I’m not under any illusions. I realize that most people would prefer to think about taxes as little as possible. It’s simply not a subject that brings us to the edge of our seat. Nonetheless, I consistently find myself writing about retirement tax strategy more than any other planning topic for two reasons. First, because retirement tax planning tends to be the single biggest value generator for retirees in the one to three million dollar net worth range. Second, because the stakes for retirement tax planning have never been higher.
Several decades of unsustainable government spending have put us on the doorstep of what is likely to be a prolonged period of generationally high tax rates. The federal government’s unprecedented debt burden will almost certainly call for several tax hikes in the coming years. These unfavorable tax rates will be especially painful for retirees who are reliant on income from traditional retirement accounts. Not only are these accounts tax-deferred, but they’re also subject to mandatory withdrawals. A healthy dose of retirement tax planning can keep the taxman at bay, but retirees should first understand how a retirement tax crunch happens.
Required Minimum Distributions
It’s hard to stomach the idea of the IRS getting a say in how much we withdraw from our retirement nest egg each year. Unfortunately, for many retirees, that’s exactly what happens. If you’re unfamiliar with Required Minimum Distributions (RMDs), you’re not alone. In my experience, most retirees are under-informed on these mandatory withdrawals, as well as the adverse impact they can have on a retiree’s tax situation. Required Minimum Distributions are IRS-mandated percentages that must be taken from traditional retirement accounts (IRAs, 401Ks, etc.) each year starting at age 73 or 75 depending on the year you were born. That may seem like a long way off for some, but the longer retirees put off planning for these withdrawals the harder they are to offset. Essentially, once RMDs start, the IRS takes a controlling interest in your annual tax situation.
While RMD amounts can start off small, over time, account owners are forced to withdraw a larger portion of their account each year. A situation arises far too often where retirees find themselves unprepared, and at the mercy of the US tax code in the back half of retirement. Their RMDs push them into higher tax brackets, forcing them to pay more taxes each year for income they neither want, nor need. For today’s retirees, these tax consequences are likely to be magnified and compounded by substantially higher tax rates. I understand that’s a lot of doom and gloom, which leads me to my infatuation with retirement tax strategy. Tilting the tax scales in your favor doesn’t take much. In fact, it’s one of the few areas of retirement planning where a simple analysis can quantify and deliver cold, hard value in real time. It should be looked at as low hanging fruit. Harvest it before it withers.
Retirement Tax Planning In Action
Retirement tax planning is about looking ahead to estimate your retirement income each year, and determining the corresponding tax rates for that income. It’s especially powerful if we know that your RMDs are going to force you to take more income than you need, and/or tax rates are going up in the future. Both of which are highly likely for millionaire retirees. In fact, we already know that tax rates are set to jump in 2026 when our current tax legislation sunsets. Therefore, the objective of retirement tax planning is twofold. We want to take and pay taxes on income in years of favorable tax rates, and make sure that RMDs aren’t going to force us into higher tax rates. It just so happens that we are in a relatively favorable tax environment today, which makes the idea of taking more retirement income over the next three years highly attractive. However, that then begs the question of what to do with the excess income we are withdrawing in favorable tax years. Often, that’s money we’ll need later on in life.
All retirees with tax-deferred accounts have the option to do what are known as Roth conversions. A Roth conversion is when you strategically take a withdrawal from your IRA to pay the taxes on it now at a favorable rate. We then roll that withdrawal into a Roth IRA, which is a tax-free retirement account. Once the withdrawal is in the Roth account it can be invested, and grow tax-free indefinitely. That means whether you choose to withdraw it down the line, or leave it to your heirs, that money will never again be subject to income taxes. Oftentimes, Roth conversions are done at the end of each year to incrementally move money into your Roth account while staying within a favorable tax bracket. By implementing a Roth conversion strategy you are killing two birds with one stone. You’re reducing your future RMD amounts, while also reducing your exposure to higher tax rates in the future.
The total value from Roth conversions can be quantified in real time by tallying up the tax savings realized each year. For retirees with over a million dollars in retirement accounts, it’s not uncommon to see savings of over one hundred thousand dollars throughout retirement. Retirees who implement a conversion strategy early on can end up substantially lowering, or even eliminating their RMDs, and the associated tax crunch all together. After which, the majority of their nest egg sits safely in a tax-free Roth account, never to be subject to RMDs or the taxman again.
If this is your first time really getting into the weeds of retirement tax planning I can understand that it may seem complex and cumbersome. Hence the lack of enthusiasm when it comes to thinking about taxes. However, when working with a financial planner, it’s mostly on their shoulders to create the plan and implement your strategy. It comes down to knowing your retirement income, and taking one extra withdrawal at the end of the year. For today’s retirees, a conversation around retirement tax planning should be looked at as table stakes. The retirement tax crunch tends to come for us all, and our nation’s ominous tax outlook has created a ticking clock. Thinking about a retirement tax plan should be your first step. It could turn out to be the single biggest source of stability and value throughout your golden years.
