FREE NEWSLETTER
RETIREMENT CAN—ironically—take work. It requires us to restructure how we think about both our time and our finances. That rethinking extends to tax planning, which tends to move to center stage once we quit the workforce. Already retired or approaching retirement? There are several tax strategies worth considering.
But before we review specific strategies, it’s worth pondering a more fundamental change wrought by retirement. During our working years, the usual goal is to minimize our tax bill each year. But in retirement, the objective is different: It’s to minimize our total lifetime tax bill.
Let’s say you have two accounts, a traditional IRA and a Roth IRA. Withdrawals from the traditional IRA will be taxable, while Roth withdrawals will be tax-free. If you simply wanted to minimize your tax bill in a given year, you could draw all of your living expenses from your Roth. But if you did that every year, eventually your Roth would be depleted, and then you’d have to turn to your traditional IRA for all future withdrawals.
Result? Because withdrawals in later years would lean so heavily on your traditional IRA, that could force you into higher income-tax brackets, causing your retirement’s aggregate tax bill to be higher than if you’d more evenly weighted withdrawals over the years. Because of this dynamic, a priority for retirees is to pick a target tax bracket—one that, they believe, will more or less remain the same throughout retirement. How should you go about choosing a bracket? I see it as a three-step process.
First, you’ll want to estimate your potential maximum tax rate in retirement. That will most likely be in your mid- or late 70s, after you’ve started both Social Security and required minimum distributions (RMDs). Next, you’ll want to estimate your minimum tax rate. That’s typically in the years immediately after retirement, before those other income sources kick in.
Finally, to choose an ideal target for the entirety of your retirement, you’ll want to pick a rate somewhere between the estimated minimum and maximum. Got that? Now, let’s turn to specific strategies.
Roth contributions. The first strategy is one you can implement even before you retire. Suppose you normally contribute to a tax-deductible 401(k) or 403(b). That usually makes sense during your working years, when your tax rate is at a high point. But for some people, this playbook has a wrinkle.
If your plan is to move gradually into retirement, perhaps working a reduced schedule for some time, your tax rate might also drop. If it drops enough, it may make sense to shift your retirement contributions to your employer’s Roth 401(k) or Roth 403(b). Yes, you’ll forgo the immediate tax deduction. But if your tax rate is lower, the benefit you’ll be giving up will be smaller, and it’ll allow you to build up valuable Roth money.
Medicare surcharges. Once you’ve entered retirement and you’re on Medicare, you may be frustrated by the income-related surcharges added to your premiums. Because these surcharges are calculated on a two-year lagged basis, they can be quite high in your first years of retirement. Fortunately, the government has an appeals process. Look for Form SSA-44. You’ll notice that it offers eight possible reasons to request an adjustment, one of which is “work stoppage”—in other words, retirement.
Roth conversions. In your first full year of retirement, you might consider a Roth conversion. In the past, I’ve described the mechanics and the many benefits of conversions. The goal: Undertake Roth conversions to smooth out each year’s income, so you remain in your target tax bracket.
Portfolio structure. The objective of Roth conversions is to reduce future RMDs. That, in turn, can help keep a lid on your future tax rate. Portfolio structure can also help to limit future RMDs. To do this, you’ll want to house your fastest-growing assets—typically stocks—in your Roth IRA, thereby taking advantage of the tax-free growth. Meanwhile, you’ll want to locate your slowest-growing assets—typically bonds—in your traditional, tax-deferred accounts. The result: Your tax-deferred account will grow much more slowly, thus limiting future RMDs.
Roth IRAs are most attractive for holding stocks, but you can also house stocks in your taxable account. Yes, this means you’ll incur capital gains taxes when you sell your stocks down the road. But capital gains rates are often lower than the ordinary income rates that apply to withdrawals from traditional retirement accounts. Moreover, at death, appreciated assets benefit from a step-up in cost basis, thus nixing the embedded capital gains tax bill.
Charitable giving. Suppose you’re further along in retirement and contending with RMDs that exceed your annual expenses, causing your tax rate to creep up. After age 70½, you could turn to a strategy known as qualified charitable distributions (QCDs). Consider a retiree whose RMD is $100,000 but who only needs $80,000 for expenses. This is where QCDs can be a godsend. If this retiree were to give $20,000 directly from his traditional IRA to a charity, it would count toward his RMD but wouldn’t add to his taxable income.
Monitoring the mix. If you’re still many years from retirement, are there any steps you can take now? Two strategies are worth considering. First, keep an eye on your mix of retirement accounts. Sometimes, high-income taxpayers become too enthusiastic over tax-deferral strategies, such as employing cash balance plans that end up deferring six-figure sums each year.
While these plans can make sense, they can also have an unintended consequence. If the tax-deferred balances grow too large, the resulting RMDs can push a retiree into a very high tax bracket later in life. This is unusual, but I’ve seen it happen, so it’s worth doing some projections to see where your retirement balances might end up once you’re in your 70s. You could then adjust your contributions, if need be.
Direct indexing. Another suggestion for those in their working years: In the past, I’ve discussed the concept of direct indexing. Instead of owning an S&P 500 index fund, for example, a direct indexing service would purchase all 500 stocks individually. While this might sound unwieldy—and the cost is certainly higher—it can deliver a benefit over time. When you reach retirement and want to take withdrawals, you’ll have much more control over the gains you realize each year. You’d also have the option of donating the most highly appreciated stocks to charity.
Because direct indexing has pros and cons, you shouldn’t view this as an all-or-nothing decision. You might establish a separate account with just a portion of your assets dedicated to the strategy.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
Want to receive our weekly newsletter? Sign up now. How about our daily alert about the site's latest posts? Join the list.
Of all the articles on HB , this is the one I keep coming back to time and time again. As I prepare for retirement at the end of the calendar year I am interested in tax consequences but I can’t seem to wrap my head around what I should do. I project our income will be similar to what we have now. We will have two pensions and two S.S. for income. Last year I transferred some money from my traditional IRA to our Roth but my CPA questioned me as to why(?) because I likely won’t have many years of growth to gain much from it. Thank you for all of your insightful articles, especially this one
If someone has enough assets in a Roth IRA to cover all future living expenses, and has an RMD of under $100k, that person should be able to live out the rest of life tax free if they max out their QCD annually, correct? Assume that his/her SS benefits fall under the taxable minimum for the sake of this question.
Yes, that sounds right. But as I explain here, paying high taxes during your career and zero taxes in retirement wouldn’t be financially sensible:
https://humbledollar.com/2024/01/called-to-account/
Of course, but I didn’t pay high taxes while I was working, either!
The problem is that for earners with high incomes, Roth’s don’t make sense while working. After retirement it would cost too much in taxes to convert a worthwhile amount, unless one retired many years before taking SS and had no other income. Also, using a $20k QCD as in this example may reduce your taxes, but it also reduces your income. If you’re in the 22% bracket you save $4400 but you lose $15,600 of your assets. QCD’s are great if you want to donate to charity, but if your only goal is to save taxes, it is not the best option. Even if it increases IRMAA, the premium increase wouldn’t be $15,600 a year.
To me the objective of a Roth Conversion is to reduce taxes and other fees (IRMAA etc.).
Thanks, Rick. The key to saving income taxes is to complete Roth conversions in years when you’re pretty sure your tax rate is at a relative low point. If you’ll be subject to the estate tax, though, then a Roth will almost always work out — because the Federal estate tax rate of 40% is higher than the 37% top tax rate that will apply to Roth conversions.
Always enjoy your articles Adam. One other side benefit of a Roth. It can serve a nice component of an estate plan. For instance, let’s say you have approx 20 years of retirement left. Further assume, that you are in a position where you will not have to touch your Roth for living expenses. An approach is this: List the secondary beneficiary (after your spouse) of the Roth as one of your relatives. In this case, make sure it is a relative who has good financial planning sense. That relative then intherits the Roth (after both spouses pass) in 20 years…tax free (if estate exemptions are not an issue.). Then that relative has the financial sense not to cash in on the Roth for another 10 years (after inheriting it). That is the IRS limit…10 years. So, that Roth has another 30 years (20 yrs of retirement and 10 years after passing) of non-taxable dividends reinvested and capital appreciation. It can serve as a meaningful long term family financial planning tool for various members of the family.
Here’s another idea. I am using my mother’s Roth IRA to pay for any living expenses that would push me above 12% tax bracket while I am performing Roth conversions. This is allowing me to significantly increase the amount I am converting, and allowing the conversions to occur earlier thus giving me more years of compounding.
Thanks for your comment. It’s a nice idea.
Good article Adam. I learned the value of considering taxes in regard to retirement income when we took control of my mother-in-law’s finances. Utilizing extensive medical deductions we were able to draw down her IRA tax-free.This helped extend the life of her portfolio by almost two years. That experience helped us understand the benefits of thinking about taxes, but not letting them rule your thinking. I wish I had started some Roth conversions earlier.
My only addition would be to consider funding an HSA if you are eligible. This is another source of tax-deferral while working, tax-free growth, and tax-free withdrawals for qualified medical expenses. This can be especially useful if an early retiree needs to buy health insurance before medicare eligibility. With a healthy HSA you could elect a high deductible health plan, and use HSA funds as (hopefully infrequently!) needed.
Unfortunately it took me a couple of years meeting with the free investment advisor at my last company before I could get it through my thick skull how valuable maximizing HSA contributions are (although they were fairly new).
I haven’t made that mistake in advising my daughter though!
Thanks, Rick. Agreed — HSA accounts are great and often not well understood.
Ahhhhh, Mr Grossman. Another one of your best! Thank you.
Thank you 🙏🏼
I have to say that, personally, we didn’t even consider Income Taxes when deciding when either of us should retire.
Our main concern was medical insurance.
And, secondly our portfolio’s Compound Annual Growth Rate.
Now our main activity is joyfully spoiling our grandchildren.
We’ve been extremely lucky in our lives.
Hi Winston, thanks. It’s a good point. We shouldn’t lose sight of what the money is for!
To consolidate accounts and provide more investment choices, financial advisors may suggest that you move your 401(k) into a traditional IRA. Before doing this here is something to consider. If you then plan to do an IRA Roth conversion and you have made pre-taxed contributions (total basis) to your traditional IRA, the converted amount will include a portion of the total basis, which is not taxed (similar to taking RMD).This amount is determined on Form 8606, Nondeductible IRAs and is based on the total value of your IRA and the amount you convert. By moving your 401(k) into your IRA the total value of your IRA will increase and therefore the nontaxable portion of your conversion will be reduced. So, if you plan to consolidate and move your 401(k) into your traditional IRA and then convert a portion into a Roth, consider calculating how much that would reduce the nontaxable portion of the converted amount.
This is a clever idea. Randy’s reply, below, offers a variation on this. I’ve done this before, and though it sounds complicated, it works!
Adam, see my response to Randy below please
Your basis in a traditional IRA consists of your nondeductible contributions (that have been taxed). It may be possible to roll all but the basis into your 401(k). Then you can do a virtually tax free Roth conversion of your IRA.
I tried to do that by transferring my IRA at Vanguard that had both deductible and non-deductible IRAs. I know my cost basis and was going to keep the cost basis amount in the Vanguard account and transfer the rest to my Voya work 401k. Then I could do a ROTH conversion on the Vanguard IRA that contained my cost basis. Voya would not allow me to do that. This means I cannot do any back door IRAs.
That’s too bad, but maybe a future employer will allow you to roll in these funds. Or a solo 401(k) if you have any self-employment income.
Luckily my 401(k) is at Fidelity. I was even able to do a mobile deposit of the rollover check from Vanguard.
Randy, that’s clever. Please tell me how do I instruct the custodian of my traditional IRA, which consists of 2 separate funds, to only move the dollar amount that hasn’t already been taxed (contributions & earnings) to my 401(k)? The custodian does not have those records.
Thank you.
Ed, you can tell your custodian exactly how much to roll over, as long as you have a record of your basis. (Check your previous Forms 8606.) It’s the total minus the basis. It may be a good idea to sell all the funds in your IRA first (and do it away from the money market monthly dividend) so you know the amounts you’ll be dealing with, and there will be no (or miniscule) tax on the Roth conversion. Once the funds are in your 401(k) and Roth IRA, you can reinvest as desired.
Thanks, Randy. This is a great strategy as long as the retirement plan provider will accept new funds (which they almost always will).
Adam, I understand the value of tax free Roth income, but not so much avoiding RMDs.
If a person is living off investments, a typical 4% withdrawal is very close to a required RMD. Aren’t they about the same?
Of course, if a person is not taking any withdrawals to live on it doesn’t much matter, the tax free part is the value.
It all depends on the investments you’re living on. I’ve got a very sizable taxable bucket, so for me it isn’t about avoiding RMDs but maxing Roth money and letting it run for decades and letting compounding work.
It’s a very good point. In fact, some folks advocate using the RMD percentages to guide portfolio withdrawals. I was addressing the minority of taxpayers whose RMDs far exceed their spending needs.
Thanks, Adam, yours is always well considered advice.
Other than making a few estimates during my working years, it wasn’t until I retired that I sat down in earnest to understand future withdrawal strategies and tax options. For me, that took building a spreadsheet covering a decade of possibilities with the then current tax rates, modest rates of return, known expenses, and long-term average inflation. The spreadsheet took about a week of work but was hugely informative. A strategy for minimizing taxes, making withdrawals, and maximizing charitable giving became clear.
Here’s something I wonder, though. Had I not been a do-it-yourselfer, could I have gone to a financial advisor like yourself to obtain similar, numeric projections?
This is what financial planners do, and as David comments, below, there are DIY tools. The most important thing, in my opinion, is simply to make a plan. Any plan — in any format or with any software — is almost always better than no plan!
NewRetirement and Honest Math are wonderful options for the DIY set not comfortable building an Excel spreadsheet. I have read enough to know the limitations of Excel. Mike Piper writes and speaks about this issue.