Conventional wisdom says that pension savings should be used with a focus on drawing taxable accounts early in retirement. Many seniors can cut their tax bills in life by, however, ignoring this advice and charting a more considered approach.
The standard advice to retirees has long been to tap savings on taxable brokerage and bank accounts first, while not touching tax-deferred accounts such as 401 (k) s or traditional individual pension accounts until the required minimum distributions take effect at age 72. This allows assets within traditional IRAs or 401 (k) is the maximum tax-deferred growth.
The problem is that this approach results in many retirees barely paying taxes early in retirement and then being hit with stiff tax bills in the 70s after they start collecting social security and begin the necessary distributions from tax-deferred accounts.
“We have had clients [in their 60s] came in and said: ̵
Sarenski says clients should instead be focused on reducing their lifetime tax. And that often means paying more tax in early retirement to reduce tax later.
As an example, he notes that a couple over the age of 65 with no other taxable income can withdraw $ 47,700 from a tax-deferred account and pay only $ 1,990 in tax, a tax rate of only 4.2%. The same couple can take out $ 108,850 and pay $ 9,328 in taxes, a tax rate of 8.6%. Either the rate is lower than they are likely to pay when they start collecting social security.
Many seniors should therefore consider draining their tax-deferred accounts earlier in retirement and paying taxes while income is still relatively low, wealth advisers and accountants say.
Some early retirees in low tax brackets can save even more by converting tax-deferred accounts to Roth accounts.
Greg Will, a financial advisor and certified public accountant in Frederick, Md., Refers to retirees’ late 60s as their “gap year.” The decisions they make then will affect their taxes for the rest of their lives. Optimally, they will enter their 70s with three buckets of money: a bucket after tax, a tax-deferred bucket and 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 hit a higher tax bracket, he would advise them to withdraw money from an after-tax account instead of a tax-deferred account.
“If we have flexibility where we can draw on one of the three accounts, we have much more leverage over their future taxes,” says Will.
For many retirees, especially those with higher incomes, early-retirement Roth conversions are the best way to lower their taxes later in retirement. In the simplest type of Roth conversion, investors transfer 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.
Consider the previous example of a couple with no other taxable income. Instead of spending $ 109,450 from a tax-deferred account, they could convert $ 109,450 in assets from a tax-deferred account to a Roth IRA account and pay the same $ 9,328 tax bill. All the money they take out of Roth for the rest of their lives is tax free. Or they could leave it tax-free to their heirs.
Roth conversions make sense for retirees who have money after tax to pay the tax on the funds being converted. Otherwise, retirees will have to deduct even more money from their tax-deferred account to cover taxes.
Marianela Collado, a wealth advisor and certified public accountant at Plantation, Fla., Analyzes each client’s expected future taxes and determines when current Roth conversions make sense to avert higher taxes in the future. A middle-income client may perform Roth conversions in the tax bracket of 12%, while a high-income client may make them all the way up to the 24% bracket, she says.
Roth conversions also make sense for wealthy retirees who have properties that are too large to be covered by the $ 11.7 million tax exemption per capita. Person, says Bruce Weininger, financial advisor in Chicago and certified public accountant at Kovitz. Wealthy clients like this are likely to pay around 40% to make a Roth conversion, which reduces the size of their property and their property taxes.
But it will be far more expensive if they do not make a Roth conversion. The tax on their estates will be greater, and their heirs will eventually pay even more tax when they withdraw money from an inherited tax-deferred account.
In contrast, with a Roth conversion, “you get all the tax-free growth from the day you do it until the day the kids take the money out,” Weininger says.
The current low interest rates make tax deferrals less valuable, says economist Laurence Kotlikoff of Boston University. Many early retirees have much of their wealth in bonds, which they keep in tax-deferred accounts to avoid taxing interest rates.
But bonds yield less than inflation, which means there is no added value in letting them sit in a tax-deferred account, Kotlikoff notes.
“If you’re in a period where you’re in a low tax bracket, this is when you want to take it out of your IRA,” he says. “The real gain from this game evens out tax brackets” later in retirement.
That’s not all. Retirees with large tax-deferred accounts are often hit with higher Medicare premiums when they start taking required minimum distributions of 72. The best way to reduce RMD is to get money out of tax-deferred accounts before they start.
It must be done with care. If a retiree withdraws too much money from a tax-deferred account or makes an excessive Roth conversion in a given year, it can also trigger higher Medicare premiums.
Kotlikoff sells software that shows safe ways for individuals to increase their income. He conducted an analysis of 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 pensioner planned to live off the savings account until the age of 66 and then start withdrawing his tax-deferred account.
If he did this, the pensioner would pay no tax from 62 to 65, and then watch his taxes soar later in retirement. The analysis showed that the retiree could increase his lifetime retirement income by $ 25,000 by tapping the tax-deferred account earlier.
Part of the gain came from using tax-deferred money at lower tax rates earlier in retirement. But the retiree was also able to dodge higher Medicare premiums down the road by lowering his RMDs.
It’s math. The reality is that it is often difficult to convince customers to pay more tax in the 60s, say financial advisers.
David Frisch, a certified public accountant in Melville, NY, says most clients come around after showing how it can lower their lifetime taxes. He recently had a conversation with a client when he told her that she needed to take extra money out of her individual pension account because they would still be taxed at 12% but would be taxed at a much higher rate later in the pension. He told her she could lower her future taxes or her children’s tax if the assets were transferred to them.
“She basically said, ‘” Frisch recalls, “” I paid for my children’s college. I even paid for my mom’s day dinner. Now I have to pay their taxes! ‘”
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