An Easier Way To Pay Fewer Taxes In Retirement

It’s not how much you make but how much you keep. This fact of life doesn’t go away once you leave the workforce. Making intelligent tax-planning decisions before and during retirement can have a significant impact on your net retirement income.  In plain English, we are talking about reducing the taxes you have to pay in retirement.

I recently had a married gay couple come in for a retirement planning consultation (I specialize in the needs of the LGBTQ+ community). The first husband was comparing their current fixed expenses against the estimated retirement income their 401k plans might produce in the future when they retired (according to the estimates on their 401k statements). Husband two didn’t know how his husband was messing this up, but there was no way that saving for retirement was going to be this easy. Without boring you with all the retirement planning details, the big glaring issue here is that the first husband was ignoring taxes on their future retirement income.  What seemed like a big retirement income number would be much smaller after paying federal income taxes and California Income Taxes.

Luckily, this couple was in their late forties, and we have time to course-correct their retirement and still allow them to have secure retirement income while retiring early, at the planned age of 60.

Taking taxation into account when making investing and retirement withdrawal choices will greatly increase a couple’s financial security in retirement. This will also help increase their net retirement income. According to Morningstar researchers, this can add 4% to your retirement income each year. An example of this would be for every thousand dollars of income in retirement, tax-efficient planning could add $40 to your net income.  So for a couple making $250,000 – could see an extra $10,000 per year in retirement income if they have a tax-efficient retirement income strategy.

The tax savings could be even more substantial for individuals with more tax-free income. This tax-free income could come from a Roth IRA, Roth 401K, and cash value life insurance. Having taxation diversification on your retirement income lets a fabulous financial planner, like myself, plan to set you up to take the maximum retirement income while keeping you in the lowest income tax brackets possible throughout your retirement.

Here are some ways your financial planner helps you be smarter about taxes in retirement.

Tax Efficient Asset Location

I am a huge fan of diversification when it comes to investing. Many of my clients are busy business owners and don’t want to have to think about the movement of the stock market every second. Let’s be honest, when you are retired, do you really want to be watching the stock market every day?

It may seem like the easiest thing to do would be to simply have all of your retirement assets in a single account like a 401(k) or a traditional IRA. But that would mean all of your retirement savings will be taxable at the time of withdrawal. You should have some diversification of taxation on your retirement accounts. This likely means having a combination of taxable investment accounts (still can be managed tax-efficiently), a traditional (pre-tax) 401(k) or individual retirement account (IRA), and a Roth 401(k) or Roth IRA. For those who are contributing the maximum amount allowed into these other accounts, you will want to throw in a Defined Benefit Plan or Rich Person Roth.

That diversification of accounts gives investors maximum flexibility when taking retirement income. Further, retirees can maximize their ongoing tax savings by holding certain investments and funds in the appropriate type of account. This is called “asset location,” which often can boost an investor’s after-tax rate of return. Lowering taxes on your investments is a great way to increase returns without having to take on more investment risk.

Many investors should generally consider holding stocks and stock funds (Mutual Funds or ETFs) in taxable investment accounts. These investments are more tax-efficient — meaning most of their returns are from capital gains taxed at a rate that’s less than ordinary income.

Bonds and bond funds are often the most tax-efficient when held in retirement accounts. Most of their returns are in the form of dividends which are taxed like ordinary income (higher tax rates) when held in a taxable investment account.

Tax Efficient Retirement Income

It may seem counterintuitive but paying a little more in taxes, now, may help save you from having to pay a ton of taxes in the future. Tax planning can help you sequence retirement income withdrawals efficiently from different buckets of savings in order to have ongoing lower tax bliss throughout your retirement.

It may be tempting to spend down your taxable account and Roth account first, in order to pay little to no taxes in your early years of retirement. For those with smaller retirement nest eggs, this may be ok. For those reaching the higher income tax brackets (starting at $85,526 in 2021 for single filers in the 24% tax brackets), more efficient retirement strategies can greatly reduce the tax drag on your income.

Paying attention to the marginal tax brackets can make a big difference. Also, be aware that some tax deductions are limited or completely phased out as your income grows. We have also seen COVID stimulus payments tied to incomes. How would you feel if you earned an extra dollar of income, and that extra dollar cost you thousands in stimulus payments? It happened this year and last.

In 2021, single taxpayers will see their taxes skyrocket from a tax rate of 12% to 22%, after surpassing just $40,525 of taxable income. You hit the highest federal tax bracket of 37% on an income of $311,025. The tax jumps are similar in many states as well. California hits a 6% tax at just $33,422, which let me just say as a Los Angeles financial advisor, that income does not go far in LA.

Required Minimum Distributions

As we age, retirees will get hit with annual required minimum distributions (RMDs), which require you to withdraw a minimum amount of money from tax-deferred accounts each year after age 72. Many people put off pulling money until they are forced to by the IRS. For those with large retirement accounts, it may make sense to begin strategically making withdrawals earlier to keep income in the lowest tax brackets possible.

Taking things a step further, Roth withdrawals can be used to reduce annual Medicare premiums and taxes on Social Security benefits. Yes, Social Security is taxable if you earn enough.

For example, single taxpayers with incomes over $25,000 will get the joy of paying taxes on their Social Security income. That tax is applied to 50% of benefits if income is between $25,000 and $34,000. The government taxes up to 85% of benefits if income exceeds $34,000. The income thresholds are for singles; they are slightly different for married couples.

Medicare premiums also increase as your retirement income does.

Strategic retirement income withdrawals from Roth IRA accounts can help retirees from passing over income thresholds that cause these higher taxes and premiums on Social Security and Medicare.

I’m sorry to be the bearer of bad news, but tax planning and retirement planning doesn’t end when you leave the workforce. A little extra strategic tax planning can leave you with more money to do the things you want in retirement. For those who don’t want to have to think about this stuff, make sure to surround yourself with amazing tax pros and financial pl