Taxes can be complex. And as much as we may not like them, they’re here to stay—even once we enter retirement.
The thing is, there are almost always strategies you can execute that can potentially lower your tax liability both now and in the future. If you have an Individual Retirement Account (IRA), there are some things you can do that may help lower your taxes in retirement.
Look into these three tactics as you get closer to your retirement date:
1. Consider a Roth Conversion
For individuals in or approaching retirement, it may make sense to do what’s called a Roth conversion. This is when you move funds from a Traditional IRA account that is tax-deferred (meaning your contributions aren’t taxed but your distributions are) to a Roth IRA account that is tax-advantaged (meaning you pay taxes on contributions but not on qualified distributions).
Roth conversions can be beneficial because early in your retirement, your income will likely be lower than usual. Your reduced income could put you in a lower tax bracket, so any Roth conversions will be taxed at this lower rate. Then, those funds in your Roth IRA have the potential to grow tax-free, and as long as your withdrawals from the account are qualified, they won’t incur any sort of tax liability either.
Compare that to your Traditional IRA: Once you turn 72, you have to take required minimum distributions (RMDs) from this account, and these distributions are taxed as part of your income. You may think that you’ll be in the same tax bracket as you were in early retirement, but you may not be. After factoring in things like Social Security benefits, pensions and your RMDs, you may actually be in a higher bracket.
Roth IRAs also don’t require RMDs, so if you do a Roth conversion, you can avoid this unnecessary bump in income that may place you in a higher tax bracket.
2. Form a Plan for Giving to Family and Charity
If you’re fortunate enough to not need to draw on the entirety of your IRA in retirement and want to name your children and/or favorite charity as the beneficiary of the account, consider the tax implications.
If you hold a Traditional IRA, you can name a charity as beneficiary, and it will receive the assets tax-free. Your estate may also be eligible for a charitable deduction from this transaction. If you name your child the beneficiary of a Traditional IRA, they will pay income taxes when they take withdrawals from the account.
However, by performing a Roth conversion, you can pass your assets on to your heirs tax-free, and they won’t owe any income tax when they withdraw from the account. Although, beneficiaries of Roth IRAs must be aware of the recent rule changes that came with the SECURE Act. While there are no longer RMDs for inherited IRAs and Roth IRAs, beneficiaries of these types of accounts must now withdraw the full amount of the account within 10 years. There is no “account minimum” exempt from this rule, however, spouses, minor children of the deceased, disabled and chronically ill individuals are exempt. Make sure you consult a financial advisor so you’re aware of all the implications of bequeathing your IRA.
3. Roll Over Funds to Your Health Savings Account
If you think you’ll have to tap into your IRA to pay for medical expenses in retirement, you may want to consider taking advantage of a provision that allows you to jumpstart your health savings account (HSA) and provide a source of tax-free money.
You can roll over funds from your IRA to an HSA without taxes or penalties just once in your lifetime, and you must already have an HSA to qualify. If you do, you can make up to the maximum HSA contribution limit for the year (for 2021, the limits are $3,600 for individuals and $7,200 for families). For those of you age 55 and over, there’s also an opportunity to contribute an extra $1,000 as a “catch-up” bonus.
However, this strategy isn’t for everyone. If you have the cash, it may be better to deposit the maximum amount of funds directly into both accounts so that you’re making the most of all your tax advantages.
The Bottom Line
As with all financial topics, there are many exceptions and alternative strategies that may be a better fit for your retirement needs. Consulting a financial or tax professional can shed more light on how these—or many other—IRA tactics may help you save a significant amount on taxes in retirement.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of the conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.
CFP®, Series 7 Securities Registration,1 Series 66 Advisory Registration,† Insurance License Mike, a Senior Financial Advisor and CERTIFIED FINANCIAL PLANNER™ professional, is the team’s primary advisor in Plymouth. Mike spent seven years in the information technologies industry before joining Wealth Enhancement Group in 2003. Mike is an nine-year winner (2012-2019 & 2021) of the...Read More