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Conventional wisdom says that retirement savings should be spent with an emphasis on withdrawing from taxable accounts at the start of retirement. However, many seniors can reduce their lifetime tax bill by ignoring this advice and taking a more thoughtful approach.
The standard advice for retirees has long been to tap savings first in taxable brokerage accounts and bank accounts without touching tax-deferred accounts such as 401 (k) accounts or traditional individual retirement accounts. until the required minimum distributions come into effect at age 72. This allows assets inside traditional IRAs or 401 (k) s the maximum tax-deferred growth.
The problem is, this approach causes many retirees to pay almost no tax when they start their retirement, and then end up with high tax bills in their 70s after they start collecting Social Security and starting social security. distributions required from tax-deferred accounts.
“We have had clients [in their 60s] come and say, ‘We haven’t paid any taxes for the past five years. Isn’t that great? ‘ “Says Theodore Sarenski, wealth manager and certified public accountant in Syracuse, NY” And I say, ‘No it’s not. “
Sarenski says clients should instead focus on reducing their taxes for life. And that often means paying more taxes in early retirement to lower taxes later.
For example, he notes that a couple over 65 with no other taxable income can withdraw $ 47,700 from a tax-deferred account and pay only $ 1,990 in taxes, i.e. a tax rate of only 4.2%. This same couple can withdraw $ 108,850 and pay $ 9,328 in taxes, a tax rate of 8.6%. Either rate is lower than what they are likely to pay after they start collecting Social Security.
Many seniors should therefore consider dipping into their tax-deferred accounts earlier in retirement and paying taxes while income is still relatively low, according to wealth advisers and accountants.
Some low-tax pre-retirees can save even more by converting tax-deferred accounts to Roth accounts.
Greg Will, financial advisor and chartered accountant in Frederick, Maryland, calls the late 60s of retirees their “sabbaticals.” The decisions they make then will affect their taxes for the rest of their lives. Ideally, they will enter their 70s with three buckets of money: an after-tax bucket, a tax-deferred bucket and a tax-free bucket for the Roth IRA, Will said.
Retirees can often save money by switching between different buckets. For example, towards the end of the year, if Will sees his clients hitting a higher tax bracket, he will advise them to withdraw money from an after-tax account instead of a tax-deferred account. .
“If we have the option of tapping into one of the three accounts, we have a lot more influence over their future taxes,” Will says.
For many retirees, especially those with higher incomes, Roth conversions early in retirement are the best way to lower their taxes later in retirement. In the simplest type of Roth conversion, investors move assets from a tax-deferred account to a Roth account. The value of the assets is taxed at the time of transfer as ordinary income.
Take the previous example of a couple with no other taxable income. Instead of spending $ 109,450 on a tax-deferred account, they could convert $ 109,450 of assets from a tax-deferred account to a Roth IRA account and pay the same tax bill of $ 9,328. Any money they take out of the Roth for the rest of their lives will be tax exempt. Or they could leave it tax free to their heirs.
Roth conversions make sense for retirees who have enough after-tax money to pay taxes on the converted funds. Otherwise, retirees have to withdraw even more money from their tax-deferred account to cover their taxes.
Marianela Collado, Wealth Advisor and Certified Public Accountant at Plantation, Florida, analyzes each client’s future withholding taxes and determines when current Roth conversions make sense to avoid higher taxes in the future. A middle-income client can make Roth conversions in the 12% tax bracket, while a high-income client can do them up to the 24%, she says.
Roth conversions also make sense for wealthy retirees who have estates too large to be covered by the $ 11.7 million per person lifetime tax exemption, says Bruce Weininger, Chicago financial advisor and expert. -Accredited accountant at Kovitz. Wealthy clients like this will likely pay around 40% to complete a Roth conversion, reducing their estate size and property taxes.
But it will be much more expensive if they don’t do a Roth conversion. Their estate taxes will be higher, and their heirs will end up paying more taxes when they withdraw money from an inherited tax-deferred account.
In contrast, with a Roth conversion, “you get all of the tax-free growth from the day you do it until the day the kids take the money out,” Weininger explains.
Current low interest rates make deferring taxes less attractive, according to economist Laurence Kotlikoff of Boston University. Many pre-retirees have a large portion of their wealth in bonds, which they keep in tax-deferred accounts to avoid interest taxation.
But bonds pay less than inflation, which means there’s no growth in value leaving them sitting in a tax-deferred account, Kotlikoff notes.
“If you’re in a time when you’re in a low tax bracket, that’s when you want to withdraw it from your IRA,” he says. “The real payoff in this game is to smooth out the tax brackets” later in retirement.
That’s not all. Retirees with large tax-deferred accounts are frequently hit with higher health insurance premiums when they start collecting the minimum required distributions at age 72. The best way to reduce RMD is to withdraw money from tax-deferred accounts before you start.
It must be done with care. If a retiree withdraws too much money from a tax-deferred account or makes too large a Roth conversion in any given year, it could also trigger higher health insurance premiums.
Kotlikoff sells software that shows safe ways in which individuals can increase their income. He did an analysis on an imaginary 62-year-old retiree with $ 1 million in tax-deferred assets, $ 250,000 in a savings account and $ 250,000 in a tax-free Roth account. The retiree planned to live on the savings account until he was 66 and then start drawing from his tax-deferred account.
If he did this, the retiree would pay no tax from age 62 to 65 and then see their taxes skyrocket later in retirement. The analysis revealed that the retiree could increase their lifetime retirement income by $ 25,000 by tapping into the tax-deferred account earlier.
Part of the gain came from spending tax-deferred money at lower tax rates earlier in retirement. But the retiree was also able to dodge higher health insurance premiums on the road by lowering his RMD.
This is the calculation. The reality is, convincing clients to pay more taxes in their 60s is often a tough sell, financial advisers say.
David Frisch, a certified public accountant in Melville, NY, says most clients come in after being shown how this can lower their taxes for life. He recently had a conversation with a client when he told her that she needed to withdraw extra money from her individual retirement account as it would still be taxed at the 12% rate, but would be taxed at a high rate. higher later in retirement. He told her that she could reduce her future taxes or those of her children if the assets are transferred to them.
“Basically she said,” Frisch recalls, “I paid my kids’ college. I even paid for my Mother’s Day dinner. Now I have to pay their taxes! ‘ “
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