3 Ways to Lower Your Retirement Tax Bill
As you approach or settle into retirement, financial planning takes on a new level of importance. One of the most critical aspects of managing your retirement funds is minimizing your tax burden. Proper tax planning can help you preserve more of your hard-earned savings and ensure financial security throughout your retirement years.
There are numerous factors to consider when structuring your retirement withdrawals and investments for optimal tax efficiency. From tax-deferred accounts to Required Minimum Distributions (RMDs), understanding how to navigate these complexities can make a significant difference in your financial well-being. Below, we’ve outlined three powerful tax-saving strategies that can help retirees maximize their savings and minimize tax liabilities.
1. Utilizing Qualified Charitable Distributions (QCDs)
One potential tax-saving strategy for retirees who are charitably-inclined is making use of Qualified Charitable Distributions (QCDs). Starting in the year one turns 70.5, this strategy is particularly beneficial for individuals that own an Individual Retirement Account (IRA). A QCD allows you to donate directly from your IRA to a qualified charity without having to include the distribution as taxable income.
How QCDs Work
Instead of withdrawing funds from your IRA, paying taxes on the distribution, and then donating to charity, a QCD lets you give directly from your IRA to a charitable organization. (QCDs can only be made from IRAs - not from 401(k)s or other employer-sponsored retirement plans.) This allows the donation to be excluded from your taxable income, which can be particularly advantageous if you claim the standard deduction rather than itemizing.
Additionally, if you are 73 or older (or 75 starting in 2033) and subject to Required Minimum Distributions (RMDs), QCDs can count toward your required withdrawals without increasing your taxable income. This can help reduce your overall tax liability while supporting a cause you care about.
Who Should Consider a QCD?
Retirees who are subject to RMDs and do not need the full distribution for living expenses.
Those who regularly give to charity and want to do so in a tax-efficient manner.
Individuals who take the standard deduction and do not benefit from itemizing charitable contributions.
If you’re considering using this strategy, it’s important to work with a qualified financial advisor to help ensure the strategy is implemented properly and qualifies for possible tax benefits.
2. Strategically Timing Your Withdrawals
Another crucial tax-saving technique involves the strategic timing of withdrawals from tax-deferred accounts such as IRAs and 401(k)s. How and when you withdraw funds from these accounts can significantly impact your tax liability.
The Power of Split Withdrawals
Instead of taking a large voluntary distribution all at once, consider spreading withdrawals over multiple tax years to avoid jumping into a higher tax bracket. Keep in mind that RMDs must be taken by December 31 each year and cannot be carried over.
Other Timing Considerations
Bridging the Gap to Social Security: If you retire before claiming Social Security, consider withdrawing from tax-deferred accounts first to take advantage of lower income tax rates in those early years.
Deferring Withdrawals When Possible: If you don’t need the funds immediately, you may delay withdrawals until required to take RMDs. However, be mindful of the tax impact of large future RMDs.
Coordinating Withdrawals with Other Income: Be strategic about when you withdraw money in relation to other taxable income sources, such as rental income or capital gains, to manage your overall tax bracket.
3. Leveraging Roth Conversions
For many retirees, converting traditional IRA funds to a Roth IRA is another potentially tax-efficient approach for certain situations. Roth conversions allow you to pay taxes now on the converted amount, enabling your money to grow tax-free and making all qualified future withdrawals tax-free. If you have a 401(k) instead of an IRA, you typically must first roll over funds to a traditional IRA before converting them to a Roth IRA.
Why Consider a Roth Conversion?
Tax-Free Growth and Withdrawals: Once converted, funds in a Roth IRA grow tax-free, and all future withdrawals—including earnings—are tax-free as long as you meet the five-year holding requirement.
Reducing Future Required Minimum Distributions (RMDs): Unlike traditional IRAs, Roth IRAs do not have RMDs during the account owner’s lifetime, allowing your savings to continue growing tax-free for as long as you like.
Taking Advantage of Lower Tax Brackets: If you expect your tax rate to increase in the future—either due to rising income, changes in tax law, or being forced to take large RMDs—it can be advantageous to convert part of your IRA while your tax rate is lower.
When Is a Roth Conversion Most Beneficial?
Low-Income Years: If you retire before age 73 and have lower taxable income, it may be a prime time to convert some traditional IRA funds to a Roth IRA at a lower tax rate.
Market Downturns: Converting funds when the market is down allows you to pay taxes on a lower balance, and when the market recovers, that growth will be tax-free inside the Roth IRA.
Before RMDs Begin: Once RMDs begin, you must first take your full RMD amount for the year before you can convert any additional IRA funds to a Roth IRA. RMD amounts themselves are not eligible for a Roth conversion, but you can still convert any amount above and beyond your RMD in the same year so planning ahead is important.
It’s important to note that tax laws governing Roth conversions are subject to change. If this strategy aligns with your financial goals, it may be beneficial to evaluate its timing with a tax professional.
Final Thoughts: Creating a Tax-Efficient Retirement Plan
Retirement tax planning is an essential component of a comprehensive financial strategy. By implementing tax-saving techniques such as Qualified Charitable Distributions, strategic withdrawals, and Roth conversions, you can help preserve more of your retirement savings and reduce your overall tax burden.
We're here to help guide you through it.
Tax laws are complex and constantly evolving. Consulting with a fiduciary who is experienced in these strategies is vital. We're here to help you make the most of your retirement, reduce your tax bill, and help create a personalized, integrative retirement plan tailored to your financial future.
Investment advisory and financial planning services are offered through Horizon Financial Services, LLC, an SEC Registered Investment Advisor. Insurance products and services are provided through New Horizon Financial Services, Inc., an affiliated company. Subadvisory and co-advisory services are provided by Advisory Alpha, LLC, a Registered Investment Advisor.
This content is for informational purposes only and is not intended to provide personalized investment, legal, or tax advice. References to financial credentials or professional certifications do not imply a particular level of skill, expertise, or success. Investing involves risk, including the potential loss of principal. No investment strategy, including diversification or asset allocation, ensures a profit or guarantees against loss in declining markets.
Past performance is not indicative of future results. Investors should consider their individual circumstances and consult with qualified professionals before making any financial decisions. Horizon Financial Services, LLC and New Horizon Financial Services, Inc. are not affiliated with or endorsed by the Social Security Administration or any government agency.
