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4 Basic Tips to Improve your Tax Planning in Retirement

Matt Kerr
October 18, 2021

Everybody knows that they should plan for retirement. However, most people fail to include tax planning in this process. The reality is that taxes are likely to be one of your largest expenses in retirement, and as such, they should play a significant role in your plan.

One reason taxes are often an afterthought is that they can get complicated. Former Secretary of Defense Donald Rumsfeld famously included letters to the IRS when he submitted his tax return each year. In one of those letters, he said the following: “As in prior years, it is important for you to know that I have absolutely no idea whether our tax returns and our tax payments are accurate.”

Even Albert Einstein found our tax system confusing.

This complexity only makes planning even more critical. Effective planning can help you to not only avoid costly mistakes, but it can also result in significant savings. In retirement, your tax rate can vary dramatically based on your decisions, and the choices you make today can have financial impacts many years later. Any effective retirement plan needs to consider the impact of taxes.

Below, we provide you with four essential tips that can help you get started in building your own tax plan for retirement.

1.) Integrate Social Security planning with your tax planning

Many people are surprised to learn that their Social Security Benefits may be taxed. The taxability of your benefits is determined by a measure called provisional income, a fancy word for the sum of your gross income, tax-free interest, and 50% of your SS benefits. Your provisional income will determine if you owe taxes on 0%, 50%, or 85% of your Social Security benefits. (See where you fall inside of our Tax Planning Guide located here.)

The most common question regarding Social Security is when you should claim your benefit. While roughly 35% of all people claim it at 62, this decision needs to consider your long-term financial plan. For example, delaying your benefits can allow you to reduce your taxable income in the early years of retirement, which can enhance the effectiveness of other tax-saving strategies, as well as materially increase the size of your benefit payments

2.) Create a distribution strategy

There are many components to an effective distribution strategy, such as how much you should spend each year, should your spending be static or flexible, and what asset classes you should use to fund your distributions. Since different accounts receive different tax treatment, an effective plan should also address the order in which you spend down your accounts in retirement.

While there is no one size fits all, for many people, the optimal sequence will start by spending down the money in your taxable accounts, followed by the funds in your tax-advantaged accounts. Often, the primary decision of whether to spend from your tax-deferred or your tax-free accounts will depend on your current tax bracket relative to your expected future tax bracket.

Order of Spending in Retirement Chart

For people in high tax brackets with money in both taxable and tax-sheltered accounts, Vanguard has estimated that following this approach can result in outperformance of 1.1% per year relative to spending down your accounts in a different order. In a low-return environment, an additional 1% per year can make a big difference. Further research has shown that incorporating opportunistic Roth Conversions can make this strategy even more effective.

It is important to remember that your distribution strategy should reflect your individual situation. You should not rely on rules of thumb when it comes to your financial plan. (Should the bold part above be an insert caption box where it is spotlighted?) There are scenarios where it can make sense to spend down your accounts differently than the order described above. For example, if you plan on leaving money to others after you pass away, you might consider leaving your taxable accounts alone since the cost basis in those accounts will be reset when the assets are passed down. Additionally, Traditional IRAs under the new SECURE Act will have to be distributed by beneficiaries within ten years, potentially creating adverse tax consequences to heirs.

3.) Consider Roth Conversions

A Roth conversion is a simple process that allows you to move money from a tax-deferred account, such as a Traditional IRA or 401(k), to a Roth IRA.

One reason Roth conversions are so attractive is there are no income limits for conversions. While the IRS does not allow high-income earners (over $208,000 for MFJ in 2021) to make direct contributions to a Roth IRA, anyone is allowed to execute a conversion.

Opportunistic Roth conversions early in retirement can help to reduce the size of your future RMDs (Required Minimum Distributions). This can reduce your risk of being pushed into a higher tax bracket later in retirement while reducing unnecessary excess distributions (and the taxes that come with them).

Money in a Roth account is tax-free, so your investments will still be able to grow without any tax drag, and better yet, you won’t have to pay any taxes when you pull the money out to cover your living expenses.

4.) Make the most of your charitable giving

For retirees who are charitably inclined and have sizable balances saved in a traditional IRA, it could be worth considering a Qualified Charitable Distribution (QCD).

Rather than taking an RMD, the IRS gives you the option to donate your RMD to a charitable organization. Since QCDs are excluded from taxable income, this allows you to avoid the tax bill normally created by RMDs.

The Benefit of Proactive Planning

Retirees often end up paying more in taxes than they expect, and we don’t want that to be the case for you. Given the complexity (as noted by both Einstein and Donald Rumsfeld), proactive planning is critical to avoid paying more taxes than necessary.

To be clear, in no way are we saying that you should avoid paying your taxes. We just don’t believe that you need to give the IRS an extra tip! We would love to help you create a customized financial plan and consider how different tax situations could impact your goals. Reach out to one of our advisors to get started.

Securities offered through Keel Point Capital, LLC, Member FINRA and SIPC. Brokerage and Investment Advisory Services are offered under the Keel Point brand. Investment Advisory services offered by Keel Point, LLC an affiliate of Keel Point Capital. Keel Point does not give tax, accounting, regulatory, or legal advice to its clients.  The effectiveness of any of the strategies described herein will depend on your individual situation and on a number of complex factors.  You should consult with your other advisors on the tax, accounting, and legal implications of these proposed strategies before any strategy is implemented.

This article makes certain references to information provided by third-party sources.  We  believe the information referenced is reliable, but you should note that we do not necessarily have access to the original source information to ensure the accuracy of the information presented, and are therefore unable to independently verify the accuracy or completeness of the information referenced, and Keel Point offers no warranty or guarantee is made as to their accuracy or completeness. All expressions of opinion reflect the judgement of the adviser as of the date of the presentation and are subject to change.

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