Sometimes conventional wisdom isn’t necessarily wise. For years, many pre-retirees were counseled to expect living expenses of around 70 to 80 percent of their current outlays.
In the past decade, financial planners have keyed in on several places where retirees spend more than previously believed. Many baby boomers are healthy and energetic at retirement and are ready to take on travel or new hobbies, which can be costly.
There are also less-enjoyable ways to spend money. People with income from jobs or self-employment are aware that taxes take a bite out of take-home pay.
However, taxes also affect retirement income. A growing number of financial professionals are advising clients how to prepare for potentially significant tax hits, even after retirement.
“Retirement should be considered simply the next chapter in an individual’s tax planning, and it’s an incredibly important one,” says Lance Christensen, partner and certified public accountant with business advisory firm Margolin, Winer & Evens in Garden City, New York.
“With retirement planning, there is often more certainty: You’re not pulling in a salary, and your investments are often allocated more to the fixed-income category. Your tax strategy should be structured to help time your taxable income so you’re reducing the post-retirement tax hit over as long a period as possible,” Christensen says.
Here are some ways retirees can mitigate their tax burdens.
Strategize your IRA withdrawals. At age 70 1/2, investors must begin taking required minimum distributions from their individual retirement accounts. These withdrawals are considered taxable income. If the account value is high, withdrawals can be significant, resulting in a greater-than-expected tax hit.
One way to plan for this is by using Roth IRAs for all or some holdings in qualified accounts. A Roth IRA is funded with after-tax money, and withdrawals are generally tax-free, which can mitigate a retiree’s tax burden.
Dean Mioli, director of investment planning at SEI Advisor Network in Oaks, Pennsylvania, says investors should consider converting some of their qualified assets from traditional IRAs to Roth IRAs.
“A key consideration here is not to push the taxpaying investor into a higher tax bracket on the Roth conversion. Roth IRAs are not subject to the required minimum distribution rules during the original IRA owner’s lifetime. Also, the Roth IRAs will be available later in retirement for tax-free distributions,” he says.
Although the conversion presents a taxable event, the tax benefits later are often worthwhile. In addition, the conversion process itself can be strategized to offer maximum tax benefits. “Sometimes people will fall into a lower tax bracket when they go off of earned income when they retire. Many times they have a window to do Roth conversions while in a lower bracket — from about the time they retire until they reach 70 1/2,” says John Piershale, wealth advisor at Piershale Financial Group in Crystal Lake, Illinois.
“At 70 1/2, required minimum distributions begin and may throw them back into a higher tax bracket, making conversions more expensive tax-wise. Using Roth conversions in a strategic manner may help to reduce future taxes or avoid the 3.8 percent net investment interest tax,” Piershale says.
Consider a “bucket” strategy. Stein Olavsrud, portfolio manager with FBB Capital Partners in Bethesda, Maryland, suggests organizing portfolios into vehicles with different tax treatments.
“Long before you retire, you should be considering how you will be taxed on your income in retirement. It’s best to think of your assets in multiple buckets, which can each generate income on your behalf,” he says.
Olavsrud notes that many savers utilize a 401(k), 403(b), SEP IRA or other tax-deferred plan as part of a savings strategy. “While these are highly recommended, 100 percent of the distributed funds are subject to taxation as you distribute the funds in retirement. I would suggest that you also consider other sources of savings, which may contribute to your income in retirement. If you effectively save in multiple buckets, you may be able to keep your taxable income at a reduced level in your retirement years,” he says.
Don’t forget taxes on Social Security benefits. Like other forms of income, Social Security benefits are taxable. For retirees who were high earners during their working years, hefty benefits combined with high required minimum distributions often mean large tax bills.
For example, a married couple with income of $44,000 a year or more may see as much as 85 percent of their Social Security benefits treated as taxable income.
Michael Lynch, vice president for strategic markets at Hartford Funds in Charlotte, North Carolina, says retirees may not realize the full impact of Social Security benefit taxation, especially when added to other income sources.
“In retirement, you may be receiving taxable retirement income from an employer-sponsored retirement plan or an IRA. Because distributions from a traditional IRA or employer-sponsored retirement plan may be subject to taxation, the distributions from these arrangements generally will increase a retiree’s taxable income. This may result in a higher percentage of the retiree’s Social Security benefit being taxable because the amount subject to taxation will generally increase as you add in other sources of income,” Lynch says.
More from U.S. News
8 Tech Funds to Buy to Invest in the Future
8 ETFs for Investors Who Love Value
12 Terms Every Investor Needs to Know
What to Know About Taxes in Retirement originally appeared on usnews.com
