How To Minimize Taxes On Your Retirement Income
By Erik Carter
Nobody likes paying taxes. But what can be a mere annoyance while you’re working can be a major headache when you retire. That’s because taxes are generally the biggest expense in retirement and retirees often need every penny of income to make ends meet while leaving enough of a nest egg to ensure that they’re income will last as long as they will. Along those lines, we recently received a couple of questions about how to structure retirement income in order to minimize taxes in retirement. Here are some things to consider:
Location, Location, Location
No, I’m not referring to moving to a lower tax area (although that would help a lot too). I’m talking about the location of your investments. If you’re like most investors, you’ve probably made investment decisions about each of your accounts (employer’s retirement plan, Roth IRA, rollover IRA, and taxable accounts) independently.
The problem with this is that not all investments are taxed alike. Since cash and bonds are taxed at ordinary income rates, you’ll want to shield them from taxes in your retirement plans the most. Next would be mutual funds with a high turnover since stocks held for less than a year are also taxed at ordinary income rates. If you have gold or any other “collectibles,” they’re next since they’re taxed at a 28% rate.
If the lower tax on qualified dividends expires on schedule at the end of the year, you’ll want to shelter high-yield stocks and stock funds too. Since stocks held for more than a year are taxed at lower capital gains rates, individual stocks and low turnover mutual funds like index funds would be a lower priority for retirement accounts. Coming in last would be international stocks and funds since having them in retirement accounts disqualifies you from using the foreign tax credit to help offset taxes withheld overseas. The volatility of the last two groups also make them good candidates for a taxable account since you can sell them and write the losses off your taxes as long as you don’t repurchase a similar investment within 30 days of the sale.
However, don’t let the tax tail wag the dog by letting the size of your accounts determine your asset allocation. For example, if you have $300k in retirement accounts and $100k in taxable investments, this doesn’t mean you should have $300k in cash and bonds and $100k in stocks. Instead, start with the appropriate asset allocation based on your time horizon and risk tolerance. Then place them in your retirement accounts, starting with the most tax-inefficient investments. Let’s say your portfolio should be $240k in stocks and $160k in bonds. You’d start by placing the $160k of bonds in your retirement account, which allows you to invest the other $140k in your retirement account in stocks (starting with the highest turnover funds) as well as the $100k in the taxable account.
Do you have company stock in your 401(k)?
Before you start selling the stocks in your 401(k), there is a special rule to be aware of that allows you to pay the lower capital gains rate on the growth of your employer stock in your 401(k). (You still have to pay tax at regular rates on the total cost of that stock.) The key is that you have to take that stock out as an “in-kind distribution,” which basically means that you move it directly into a brokerage account instead of selling it first as most 401(k) distributions are done. You also forfeit this option if you roll it into an IRA.
How young are you?
Speaking of IRAs, the next question might be whether to withdraw first from your IRAs, your 401(k), or your taxable account. The first timing factor is your age. If you retire in the year you turn 55 or later, you can take withdrawals immediately from your 401(k) without a penalty, but you’ll have to wait until age 59 1/2 to make penalty-free withdrawals from your IRAs (unless you take substantially equal periodic payments until the later of 5 years or when you turn 59 1/2). Keep in mind that you can always withdraw anything from your taxable accounts and the contributions from your Roth IRAs without penalty at any time and for any reason. Finally, when you turn 65, you can also access any HSAs you have for any purpose without penalty (although HSA distributions are subject to ordinary income tax if not used to pay for qualified medical expenses).
Will your tax rates be going up or down?
The second timing factor is whether you see your tax rates going higher or lower in the future. For example, if you think the lower capital gains rate will expire at the end of the year, it could be a good time to take some gains out of the taxable account. If you’re more worried about higher income tax rates, take withdrawals from your pre-tax accounts or consider converting them into Roths, which means you pay the tax now at the relatively lower rate instead of at the higher future rates. Just be aware that you may need to spread those Roth conversions over more than one year so they don’t push you into a higher tax bracket and thus defeat the whole purpose.
Another reason to take withdrawals from your pre-tax IRAs and 401(k) accounts first is if you’re retiring early and haven’t started collecting Social Security yet. That’s because future withdrawals from these accounts could cause more of your Social Security to be subject to taxes and push you into a higher tax bracket. In this scenario, it could make sense to reserve the taxable accounts and nontaxable Roth IRAs for when you’re taking Social Security since they won’t have the same effect.
The reverse would be true if you’re receiving income from part-time work or a side business for the first part of your retirement. In that case, withdrawals from taxable accounts and Roth IRAs could be preferable since your tax bracket is likely to be higher than when you eventually stop working. Between the two, you’ll want to tap the taxable account first and let your Roth IRA continue growing tax free.
The Bottom Line
Unfortunately, there’s no way to eliminate taxes altogether, but you can use some of these strategies to minimize their impact on your retirement income. You can do this yourself or hire a financial professional who does proactive tax planning rather than just tax preparation. Either way, I hope these techniques can make this time of year a little less taxing for you in retirement.
Are you looking for an unbiased answer to your own financial question? Once a week, we’ll be responding on this blog to questions from our Financial Helpline or posted on our Twitter or Facebook site.
Erik Carter, JD, CFP® is a resident financial planner at Financial Finesse, the leading provider of unbiased financial education for employers nationwide, delivered by on-staff CERTIFIED FINANCIAL PLANNER™ professionals. For additional financial tips and insights, follow Financial Finesse on Twitter and become a fan on Facebook.