Tax Saving Strategies While Approaching Retirement

October 27, 2021

Taxes are difficult to avoid, but there are many tax saving strategies that can help you minimize your lifetime tax bill.

Do you know what tax savings you’ll use when you retire? So much of retirement planning is focused on accumulating the largest nest egg possible. However, the income that your nest egg will generate can evaporate quickly if your tax bills are higher than they need to be.

As Judge Learned Hand once said, “Any one may so arrange his affairs that his taxes shall be as low as possible.” In this post, we’ll go through three possible ways you can keep your taxes in retirement down to a minimum.

Tax Saving Strategies in Retirement: Pull from the Right Buckets

Chances are that your retirement income will come from more than one source or “bucket.” Most accounts will fall into one of three types:

Taxable bucket – Bank accounts, CDs, non-retirement investments, etc.
Tax-deferred bucket – 401(k)s, 403(b)s, 457s, traditional IRAs, self-employed accounts, etc.
Tax-free bucket – Roth IRAs, Roth 401(k)s, HSA accounts (within certain rules and limitations)

How you go about making withdrawals can play a major role in your retirement. Your decisions can affect how much you’ll pay in taxes, how your Social Security will get taxed, as well as how much your RMDs (required minimum distributions) will be when you turn 72 years old. As a general rule, the more you can convert from your tax-deferred bucket to your tax-free bucket, the lower taxes you’ll have to pay in the future.

Now, most people want to shift their taxes to a time when their tax rate is relatively low. This requires careful consideration of your current tax rate, as well as a reasonable guess about what your future tax rates may look like. The best way to go about this is to structure your withdrawals so that you’ll strike a balance between using up your current tax bracket without going up into a higher one.

As SYM senior financial advisor Brad Duling suggests, “If you’ve got enough deductions and other reductions, you may want to withdraw as much as you can from your retirement accounts to get yourself to the top end of the 10 or 12 percent tax brackets.”

For instance, if you file a joint return, then the 12 percent tax bracket currently stops at $80,250. Depending on your income flow and needs, you might withdraw some income from each of your buckets and still be under this threshold.

Duling recalls, “I had a client with so many itemized deductions that they offset her income entirely. Since she was retired, did not have a pension, and was too young to take Social Security or to have RMDs, she essentially had all the deductions with virtually no income. We were able to take over $50,000 out of her retirement savings just to use up her itemized deductions without even incurring any tax liability at all! Then we could take another $50,000 on top of that to get her into the top of the next lowest tax bracket (which was 10 percent).”

What could you do with this extra money? Well, depending on your needs and timing, you could potentially put it into savings — or convert it to a Roth account.

Tax Saving Strategies in Retirement: Roth Conversions

A Roth conversion is a strategy where you take a portion of your tax-deferred retirement savings and convert it over to your tax-free bucket.

As Duling reminds us, “The goal is to pay lower taxes over the life of your retirement. So, if we can pay some of that tax by accelerating it into a lower tax bracket today, this will allow your money to grow tax-free for the remainder of your retirement. That can be a really effective strategy.”

Be aware that any portion of your savings that you decide to convert using this strategy becomes a part of your taxable income for that year. It is important to do the math carefully! You don’t want to accidentally push yourself out of your current tax bracket into a much higher one. For example, if you’ve got a 401(k) with $700,000, in most cases it wouldn’t make sense to convert the whole thing in one year — because you’d end up paying a top tax rate of 37 percent.

The idea is to convert just enough to stay within the lowest tax bracket possible, and to potentially repeat this process year after year (after carefully doing the math and reassessing tax brackets and your personal situation).

Roth Conversions: A Word of Caution

Before you decide to convert any of your savings to a Roth, be sure to keep these other important points in mind.

The 5-year rule. If this is the first time you’re opening a Roth IRA, you’ll have to wait at least 5 tax years before the earnings are eligible to be withdrawn tax-free. This is true even if you’re over age 59-1/2. The good news is that any amount of funds in a Roth account starts the “seasoning” clock on that account, and that you get credit for having a funded Roth account for the full calendar year — no matter when you funded the account during that year.
Have enough money to cover your new tax liability. Most people create a taxable event when they make their conversion, so it’s wise to be prepared for the incoming tax bill. You may not want to use money from the Roth itself to cover this tax bill because that would hamper its growth. Instead, use outside resources (such as your taxable bucket) to cover additional tax bills.
Get your timing right. Remember that the more taxable income you have, the more it can impact how your Social Security is taxed and what your Medicare premiums will be. Therefore, try to be strategic about your conversions and maximize them before these factors come into play.

One final note of caution on Roth IRAs: President Biden’s “American Families Plan” tax proposal in its current state has the potential to phase out the backdoor Roth conversion strategy. The ability to convert money via this particular strategy could change over the period of 2022 to 2032. At the time of this writing, the proposal has not been signed into law yet. We will continue to monitor its development. For now, keep in mind that if you have been thinking about doing a backdoor Roth conversion, you should discuss this with your advisor to plan for possible changes in this specific opportunity. Speak with your financial planner, or reach out to a member of our team at SYM Financial if you have any questions about this tax planning.

Tax Saving Strategies in Retirement: Taxable Accounts

When it comes to your taxable bucket, it is one of the best places to hold securities like stocks or ETFs (exchange-traded funds) that can produce long-term capital gains and qualified dividends.
Why? Because these types of assets can be taxed according to a different marginal tax bracket system. Whereas ordinary income has seven progressive tax brackets with a top tier of 37 percent, long-term capital gains and qualified dividends have just three tax brackets with a top tier of 20 percent.

The net result is that you could potentially be paying less in taxes than you normally would compared to withdrawals from your tax-deferred bucket.

Another note of caution related to “American Families Plan”: In its current proposal state, the tax plan could potentially increase the top marginal capital gains tax rate from 20% to 25%, while simultaneously lowering the dollar threshold for that rate. It is still a bargain compared to the ordinary income tax rate, but it is important to understand that the top capital gains rate could potentially increase (and apply to a greater portion of your capital gains).

Tax-Loss Harvesting

Another powerful benefit that stocks and ETFs can provide is tax-loss harvesting. Tax-loss harvesting is a strategy where you intentionally sell investments at a loss. The IRS lets you use those losses to offset your gains, effectively creating a zero-tax situation if the two are in balance.

This strategy could be especially valuable during the times of market downturn. In the words of Brad Duling, “If we have a major market downturn, those losses can be carried forward into multiple future years. That can provide us with a legal tax shelter for future capital gains.”