requires regular monitoring and adjustment. By staying proactive, you can create a retirement distribution strategy that provides the income you need while minimizing your tax burden.
Conclusion
Navigating the complex world of retirement income planning can be challenging, but with the right strategies and guidance, you can create a tax-efficient distribution plan that supports your lifestyle and financial goals.
At Compound Planning, we specialize in helping individuals like you create comprehensive retirement plans that account for your unique financial situation, goals, and tax considerations. Our team of experienced advisors can help you develop a personalized distribution strategy that maximizes your after-tax income and ensures a worry-free retirement.
If you're ready to take control of your retirement income and minimize your tax burden, you can schedule a free consultation with one of our advisors. We'll take the time to understand your needs and develop a customized plan that helps you achieve your retirement goals. You can also sign up for our online dashboard to get a 360-degree view of your financial picture and track your progress in real time.
Don't leave your retirement income to chance. Take the first step towards a tax-efficient retirement today and let Compound help you achieve the retirement you've always dreamed of.
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