By Wesley Sebacher CFP®
You may wonder how you will provide yourself a paycheck in retirement? Or how you will coordinate your savings and future retirement income. Often forgotten, is how your retirement savings and income will be affected by taxes today and throughout retirement.
Much of life is spent working and saving toward the goal of retirement. Often, this is done through tax-deferred vehicles, such as a traditional 401(k) retirement plan. A traditional retirement plan can allow you to save, invest, and receive a tax deduction on pre-tax contributions. However, the IRS stipulates mandatory distributions be taken from tax-deferred accounts via a required minimum distribution (RMD) beginning at age 73. Annually, you will be required to distribute an amount from your tax-deferred accounts (traditional IRAs, traditional 401(k)s, etc.) and pay tax on the distributions at your ordinary income tax rate. If tax-deferred accounts are your primary source of retirement savings, you may have a considerable tax liability in the future and a tax rate equivalent or higher than in working years.
Here are some strategies to consider while working and in retirement to reduce future tax liability and required minimum distributions:
- Roth Conversions
- The conversion of assets from a traditional IRA into a Roth IRA will lower future RMDs. You will pay tax on the conversion today at ordinary income tax rates. The growth and distributions from a Roth IRA are tax-free for all qualified distributions. Beneficiaries will inherit assets tax-free if the estate is under the applicable estate tax exemption amount. If you have tax years where you are in a lower tax bracket than you expect to be in throughout RMD age – a conversion strategy may be considered.
- Tax Projections and Distribution Strategies
- Annual tax projections are crucial to understanding your tax liability and estimating future liabilities. Projections will aid in devising a distribution strategy that is most optimal. Every account type has differing tax consequences; thus, distributions must be coordinated between these buckets to minimize your tax burden.
- For example, Client A is 67 and retired, with a significant amount of savings in tax-deferred accounts and is in the 12% tax bracket. However, the client expects to be in the 22% bracket when forced to take RMDs at 73. It may make sense to take distributions or perform Roth conversions today to take advantage of the 12% bracket versus paying at 22% later. By moving funds out of the tax-deferred bucket prior to 73, the client will be reducing their future RMDs and tax liability. Any distributed funds not used toward living expenses can be reinvested in a taxable account or any Roth converted dollars will enjoy tax-free growth.
- Asset Location
- Asset classes have different characteristics, such as growth, income, capital preservation, etc. It is prudent to consider asset location when you are investing in your different account types. For example, you may consider placing your income producing securities in a tax-deferred account to reduce taxable income each year. You may also consider placing the capital preservation or less growth-oriented investments in your tax-deferred accounts. This will help minimize the growth of your tax-deferred accounts and thus, your future RMD and tax liability. Growth-oriented investments can then be placed in your tax-free or taxable buckets.
- Contribution Strategy
- Savings can be in taxable, tax-deferred, and tax-free buckets. How you choose to contribute to these differing account types throughout your working career will have a significant impact on your future RMD and tax liability.
- Here is an example of a tax-free contribution strategy and one that avoids required minimum distributions. A health savings account (HSA) is available to participants in a high-deductible health plan. An HSA is a tax-deferred & tax-free option depending on how you distribute the funds. Contributions get an income tax deduction and distributions for qualified medical expenses will be tax-free. Distributions for non-medical expenses after age 65 will operate in the same manner as an IRA, taxed as ordinary income (before age 65, there is an additional 20% tax penalty for non-qualified medical expenses). HSAs typically offer a menu of investment options, allowing you to invest your contributions and experience tax-free growth towards future qualified medical expenses and tax-deferred growth towards non-medical expenses after 65.
- Continue Working
- The idea of retirement may not be a primary goal. Continuing to work and participate in a qualified retirement plan will delay the required minimum distribution on that specific plan, if you are an active participant and do not own 5% or more of the business. However, if you have any previous retirement plans or IRAs, you will be required to take distributions from those accounts. You may consider rolling existing retirement plans and/or IRAs into your current retirement plan, which defers the required minimum distribution.
- Qualified Charitable Distributions (QCD)
- For those with charitable intentions, you may distribute up to $100,000 per year from an IRA as a gift directly to a qualified entity beginning at age 70 ½. If qualified, you can treat the distribution as nontaxable. This allows you to reduce your tax liability and future required minimum distributions. You also do not need to itemize deductions or apply percentage of income limitations to get a tax benefit for your gift. A QCD also counts toward your RMD for the year, which can reduce your adjusted gross income once RMDs begin.
- Qualified Longevity Annuity Contract
- A less common approach to reducing required minimum distributions is a Qualified Longevity Annuity Contract (QLAC). You may invest up to $200,000 (indexed for inflation) of your IRA or 401(k) plan into a QLAC without having to take required minimum distributions on that money when you turn 73. You’ll pay taxes once you start receiving payments from the annuity, but you can delay payouts until age 85. There will be benefits and drawbacks of this insurance product, so we recommend speaking with an annuity professional before considering this option.
There are many different strategies for tackling your future tax liabilities. Consider discussing this with a qualified financial professional who can help evaluate the appropriate strategies for you.
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