How to plan for taxes in retirement


How can I best plan for a tax-free retirement?

For many retirees, even those who have carefully planned their retirement income, the amount of tax they expect to pay can be an unexpected surprise.

It’s understandable. It’s a new income that they may not be aware of.

“Sometimes they think that because they’re retired, they don’t have to pay taxes. Then they’re surprised,” says Chris Chen, a certified financial planner at Insight Financial Strategists. “Sometimes they think that Social Security is tax-free, and it’s not.”

Or, he says, surprises arise from mismanaged expectations. “When they take an IRA distribution, they may not have taxes withheld or have some sort of job that pushes distributions from Social Security and retirement accounts into a higher tax bracket.”

Chen says a big pitfall in facing this type of tax is short-term planning. If you only plan for one year, situations will arise that are not good tax situations.

Rather, he proposes to make a plan to reduce taxes, planning over several years.

Assess your income needs

First, determine your retirement cash flow needs, says Lauren Zangardi Haynes, a certified financial planner at Spark Financial Advisors. And identify your sources of income.

You will need to determine when Social Security will begin. How much (if any) pension income will you receive? Are you receiving a temporary increase in pension income until you reach your Social Security retirement age?

Zangardi Haynes says you need to know required minimum distributions, or RMDs. Then, IRA owners and qualified plan participants are forced to withdraw from their retirement accounts. Retirements must be made on April 1 of the year following the year in which the person turns 701/2.

“Sometimes people take early withdrawals from Roth IRAs or taxable accounts because they don’t want to pay taxes on regular IRA withdrawals, but then end up with big RMDs at age 70,” he notes.

As you analyze your income and expenses, Zangardi Haynes says, you can find some tax advantages by making charitable distributions directly from your traditional IRA. These charitable contributions can count toward your RMD if you’re over age 701/2.

Use tax diversification

One of the best ways to position yourself for retirement is to have three assets: taxable, tax-deferred, and tax-deferred, says Michael Troxell, financial planner and CPA at Modern Financial Planning. For example, you’ll have brokerage accounts, Roth IRAs, and traditional IRAs.

“That way, when you draw your retirement income, you can cherry pick,” says Troxell. “For example, one could withdraw money from their IRA up to the 12% tax bracket, which is $77,400 if you’re married.”

Then, he says, you can withdraw from your brokerage account. You will have to pay capital gains rates on the long-term gains there.

“Finally, you’d be withdrawing from your Roth IRA,” says Troxell. “Ideally, the Roth would be last, because you’d want that money to grow tax-free for as long as possible.”

Tax window planning

What often happens to retirees is that all of these sources of income can be activated at once in retirement, says Adam Beaty, a certified financial planner at Bulgologic Wealth Management. And if you’re not prepared for the time between 70 and 70 years after you retire (called the tax window) you could be hit hard and miss out on lowering your future tax bill.

“They will have to take the required minimum distributions at age 70,” he says. “They will also request the activation of Social Security, if they don’t already have it.”

If the joint estate is large enough, the required minimum distribution will result in 85% of Social Security being taxed. They are also paying taxes on the distribution.

“This is usually a big, unexpected tax bill that can be avoided if they take the right steps,” he says. The tax window will allow the client to make some moves to reduce their future tax bill if a retiree is diversified with three types of accounts – always taxable (IRA/401(k)), never taxable (Roth IRA/Roth 401(k)), and sometimes taxable (brokerage account).

“In this tax window, they’re probably going to have very low incomes and so they’re going to be in a low tax bracket,” Beaty says. He then recommends always taking assets from a taxable account and never putting them into a taxable account.

“By paying taxes now, at a lower bracket, we will be able to save money in the long run,” he says. “If Social Security isn’t activated, it may be a good time to start spending money from your taxable accounts and never keep your taxable accounts past age 70.”

CNNMoney (New York) Posted October 25, 2018: 2:46 pm ET