PLAN NOW TO BE TAX-EFFICIENT IN RETIREMENT

February 01, 2024

Does anyone like to pay taxes?  Most of my clients tolerate paying taxes like eating their least favorite vegetables.  They are difficult to calculate and hard to understand, especially with a business generating uneven cash flow or an employed couple with disparate incomes.  What if I told you that there are ways to eliminate taxes in retirement or minimize federal taxes to a palliative 12% bracket?

 

Tax planning is an important part of retirement planning.  When I ask clients what their target monthly spend in retirement is, they never consider the tax effect.  For instance, a married couple may say they need to generate $6000 per month to pay all their bills when they retire.  Typically, this means the dollar amount that is deposited in their bank account.  As a financial planner, I immediately think of the gross amount.  How much do we need to generate on a gross level, before taxes, to net them $6000?  Depending on the source of funds, some of my clients may have a tax bill of 0, allowing them to only draw the $6000 per month out of their investment account(s)!

 

How can this be?  Most retirees rely on social security to generate a large portion of their income.  Some people pay tax on social security and others do not.  Whether you pay taxes or not depends upon your total combined taxable income.  Combined income includes your adjusted gross income, any nontaxable interest you receive and half your Social Security benefits (Adjusted gross income includes earnings, investment income, retirement plan withdrawals, pension payments and other taxable income.)  If a married couple has a combined income of less than $32000 then none of their social security income is taxable on a federal level or in our state of Massachusetts.  For a single person, the limit is $25000.  Depending on the outcome of this formula, 85% of social security benefits could be taxable. The key to paying 0 federal taxes in retirement is to have other, non-taxable sources of funds!

How can you plan now to possibly pay 0 taxes in retirement?  A Roth 401k or Roth IRA is the best place to start.  Most employer 401k plans now have a Roth option.  This is when your contributions are made on an after-tax basis instead of pre-tax.  If you are in a high tax bracket now, you would need to consider the tradeoffs of paying taxes now to not pay later.  In 2023, the limit for Roth 401k contributions is $22,500 with a $7500 catch up contribution for those over the age of 50.  If you do not have a 401k plan at work, you can make a Roth IRA contribution of $6500 per year or $7500 per year if you are over age 50.  When you withdraw Roth funds after age 59 ½, the withdrawals are tax-free and do not impact taxable income. 

Another great source of non-taxed income in retirement are investment accounts or savings outside of retirement accounts.  If invested efficiently, where capital gains and interest income can be minimized, drawing from these accounts in retirement can have little effect on taxable income.  Tax-efficient investing may involve putting interest generating investments in a Roth IRA and keeping investments that generate long-term capital gains in a brokerage account.

For an example of efficient tax planning, consider Client couple A versus Client couple B.  Both clients are married and file taxes jointly.  Each of these couples would like to generate $6000 per month in cash to spend in retirement.  Each client couple generates $3000 per month in social security, after paying for Medicare.  Client couple A each has a Roth IRA and draws the remaining $3000 per month out of one of their accounts to meet spending needs.  Since withdrawing from Roth accounts is non-taxable after age 59 ½, they would pay 0 dollars in federal and 0 dollars in Massachusetts state taxes.  Client couple B only has taxable retirement accounts.  They draw the needed $3000 from one of their taxable accounts.  If there are no other factors, according to 2022 federal tax tables, they could owe approximately $4500 in federal taxes and $1600 in the state of Massachusetts for a total of over $6000 in total income tax!  As a financial planner, I would need to generate an additional $500 per month to cover Client couple B’s taxes.  If Client couple B withdraws a standard 4% from their retirement accounts in retirement, they would need to save another $150,000 during their working years compared to Client couple A!

Proper tax planning should be a very important part of retirement planning.  Many times, income taxes cannot be avoided but they can be managed efficiently.  Working with your CPA and financial planner is always a good place to start!

 

 

Securities offered through LPL Financial. Member FINRA/SIPC. Advisory services offered through Trombley Associates, a registered investment advisor and separate entity from LPL Financial.

 

This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice.  If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.

 

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.