6 Tax Planning Strategies to Optimize Your Retirement Wealth
6 Tax Planning Strategies to Optimize Your Retirement Wealth

6 Tax Planning Strategies to Optimize Your Retirement Wealth

You’ll benefit from the tax planning strategies in this post, whether you are currently retired or are still counting down the years, months, or days until retirement.

Being deliberate about your income, investment vehicles, and tax planning now could have a material effect on your wealth during your retirement years. It can also impact the legacy you leave to your loved ones when you die.

In fact, beginning your retirement tax planning years in advance will give you the best chance of realizing long-term tax savings.

Table of Contents

  1. Strategic Income Planning
  2. Social Security Planning
  3. Roth IRA Conversions
  4. Asset Location
  5. Investment Vehicles
  6. Work with a Qualified Wealth Advisor

Strategic Income Planning

Tax planning strategies for retirement income
Tax planning strategies for retirement income

When you reach your retirement years, you have an element of control over your income that most people in their working years don’t have. By taking a strategic approach to when you withdraw funds from your retirement accounts, how much you withdraw, and where the withdrawals come from, you may be able to maximize your wealth and lower your overall tax obligations.

Some retirees intentionally refrain from making withdrawals from tax-deferred retirement accounts until absolutely necessary. The goal for most people with this type of planning is to shift their income to the years when they would otherwise have a lower tax liability, rather than drawing on tax-deferred retirement accounts when in a higher tax bracket.

Under the Tax Cuts and Jobs Act of 2018, tax brackets are broad. So, there may be an opportunity to “fill up” your current tax bracket by adding retirement income without moving to a higher marginal tax bracket. For retirees with a significant amount of tax deductions in a given year, it may be smart to increase retirement plan distributions for that year to take full advantage of all available deductions. And, pre-retirees and early retirees should both take advantage of years when income is lower to prepare for the increase in taxable income brought on by both Social Security and required minimum distributions (RMD’s).

These strategies look different for everyone. Ultimately, it often comes down to evaluating all available options and striking the right balance between paying more taxes now or potentially paying higher tax rates and ultimately even more taxes in the future.

Tax Planning Strategies for Social Security

Tax planning strategies for social security income
Photographer: NeONBRAND | Source: Unsplash

Many retirees automatically assume they should start taking Social Security the moment they reach full retirement age. However, that may not be the most advantageous from a tax planning point of view. Delaying the date you begin drawing benefits may provide for a greater benefit over time. For other retirees, it is smarter to actually claim Social Security benefits at an earlier date.

These decisions depend on a number of factors. If you have not already begun drawing Social Security benefits, talk to your financial professional about your options. Your wealth advisor can help you evaluate Social Security retirement income planning strategies, so you can make more informed decisions.

Roth IRA Conversions

Tax Planning Strategies using Roth IRA Conversions
Tax Planning Strategies using Roth IRA Conversions

Another strategy investors should evaluate is whether it makes financial sense to convert part or all of a traditional IRA to a Roth IRA. Looking at some of the features of both traditional IRAs and Roth IRAs helps explain why this is a good option for some people.

Traditional IRAs

  • When you contribute to a traditional IRA, you may get a tax deduction for your contributions. Your account balance then grows tax-deferred until you’re ready to take distributions, or until age 70½, when you are required to begin taking RMD’s. When you take a distribution, you are generally taxed at ordinary income tax rates on the entire amount withdrawn.

Roth IRAs

  • When you contribute to a Roth IRA, there is no tax deduction for your contribution. Similar to traditional IRAs, you also don’t pay taxes on the growth of your investments if the account’s value increases over the years. Unlike traditional IRA distributions, all qualified distributions of the initial contribution and the subsequent growth from Roth IRAs are income tax-free! For any distribution to be considered qualified, the contribution must have been in the account for at least five years. Distributions of the contribution growth incur an early distribution penalty if the owner has not reached the age of 59 1/2, there are however a few exceptions to this rule.

Roth IRA Conversion Benefits

There are actually several potential benefits to Roth IRA conversions:

  1. Roth IRAs do not have the RMD rules that traditional IRAs come with. For unprepared retirees, RMD’s can create an unwelcome “tax bomb” because the entire distribution is taxable as ordinary income. Without careful planning, traditional IRA RMD’s can send retirees into a higher tax bracket.
  2. As mentioned above, Roth IRA’s offer tax-free accumulation and qualified withdrawals are income tax-free. So, when you convert from a traditional IRA to a Roth IRA, you will be shifting from tax-deferred growth to tax-free growth. That’s a beautiful thing.
  3. Many of the provisions of the Tax Cuts and Jobs Act, including the lower tax rates for most taxpayers this year, are set to expire in 2025. That means RMD’s and other distributions from traditional IRAs in 2025 or later could have even bigger negative tax consequences for retirees.
  4. Last, but not least, when you convert a traditional IRA to a Roth IRA, your heirs will inherit a lifetime source of tax-free growth and income.

Of course, Roth IRA conversions do not make sense for every investor. And, it is important to understand that converting a traditional IRA to a Roth IRA may negatively impact your taxes in the year of conversion. That’s because the entire amount converted is generally taxed as ordinary income. Still, the benefits above may offset the tax hit you would realize from converting. Talk to your wealth advisor about whether a Roth conversion may make sense for you this year.

Asset Location

Asset location,not to be confused with asset allocation

When you are evaluating potential retirement tax solutions, don’t overlook the importance of asset location (not to be confused with asset allocation.) Simply put, asset location refers to making careful decisions about where (in what types of accounts) you hold different types of investments. That’s important because different types of investments, such as municipal bonds, growth stocks, and real estate investments, come with different tax implications. And, different types of investment vehicles are taxed differently too. Ideally, the most tax-efficient investments should be held in the least tax-efficient vehicle.

Asset location, when effective, can positively impact the tax efficiency of your overall investment portfolio. A skilled wealth advisor will look at each element of your portfolio and help you structure investments in a way that is designed to give you the most favorable tax treatment in your retirement years.

Investment Vehicles

Which investment vehicles are right for you?
Which investment vehicles are right for you?

While tax efficiency is an important component of your retirement income planning, remember to also factor in investment gains and expenses when making decisions about what types of investment vehicles to buy, or what types of assets to invest in. An otherwise-tax efficient investment may not make sense if it comes with fees and expenses that negate the tax benefits.

Unfortunately, many retirees own annuities or other products that were sold on the basis of an attractive tax-deferred potential growth. The reality is that some insurance and investment products come with exorbitant fees — fees that can quickly negate half or more of the expected gains. To add insult to injury, those gains and principal distributions are generally taxed as ordinary income at the investors’ highest marginal tax rate.

That’s not to say you should never invest in an annuity. But, you should always understand the potential implications and expenses associated with different types of investments and investment vehicles. An ideal retirement portfolio typically consists of a diversified mix of tax-deferred, tax-free, and taxable investments, and a variety of vehicles. Optimizing retirement wealth means considering each element of your portfolio individually and as part of the whole.

Work with a Qualified Wealth Advisor

Having a plan in place for your retirement distributions can help you make the most of the money you spent a lifetime accumulating. Your plan should be tailored for you, and should be based on your specific goals, income, expenses, tax bracket, risk tolerance, investment holdings, and more. For most retirees, the traditional “one account at a time” method of drawing down retirement savings simply isn’t the most tax efficient method.

Working with a tax-focused, fiduciary, fee-only wealth advisor is key to creating a tax saver plan customized to help you meet your goals. To learn more, contact us today.

We are proud to be a tax-focused, fiduciary, fee-only wealth advisor

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About the Author Doug Finley

Douglas Finley founded Finley Wealth Management, a Fee-Only Registered Investment Advisor, with the goal of creating a firm that eliminated the conflicts of interest inherent in the financial planner – advisor/client relationship. The firm specializes in financial planning and investment management for high-net-worth individuals and families.

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