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Many retirees think taxes are largely a thing of the past once they hit retirement. Unfortunately this is generally not the case. In helping clients prepare financially for retirement, planning for taxes is always part of the process. Let’s look at some of the reasons that taxes can be high, sometimes higher than when you were working, in retirement.
Required minimum distributions (RMDs) must be taken from IRAs and most retirement accounts at age 72. The required beginning age increases to 73 and later to 75 under the recently passed Secure 2.0 legislation. RMDs are based on your age and the balance in the account as of the prior year end.
RMDs can be quite large if your IRA balance continues to grow in retirement. RMDs are fully taxable. No RMDs are required from Roth IRAs and soon will not be required from Roth 401(k)s under Secure 2.0.
RMDs can dictate your tax bracket in retirement. If your income is enough, your Social Security benefits may be subject to taxes. With many retirees continuing to work into their retirement years, the income earned from working can also serve to push them into a higher tax bracket.
Additionally, retirees find themselves without many of the tax deductions they were able to utilize in their working years. Their children are grown, so, no child tax credit. Often their mortgages are paid off, so, no mortgage interest deduction.
We believe that planning for taxes in retirement should start during your working years.
One strategy is to make at least a portion of your 401(k) or other workplace retirement plan contributions to a Roth account. This allows the money in these accounts to be withdrawn tax-free in retirement and to avoid RMDs on Roth IRAs, and on Roth retirement plan accounts in 2024 as part of Secure 2.0.
Converting money in traditional IRAs to a Roth IRA can also be a way to reduce the impact of RMDs in retirement. Conversions can be done from traditional IRAs and in some cases 401(k)s and other retirement accounts. Backdoor Roths and mega backdoor Roths are additional conversion strategies for higher income folks.
Taxes have to be paid on the amounts converted, so it’s important to do these conversions strategically in years when the tax impact will be the lightest. This can include the early years of retirement before the retiree claims their Social Security benefits.
For retirees who are charitably inclined and who don’t need their entire RMD amount, there is a charitable option connected with traditional IRAs called the qualified charitable distribution (QCD). For those who are at least age 70 ½ they can give up to $100,000 from their traditional IRA to a qualified charity or nonprofit. The distribution is tax free, though there is no ability to take a tax deduction.
QCDs will reduce future RMDs. For those taking RMDs, the QCD can be used to satisfy all or part of the RMD.
Qualified longevity annuity contracts (QLACs) are deferred annuities that can be purchased inside of an IRA or other retirement account. QLACs serve the dual purpose of providing annuity income that can be delayed out to age 85. Additionally, the money used to purchase the QLAC will not be subject to RMDs until the annuity payments commence.
Perhaps the most important step that can be taken when moving into retirement is to develop a sound retirement distribution strategy. This entails deciding which accounts to tap each year to meet your retirement income needs. Your tax situation is a key component in deciding which accounts to tap and in what order.
In some cases, in the early years of retirement a retiree’s income may be reduced and tapping traditional IRAs or other retirement accounts makes sense. This will also serve to reduce RMDs later on. Other types of accounts such as taxable investment accounts can be tapped in other years.
Tax planning is a key part of retirement planning. We suggest that those planning for retirement take the impact of taxes into account when planning for retirement during their working years and certainly as they move into their retirement years.
Bill Lourcey, CRPC, is a financial advisor with Walton Lourcey Wealth Advisors in Fort Worth. This material is intended to provide general financial education and is not written or intended to provide — and should not be relied on for — tax, legal or accounting advice, or for avoiding any federal tax penalties. You should consult your own tax, legal, and/or accounting professional for any advice pertaining to your specific situation.