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Saving enough money for retirement is a primary concern when it comes to financial planning for Americans. However, it’s also important to consider the amount you’ll pay in long-term capital gains taxes, or ordinary income taxes, and what impact those tax rates will have on your nest egg.
“If financial planning doesn’t address the impact of taxes on retirement income, putting money into a 401(k) may not be enough to retire comfortably,” said Aditi Javeri Gokhale, chief strategy officer at Northwestern Mutual.
“Most people don’t realize that when they withdraw and spend their retirement income they may be taxed about 20% or 30%. By the time they understand the impact, it is often too late for them to make adjustments.”
He added, “A comprehensive financial plan can help people reach retirement by reducing risk and preventing anyone from overpaying in taxes, allowing them to potentially preserve thousands of dollars in their nest egg.”
There are several strategies you can use to reduce your taxes in retirement. Here’s a look at the top strategies Americans are using that you should consider when creating your retirement plan.
1. Make strategic withdrawals to stay in the lower tax bracket
Among Americans who plan to minimize the taxes they pay on their retirement savings, many plan to strategically make withdrawals from traditional and Roth accounts to remain in a lower tax bracket for each tax year in retirement.
“This can be a great way to manage tax brackets because distributions from traditional (individual retirement accounts, or) IRAs are generally taxable to the recipient, while money coming from a Roth is tax-free,” said Ben Glassman, a private wealth advisor and director of financial planning at Northwestern Mutual. Haven Wealth Advisors.
“This allows you to use tax-free dollars to take distributions up to a certain limit and avoid getting stuck in a new tax bracket. This method allows individuals to spend their income-taxable, less efficient inheritance dollars as intended.”
2. Use a mix of traditional and Roth retirement accounts
Additionally, Americans who plan to minimize the taxes they pay on their retirement savings said they use a mix of retirement accounts. Diversification between 401(k) plans, Roth IRAs or other retirement accounts keeps all your nest eggs out of one basket.
“This is similar to the above, and it’s a great example of why we work with our clients to build tax diversification into their planning,” Glassman said. “By doing the work in advance, it gives you the ability to decide which accounts to use in creating a tax-efficient distribution plan.”
3. Make a calculated charitable donation
Charitable giving is part of a strategy for those considering reducing taxes in retirement. These donations can be used as a tax write-off up to a certain percentage of your adjusted gross income (AGI) when filing.
“In addition to cash gifts, you can also gift long-term, highly appreciated assets,” Glassman said. “By doing this, you generally avoid taxes on the gains and receive a deduction on the fair market value of the asset (up to applicable AGI limits). It is important to always consult a CPA for tax questions.”
4. Use a Tax-Advantaged Health Care Savings Account
If you plan to minimize the taxes you pay on your retirement savings, you may consider a Health Savings Account (HSA) or other tax-advantaged health care account.
“This is another great resource, especially for health care expenses,” Glassman said. “Your contributions are made on a pre-tax basis, and you can use the money to pay for qualified medical expenses without incurring taxes.
“It’s also worth noting that HSAs can be used as part of retirement planning after age 65 (not 59 ½) without getting hit with the 20% penalty imposed by the IRS for non-medical expenses.”
5. Use other tax-advantaged products
Another plan to reduce retirement taxes is to use products such as permanent life insurance or annuities for tax benefits. Those in the know use the payout basis in the cash value of permanent life insurance to stay in the low tax bracket.
“A well-designed permanent life insurance policy is a tax-efficient way to grow, use and transfer wealth,” Glassman said. “As part of a retirement income plan, you have access to accumulated values without the impact of taxes. Life insurance uses the FIFO (first in, first out) accounting method, which allows you to take out the basis (your contributions) without taxes.
“You can also avail benefits through a policy loan in the form of an advance against the death benefit,” he adds. “For early retirees, who are retiring before 59 ½, there is no 10% early distribution penalty, unlike many retirement accounts.”
It’s important to remember that the primary purpose of permanent life insurance is to provide a death benefit, Glassman said.
“Using permanent life insurance accumulated value to supplement retirement income will reduce the death benefit and may impact other aspects of the policy,” he said.
6. Do a Roth Conversion Before Taking Social Security
For retirees, performing a Roth conversion before taking required minimum distributions (RMDs) or collecting Social Security benefits only lays a better financial foundation for their golden years.
“Roth conversions can be a great strategy for addressing many aspects of retirement income planning,” Glassman said. “Roth conversions create tax-free retirement dollars in the future by pre-paying taxes today, reducing the IRA dollar balance that will be subject to required minimum distributions (RMDs), and Roth IRAs are more tax-efficient inherited assets than traditional IRAs, given the tax treatment given to beneficiaries upon withdrawals.”
There are several important considerations when evaluating a Roth conversion within your own plan, Glassman said.
“Do you believe taxes today are higher or lower than they will be in the future? Do you have enough time horizon on the money to earn more than it costs to pay taxes today?” asked Glassman.
He adds, “Conversions are also an income-taxable event that can impact IRMAA (the monthly adjusted amount related to your income) once you’re on Medicare. The importance of where the conversion fits in the context of financial planning, the timing of the conversion, and the amount of the conversion cannot be overstated.”
7. Use qualified charitable distributions from an IRA
Retirees who plan to minimize taxes in retirement will often use qualified charitable distributions from IRAs.
“Qualified charitable distributions (QCDs) are a great planning tool, especially for individuals or families with large, qualified balances who are interested in donating,” Glassman said. “This allows you to make a distribution from your IRA to a charitable organization without incurring income taxes on that distribution.
“For people who have RMDs in excess of their income needs, who are not dependent on those dollars for their future income planning, this can be a very efficient use of surplus funds,” he said.
8. Contribute to other tax-advantaged accounts
“If your state has an income tax, you may be able to get a deduction on your state income tax up to a certain limit,” Glassman said. “The money grows without taxes and can be used tax-free for qualified educational expenses.”
Now, under the SECURE Act 2.0, you can use surplus 529 account funds to fund a Roth IRA (up to annual and lifetime limits) for a beneficiary.
9. Take Advantage of a Qualified Longevity Annuity Contract
You can also take advantage of a qualified longevity annuity contract (QLAC) to set aside funds for later retirement. Retirement planning is not for the short term but for the long term.
According to Glassman, “This is another strategy that, for the right individual, can serve multiple purposes in retirement income planning. Funding a QLAC reduces the current balance of your qualified accounts, which reduces future RMDs.”
“Once inside a QLAC, withdrawals of the funds can be deferred until age 85. And finally, once withdrawals begin, they come as a lifetime income stream, creating a stable, predictable income level for the later years of the plan,” he said.
Caitlin Moorehead contributed reporting to this article.