Year after year, after year millions of retirees will needlessly pay more in taxes than is required. Why? People believe they have no control over how much they pay in taxes to Uncle Sam. The reality is you have more control over how much you pay in taxes than you think.
So where do you start?
When we look at reducing taxes in retirement, it’s important to understand the concept of tax diversification. There are three specific pools of money in which someone can invest and they are all taxed differently.
- Tax-free pool, including Roth IRA’s or Municipal Bonds. This pool is the most advantageous. The income will not be taxable in retirement. Spending from this pool in retirement can be advantageous once your income from other sources has placed you in a high tax bracket. Generally, it’s still good to have other sources since you don’t want to spend your tax-free money when your tax liability is low. That’s why the next two options are also good to have.
- Taxable pool, including any assets outside of retirement which may be subject to special long-term capital gain tax rates of 0% to 20%. This rate of tax is more favorable than the “ordinary income” rate you will pay on other types of income such as wages or withdrawals from our next pool of money, the tax-deferred pool. The rate applies to both dividends and long-term capital gains.
- Tax-deferred pool, including traditional retirement accounts which are subject to ordinary income tax rates of 10% to 39.6%. Remember that deduction you got when you made your contribution? You eventually do have to pay taxes on the amounts in these accounts, although hopefully you do so in the most efficient way possible, making withdrawals strategically so that you are not placed in a higher bracket than necessary. Once you’re no longer getting a good deal on your withdrawals, you still have the taxable and tax-free tools as additional income sources.
When you are ready to create a retirement income stream from these accounts, it’s critical to devise a balanced tax-efficient withdrawal strategy. In this manner, income taxes can be controlled throughout retirement. The problem is that most individuals have the majority of their assets located in the tax-deferred pool, subject to the highest of income tax rates. The generation that has depended solely on 401(k)s and tax-deferred individual retirement accounts may not realize how much of a tax hit they will take when they start withdrawing the money and living on it.
How do we fix this problem and move money to tax-free accounts?
To correct this problem, we will often recommend strategies to shift assets to the tax-free pool in order to more effectively control taxes in retirement.
Shifting assets to the tax-free pool can be achieved in two ways.
1) Contributing to a Roth IRA
Contributing to a Roth IRA is available to employees and business owners with earned income. The maximum contribution limits in 2014 are $5,500 ($6,500 when 50 and older). There are income limitations and not everyone can qualify for a Roth IRA contribution.
2) Roth conversions
Everyone can do a Roth conversion and there are no income limitations. To do this you simply convert some or all of your IRA, 401k, 403b, etc. to a Roth IRA. The good news about Roth conversions is that all future income, growth and principal is tax free; however the bad news is that taxes need to be paid on the amount that was converted. But consider this: there is no way around paying income taxes on your retirement savings. With a Roth conversion, you simply “prepay” the taxes which allow you to capture all future growth and income as tax free.
Control your Tax Bracket in Retirement
To make Roth conversions tax-efficiently, we recommend that you review your current income tax bracket and projected bracket in retirement. Many are shocked to find that they will be in the same or higher tax bracket in retirement. Since Roth conversions can be made by all taxpayers, working or not, it’s a good idea to review on an annual basis. Some may find that combining other tax deductions (such as increased 401(k) contributions and charitable donations) allow for larger Roth conversions. Imagine having some of your future retirement income as tax-free!