Avoiding a Tax Bomb in Retirement
We encounter many retirees who have diligently saved into pretax retirement accounts for several decades and have amassed very large 401(k) and IRA portfolios. They have made the most of tax-saving strategies during their working years and are now ready to begin withdrawing these funds while retired and in a lower tax bracket. However, investors who do not anticipate potential changes can find themselves running into a tax bomb in retirement. This article is intended to discuss some different strategies to avoid paying too much.
First, be aware that the current tax rates are set to expire in January 2026, and at that time, tax rates are scheduled to return to the pre-2017 levels. For many people, this amounts to only a small increase in rates. For example, the 22% marginal bracket changes to 25%.
However, the standard deduction is scheduled to go down as well. Furthermore, given the deficits that our lawmakers have been racking up over the years, there is certainly a potential for everyone’s tax rates to go up even further than they are scheduled to, depending on new legislation.
Of course, many experts expect Congress to take action in 2025, so we will have to wait and see if the current rates are extended or modified. Regardless of what happens in the future, we are in a historically low tax landscape now, so it is important to make the most of it.
To avoid a retirement tax bomb:
First, consider delaying Social Security and converting traditional IRA funds to Roth. Here’s a good example: let’s say that you have significant pretax and non-qualified funds and retire at age 65. You have a five-year window before you reach your maximum Social Security benefit. Often, we advise investors to convert pretax money to Roth during this window and meet their living expenses from their after-tax money. For instance, if you are married and filing jointly, and have no additional income, you can convert over $100,000 from traditional to Roth annually and stay in the 12% tax bracket, which equates to a blended federal tax rate of 7.7 percent. If you convert over $200,000 from traditional to Roth, this lets you get money out of your pretax IRA at a marginal rate of 22% and a blended rate of 13%. After you convert the money into a Roth, it will never be taxed again and will be available for you later to draw tax-free or to leave to your children.
Second, consider a donor-advised fund with a Roth conversion. If you give to your favorite nonprofits, direct gifts may not benefit you from a tax standpoint the way they have in the past because the standard deduction is so much higher. Because of this, you may want to pair up a donor-advised contribution along with a Roth conversion. Here is a good example: Let’s say you and your spouse are 65 years old and you give $20,000 per year to your nonprofits. So between 65 and 70, you plan on giving $100,000 to nonprofits. You know that you can make qualified charitable distributions (QCDs) after age 70.5, so after that date, you’ll most likely make your charitable gifts directly from your IRA. Consider transferring or cash gifts to a donor-advised fund when you are 65 years old for $100,000. The same tax year, you can convert a significant amount of your pretax IRA over to a Roth IRA. By doing this, you’ll be able to offset the taxes that will come with a conversion with the donor gift, resulting in a lower overall tax bill for you and your family. Then, in subsequent years up until 70, just take the standard deduction and make all charitable gifts from your donor-advised fund. After you are 70.5, switch over to QCDs.
Third, make the most of the 0% long-term capital gains rate. Many taxpayers do not know that investors in the 12% tax bracket will pay a 0% long-term gain rate. Couples who are married filing jointly and take the standard deduction can earn over $125,000 of total income and still be within the 12% tax bracket. So when you retire, consider selling some of your taxable investments that have large gains on them and income to meet your needs in the early years of retirement, saving your Social Security benefits until later. This will allow you to cash out stocks with accumulated gains at a 0% federal rate. Note that you may have state taxes due, depending on where you live
We hope you benefited by reading this blog. To meet with an advisor to discuss these strategies in more detail, click here to schedule an initial conversation. We have also created a free guide for you to download here: 5 Tax Strategies Often Overlooked
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
This information is not intended to be a substitute for individualized tax advice. We suggest that you discuss your specific tax situation with a qualified tax advisor.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.
Traditional IRA account owners have to consider things before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.