3 strategies to reduce tax risks in retirement
Think back to when you got your first paycheck. You were so excited. You knew how much you earned per hour and how many hours you worked, and you couldn’t wait to go out and splurge on something you were dying to get. You were handed your paycheck envelope and you tore it up with great anticipation and…wait a minute…it’s not even close to what you expected.
That was your first hard tax lesson – the government wants a portion of what you earn at work.
Unfortunately, stopping working in retirement doesn’t mean the taxes stop either. But developing a plan now to mitigate risks like rising taxes can help you avoid unpleasant surprises while you try to enjoy your golden years.
Thinking about how your retirement savings and income will be taxed — and creating a tax-efficient withdrawal strategy to minimize the effect of taxation — can help you get a better idea of how much money will end up in your pocket rather than Uncle Sam’s. Of course, there is some uncertainty – taxes change. Rates could go up or down in the years to come.
In Allianz Life’s most recent quarterly market perceptions survey, 64% of respondents said they feared their income would not keep pace with tax increases. And taxes, along with other factors, lead 61% of respondents to say they’re worried their current financial strategy isn’t giving them the lifestyle they’d like to have in retirement.
The good news is that current tax laws provide options to help reduce taxable income, such as tax credits, increased standard deductions, and pre- or post-tax retirement plans.
Not surprisingly, not all tax provisions reduce your taxes. State and local income tax deduction limits (only $10,000 per tax return are deductible), increased Medicare taxes on high earners, and variable rates on earnings in long-term capital could lead to a higher tax bill. You will therefore want to work closely with your financial professional, as well as a tax advisor, throughout your approach to reducing taxes on your retirement income.
Either way, you want to have a tax-efficient strategy. Here are some strategies to consider that can lessen some of the impact of taxes during retirement.
1. Consider Roth IRA conversions
A common way for many to save money for retirement is to set aside money in an employer-sponsored plan or IRA. These retirement savings vehicles allow you to invest pre-tax dollars and hopefully enjoy tax-sheltered growth over time. The trade-off, however, is that taxes will be due when you start withdrawing that money to fund your retirement.
Pre-tax money from a retirement plan or IRA can be converted to a Roth IRA. Thanks to the conversion, the income tax will be paid now, and not later, when the money is withdrawn.
Converting your tax-deferred assets to a Roth IRA now could give you some flexibility later, which could help reduce taxes paid during retirement. That means more money to enjoy that well-deserved retirement or to pass on to beneficiaries.
For example, let’s say your marginal tax rate at the time of conversion is 12%. Later, either through changes in tax law or increases in total income, this withdrawal would be taxable at the marginal tax rate of 24%. A Roth IRA conversion could earn you 15.8% more after-tax income.
The advantage of conversion, provided you follow the rules regarding Roth IRA withdrawals and appropriate waiting periods, is that there will be no income tax paid for the owners or beneficiaries of the account. A Roth IRA conversion can convert an entire IRA all at once or can be spread over several years. For some people, it makes sense to convert over multiple tax years to avoid falling into a higher tax bracket.
Like any retirement or tax strategy, this doesn’t work the same for everyone. Converting an employer-sponsored plan or IRA to a Roth IRA is a taxable event that can have far-reaching effects. Unintended consequences could include increased taxes on Social Security benefits or increased Part B and D health insurance premiums. The conversion could require additional tax withholding or estimated tax payments. You will need to decide whether the taxes will be paid from the converted funds or from another account, perhaps after tax. It could also mean that you lose certain tax deductions or credits or protection from cost-of-living adjustment increases for Medicare.
Consult a qualified tax advisor to help you make decisions about converting from a traditional IRA to a Roth. You should be aware that certain provisions of proposed tax bills in 2021 would limit Roth conversions and prevent the conversion of non-deductible IRA contributions. These proposals may come back, your adviser must keep you informed. Roth conversions must be completed by December 31, and you can no longer change your mind later and switch a Roth conversion back to a traditional IRA.
2. Explore Charitable Giving Options
For the philanthropically minded, charitable giving can help reduce the tax burden and preserve wealth while leaving a legacy.
A charitable trust is often used by people with large assets, but there are other charitable giving strategies that people with smaller assets might consider, including qualified charitable distributions and donor-advised funds.
A qualified charitable distribution (QCD) can be used to make charitable donations using funds from a traditional IRA or, in some cases, a Roth IRA. QCDs will not increase your Adjusted Gross Income. When you withdraw funds from an IRA and donate them yourself to charity, the withdrawal is taxed as income and your adjusted gross income increases.
With a QCD, the withdrawal is made from the IRA and the IRA provider issues the check directly to the charity. Even though it may satisfy some or all of the IRA owner’s Required Minimum Distribution (RMD), it is not considered income and does not have to be recognized by the IRA owner. A QCD can be used by IRA owners over age 70.5 with a limit of $100,000 per year per person.
How QCDs affect your state taxes will be different in states with an income tax structure that does not tax IRA distributions while allowing a deduction for charitable contributions. Since the withdrawal is not recognized as income, a QCD could still benefit people who wish to donate their RMD and could not use the donation as a federal tax deduction due to the increased standard deduction.
The other strategy—the donor-advised fund—will separate the actual gift from its tax benefits. The tax advantages of a donor-advised fund can be used now and the gift can be sent to the charity later. This could be used to make a large charitable donation without having to donate all at once.
A donor-advised fund allows for the accumulation of charitable donations in a high tax bracket that will be distributed later in a lower tax bracket. Thus, you can benefit from the largest tax deductions while being in a higher marginal bracket. The fund can also help avoid taxes on long-term capital gains.
3. Use a health savings account for accumulation
Health Savings Accounts (HSAs) have unique features that can help in retirement. Yes, there are tax benefits you can take advantage of, but the bottom line is that your health care expenses will increase as you age. An HSA can help cover these expenses while providing tax benefits.
The accounts, which are available to those enrolled in high-deductible health plans, allow for pre-tax contributions, tax-free earning potential, and tax-free distributions for eligible medical expenses. Additionally, unused balances in an HSA are available and portable – not in a “use it or lose it” scenario.
Keep in mind that once a person is enrolled in Social Security or when they apply for Medicare at age 65, they are no longer eligible for HSA contributions.
Everyone eligible to contribute to an HSA can’t wait to use it. People with limited cash who are struggling to save for retirement would be better off using an HSA for day-to-day medical expenses and saving money for retirement in a 401(k), 403(b), a traditional IRA or a Roth IRA.
Among the various risks people can face in retirement, taxes are unavoidable – and no one wants a surprise tax bill that can spoil the fun of retirement. These and other strategies could help you mitigate tax risks in retirement. The first step is to find a financial advisor and tax advisor who will help you start planning now to create a tax-efficient strategy to reduce your tax burden later.
This content is for general educational purposes only. However, it is not intended to provide fiduciary, tax or legal advice and may not be used to avoid tax penalties or to promote, market or recommend any tax plan or arrangement. Please note that Allianz Life Insurance Company of North America, its affiliates and their representatives and employees do not render fiduciary, tax or legal advice. Clients are encouraged to consult their tax advisor or attorney.
Vice President, Advanced Markets, Allianz Life
Kelly LaVigne is Vice President of Advanced Markets for Allianz Life Insurance Co., where he is responsible for developing programs that help financial professionals serve clients with retirement, estate planning and tax strategies.