Close your eyes and picture your ideal retirement. Some of you are probably on a beach, others may be touring Europe and a good number of people probably are thinking of family get-togethers, surrounded by kids and grandkids. But we’d bet that one thing you aren’t imagining is paying a big tax bill.
Unfortunately, that’s the reality for many retirees because income tax doesn’t go away when you stop earning income. When the majority of Americans go to pay for that beachside rental, global adventure or even the family reunions, that money is coming from a 401(k) or IRA. Because those investment vehicles are tax-deferred, that means they are stuck paying tax on anything they withdraw, so that $7,000 vacation you are planning for will require you to take out much more than that to cover the taxes.
And what’s worse, when you reach age 70.5, the government requires that you start taking Required Minimum Distributions (RMDs) on any of the your tax-deferred accounts, which could end up being thousands more than you need for your lifestyle and thus push you into an unnecessarily high tax bracket.
As you can see, that tax bill can add up fast.
But there are ways to help keep taxes low in retirement, even if all of your money is currently sitting in tax-deferred investments. The most common is a Roth conversion. For many retirees, when they stop working, their income drops, which means their tax rate may also go down. That makes early retirement a great time to pay the tax on your tax-deferred savings, transfer the money to a tax-advantaged Roth IRA and avoid being bumped into a higher bracket later on when RMDs kick in. The key here is to only convert up to the amount of tax-deferred money that would keep your income at your current marginal tax rate.
Because of this, it may be smart for individuals make multiple conversions throughout their early retirement years in smaller amounts. One thing to consider before making a Roth conversion is that the option to recharacterize is no longer on the table thanks to tax reform, so be sure that all income for the year is accounted in your tax calculations before completing the transfer.
Another way to reduce your tax bill in retirement is to withdraw from tax-deferred sources when tax rates dip, as they have recently thanks to the 2017 Tax Cuts and Jobs Act. Given that taxes are at the lowest rate in decades, it’s likely that sometime in the next 40 years, tax rates will climb, so it’s important that we don’t take these currently low rates for granted.
In fact, these low tax rates are only guaranteed until 2025, when they’ll sunset to the 2017 rates if Congress doesn’t extend them. And even if action is taken to extend current rates further, taxes are likely to rise again at some point in your lifetime, so having your assets diversified by tax treatment gives you options when tax rates are high and when they are low. Be sure to talk to a tax specialist and your financial adviser about which options work best for your unique circumstances to keep your tax bill as low as possible throughout your retirement.
