We’ve all heard the mantra, especially popular toward the end of the year, when most of us are thinking about next April’s tax bill: “Defer income, accelerate deductions.” It’s generally good advice, of course. If you can push income past the end of the year, you won’t have to pay taxes on it this year, and a deduction taken now is of more immediate benefit than one in the future.
But for thriving retirees, this tried-and-true proverb needs a caveat or two. For some who have been methodically and faithfully contributing as much as they can to traditional IRAs, 401(k)s, and other tax-favored plans, it is actually possible to find themselves in a higher tax bracket in retirement once their required minimum distributions (RMDs) kick in at age 70 ½. Especially in future years, as more people enjoy longer lifespans, it could be possible to live for twenty, thirty, or more years in retirement in a higher tax bracket than you occupied when you were still working full-time.
So, what’s the answer? Well, like most things in financial planning, it starts with some in-depth conversations with a qualified, professional financial advisor. It will probably also entail involvement from your tax advisor. Ideally, some years prior to retirement, you will work with your team to project current and future income and analyze all your sources of retirement income, including tax-qualified and taxable accounts, and Social Security. Once you’ve gathered the necessary information, you’ll be in a position to decide which of several available strategies will help you find the “sweet spot”: carefully balancing your income for maximum tax efficiency, both now and after you stop working.
Strategy 1: Make a Roth Conversion
You might decide that it makes sense to convert some of your traditional tax-deferred accounts to Roth accounts. This will entail paying taxes on a portion of the funds now but ensures tax-free income in later years, when RMDs begin. What you must determine is whether, in your particular situation, it makes more sense to pay taxes on the money in your current bracket or in the bracket you’re likely to be in at age 70 ½ or later, especially if it is likely that your other income will cause part of your Social Security income to be taxable (for some wealthy retirees, up to 85% of Social Security benefits can be taxable).
Strategy 2: Prioritize Accounts for Withdrawals
Another strategy involves shifting the traditional order in which retirement accounts are tapped for income. The usual advice is to spend down taxable accounts first, allowing the tax-deferred accounts to continue to compound tax-free. But depending on their other sources of income, this could put some thriving retirees in the position of having “too much” income in later years, especially if they defer Social Security benefits to age 70 (when they reach their maximum level). All this together could shove them into a higher tax bracket from which they may never escape. Instead, it may make more sense to take income from the deferred (traditional accounts) earlier in retirement, before the onset of RMDs takes away flexibility.
Strategy 3: Go Full Roth
A third idea, applicable to those who are still working but approaching retirement, is to contribute to a Roth, rather than a traditional account. This means that they will be paying taxes on the funds contributed now, rather than deferring taxes until after retirement. When the analysis reveals that these individuals are likely to be in a lower tax bracket now than in the future, paying the taxes “up front” may pave the way for a more tax-efficient income stream in later years.
You have a certain number of “tax buckets”; some are based on lower rates, and some are based on higher ones. The ideal equilibrium means filling as many of your lower-rate buckets as possible and avoiding the higher-rate buckets. I specialize in helping thriving retirees develop tax-efficient strategies to keep their “income buckets” flowing freely.
Stay Diversified, Stay YOUR Course!
