Congratulations, you made it! You worked hard and successfully retired. However, the transition from accumulating wealth to spending it introduces new complexities, particularly around managing taxes and seeking to sustain your income. For retirees, “taxes” stop being a once-a-year preparation chore and become a vital, year-round planning strategy.

A proactive plan helps you work toward your financial goals, which includes optimizing your income strategies so you can feel confident in your retirement.

The Retirement Tax Mandate: Understanding RMDs

If you saved money in tax-deferred accounts during your working years such as a Traditional 401(k), SEP IRA, or Traditional IRA, you deferred paying income tax on that money. The government allows you to do this because it ensures that eventually, you pay your deferred tax liability.

This is where the Required Minimum Distribution (RMD) comes in. An RMD is the money that you must take out of those traditional tax-deferred accounts once you reach age 73 (depending on your birth year).

The Problem: The Penalty and Tax Risk

It is critical to calculate and take your RMD correctly because the penalties for failure to withdraw the correct amount are severe.

• The Penalty: If you fail to take your RMD by April 1st after you turn 73 (for your first RMD) or by December 31st of subsequent years, you may be subject to a significant 25% penalty on the amount not withdrawn.
• Tax Risk: When you withdraw funds from a Traditional retirement account, those RMDs are taxed as ordinary income. This can be problematic because the RMD distribution could push you into a higher tax bracket, causing the distribution to be taxed at a higher rate.

Working with a financial planner early in retirement can help you have a plan in place to seek to avoid these costly penalties.

Strategy 1: Diversifying Income with “Tax Buckets”

Managing your RMDs and overall taxable income is significantly easier if your retirement nest egg is diversified across different tax categories, often referred to as “tax buckets.” Relying too heavily on tax-deferred accounts can lead to higher taxable income in retirement.

A strategic mix of accounts provides the flexibility to manage your annual taxable income and aim for a lower tax bracket:

• Tax-Deferred Accounts (Traditional 401(k), Traditional IRA): You pay taxes when you withdraw the funds.
• Tax-Free Accounts (Roth 401(k), Roth IRA): Contributions are made with after-tax dollars, but qualified withdrawals in retirement are tax-free.
• Taxable Accounts (Brokerage Accounts): Subject to capital gains taxes.

By strategically withdrawing from these three different buckets, you gain control over your annual taxable income.

Strategy 2: Pre-Retirement Roth Conversions

The most powerful advantage of the tax-free bucket is that Roth 401(k)s and Roth IRAs generally do not have RMDs during the owner’s lifetime.

For pre-retirees, this is a critical planning period. You should consider converting some traditional savings into a Roth IRA. A Roth Conversion involves paying the associated tax on a portion of your pre-tax IRA now, and moving it into a Roth IRA.

This strategy is particularly effective if you think your tax rates will be higher in the future or during “low-income years.” By paying taxes on a portion of your savings today, you permanently reduce the future balance of the tax-deferred account, thereby reducing the size of your future RMDs and lowering your overall potential tax risk in retirement.

Strategy 3: Tax-Smart Charitable Giving

For retirees focused on optimizing their wealth and leaving a legacy, charitable giving can be integrated with tax planning to create greater efficiency.

• Donor-Advised Funds (DAFs): A DAF allows you to donate cash or investment strategies. This allows you to potentially “bunch” several years’ worth of donations into one year to receive a larger tax deduction. You receive the tax break immediately but can distribute the money to charities over time.
• Charitable Trusts: Retirees can also consider incorporating Charitable Remainder Trusts (CRTs) into their giving strategy, which can help manage income tax while fulfilling the goal of leaving a legacy.
• Life Insurance: Life insurance dividends can be gifted now, or the death benefit can be directed to one or more charities as part of your estate plan. Additionally, evaluating your Will and estate plan documents yearly is essential to help pass your assets as you intended upon death.

Conclusion: Partnering for Protection

The years leading up to and immediately following retirement are crucial for setting up a durable tax strategy. Successfully navigating RMDs, managing your withdrawal sequence, and implementing charitable strategies requires complex planning.

A financial professional can help you run projections on your tax burden in retirement, identify the best accounts to withdraw from first, and help seek to preserve your income. By strategizing withdrawals accordingly, you help avoid costly penalties.

If you have questions on how to best prepare for the future, one of our advisors would be happy to help.

Sources:

https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds

https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-iras

https://www.investopedia.com/required-minimum-distributions-impact-traditional-ira-balance-11711080

The source(s) used to prepare this material is/are believed to be true, accurate and reliable, but is/are not guaranteed. This information is provided as general information and is not intended to be specific financial guidance.  Before you make any decisions regarding your personal financial situation, you should consult a financial or tax professional to discuss your individual circumstances and objectives.