According to the October 2018 Retirement Income and Tax Planning Consumer Survey conducted by Harris Poll on behalf of Nationwide Financial, nearly half of retirees surveyed wished they had put more thought into tax planning once they reached retirement.
One-quarter of those surveyed reported they paid thousands more in taxes in retirement than they had anticipated. So how can you maximize income while minimizing your tax bill in retirement? Here are some ideas:
1. Think bucket list
I’m not referring to skydiving or hiking the Grand Canyon. Rather, picture your retirement savings as three distinct buckets: tax-deferred, taxable, and tax-free.
- Your tax-deferred bucket includes traditional 401(k) accounts or IRAs. You made pretax contributions to these accounts, and you’ll have to pay taxes on both the contributions themselves plus any earnings when you withdraw upon retiring.
- Your taxable bucket includes plain old savings or brokerage accounts. You made after-tax contributions to these accounts, but you’ll have to pay taxes on any interest, dividends and capital gains at the time of withdrawal.
- Your tax-free bucket includes Roth 401(k) accounts and Roth IRAs. You made after-tax contributions to these accounts, but in most cases, both the contributions and earnings may be withdrawn tax-free when you retire.
Having multiple buckets of retirement savings offers you more control over your retirement income, which subsequently can reduce your tax burden if you plan your withdrawals properly.
2. Sneak in the back door
Roth IRAs are great savings vehicles, but one roadblock that high earners face are the income restrictions on making direct contributions to a Roth IRA (which start at $120,000 for single filers and $189,000 for those married filing jointly).
Luckily, high earners can still take advantage of the tax-free growth that Roth IRAs offer by converting a traditional IRA to a Roth IRA via a back-door conversion. You will have to pay taxes on the amount converted, but once your money is in the Roth IRA, earnings will grow tax-free. Keep in mind there are a few important caveats for these transactions, such as a possible bump in your tax bracket in the conversion year and potentially higher Medicare premiums.
3. Plot your RMD strategy
At first glance, taking the annual required minimum distribution (RMD) once you reach age 70½ may seem to be a straightforward process. But you may face negative tax consequences if you don’t plan carefully.
- If you fail to take your annual RMD, you’ll pay a 50% excise tax on the amount that you should have withdrawn.
- If you make non-deductible IRA contributions, but don’t track your contribution basis and earnings separately, you may inadvertently pay taxes on those contributions twice—since non-deductible IRA contributions are not subject to taxes, but earnings are. Read more about that here.
While we’re on the subject of RMDs, one possible way to minimize their tax impact is by making a qualified charitable distribution (QCD), as we discussed recently. A QCD reduces your adjusted gross income, which may also lower the taxes you pay on Social Security benefits and decrease your Medicare premium.
4. Explore HSAs
Healthcare is a major expense for retirees. If you have a high-deductible health insurance plan, you may want to consider opening a health savings account (HSA) to pay for qualified medical expenses in your golden years—which, according to Fidelity Investments, will total about $280,000 over the course of retirement for a healthy 65-year old couple today.
You may make either pretax or tax-deductible contributions to a HSA. The contributions grow tax-free (in most cases) and may be withdrawn with no tax consequences if applied to IRS-qualified medical expenses.
Looking for more ideas to save on your tax bill in retirement? Our financial advisors can help. Sign up for a complimentary, no-obligation conversation with one of them today.