Even though you may be retired, the tax man is ready to take a slice of your Social Security and retirement fund payouts. How can you minimize his cut? Stephen Nelson, a wealth manager at Aldrich Wealth in Carlsbad, Calif., has some very good advice here:
Larry Light: With boomers retiring every single day, how can they minimize their tax bill in retirement to keep more money in their pocket?
Stephen Nelson: Some people in retirement find out that they actually pay more in taxes than they did when they were working. This is because they’ve begun to collect Social Security, have more interest and dividends being paid to them from their portfolios due to their allocation being more conservative, and are also required to take RMDs or required minimum distributions from their 401(k) or IRA, which will subsequently be taxed. With a little bit of planning, you can save yourself potentially thousands of dollars in taxes.
Light: What’s a really simple way to decrease taxes as it relates to Social Security?
Nelson: Conventional wisdom states that retirement and Social Security go hand in hand. As a result, some people automatically file to take Social Security even though they have retirement income from other sources, be it a pension, annuity or real estate. A very simple way to decrease your taxes is to delay paying Social Security for as long as you can.
This has three benefits: The first is that up to 85% of the benefit you receive from Social Security may be taxable, so the longer you can put this off, the lower your tax bill will be. Second, not only will you pay less in taxes, but your benefit will also grow by 8% each year you delay after full retirement age until age 70.
Third, the “gap years”—the age at retirement to age 70½—can be used to convert traditional IRA or 401(k) money to Roth money during these lower income years and lower your tax bill during your RMD years. Talk about a win-win-win.
Light: A lot of retirees invest in fixed-income or bond securities and get taxed on these interest payments at the higher marginal rates. How can this be mitigated?
Nelson: By utilizing what’s called “asset location optimization.” This is a fancy phrase that means to put your investments into specific accounts so you pay the least in taxes. Typically, there are three types of accounts. Those are taxable: individual, joint, trust). Then tax deferred: IRA, 401(k), 457). And tax-free :Roth IRA, Roth 401(k)). Each one has certain tax advantages for the different types of investments you choose.
You’ll want to place your tax-inefficient investments into accounts where taxes are either deferred or tax-free. For instance, bonds and REITs pay interest and dividends that get taxed at ordinary income rates. These investments would be best held in a tax-deferred account, such as your IRA or 401(k), which will prevent you from paying taxes each year on those distributions.
Large company stocks would be best held in your taxable accounts as the dividends and the sale of holdings are taxed at the lower long-term capital gains rate. Plus, upon the account holder passing, the investments could receive a step-up in basis, meaning the heirs of the account won’t owe any capital gains taxes. This step-up isn’t available in tax-deferred accounts and is one of the reasons why growth investments should be place in taxable accounts.
Finally, the riskiest investments such as emerging market or small cap stocks should be placed in Roth accounts as those offer the largest tax benefit, meaning not taxed at all, to the assets with the highest potential to earn a large return.
Light: With more time on their hands, a lot of retirees are looking to get involved in volunteer work or different charities. What are the benefits for those who are charitably inclined?
Nelson: There are a lot of tax planning opportunities for people who give that easily get overlooked. One such way is called a qualified charitable distribution or QCD. If you’re someone who supports a local non-profit or religious organization on a regular basis, you can give part or all of your RMD, limited to $100,000, to charity and fulfill your RMD requirement without paying income taxes on the distribution.
As a result of the tax law causing the standard deduction to double to $24,400 (for married couples), less people will itemize and therefore, won’t receive a deduction for their charitable giving. But by utilizing a QCD, essentially, you get a double advantage: You can take the standard deduction and exclude the RMD given to charity from your income, effectively gaining a charitable deduction.
Because a QCD is not included in income as a distribution, using this strategy is better than taking a taxable IRA distribution and trying to offset it with a charitable contribution deduction. A QCD does not increase AGI—that’s adjusted gross income—unlike a taxable IRA distribution. As an older taxpayer, it would be wise to limit your AGI because that is what determines the income tax on your Social Security benefits and how much your Medicare premiums are.
Light: What if someone chooses to continue to work past 70?
Nelson: Once you reach age 70½, the IRS requires you to take RMDs from your IRA or 401(k) if you’ve retired. If you’re still working at your job, you can delay taking RMDs from your 401(k) until the year you retire, but will still be required to take RMDs from your IRA and pay taxes on those distributions.
One strategy to avoid having to take RMDs from your IRA when you’re still working is to do a direct rollover of your IRA back into your employer’s 401(k) plan. All of your tax-deferred money will be in a 401(k) and you won’t be required to take RMDs until the year you retire.
You’ll have to see if your 401(k) plan allows for this and work with your advisor and accountant to make sure you’re following all the correct steps, but this is a powerful option to avoid taking RMDs and paying taxes on those distributions when you’re still working.