As you near retirement, it is critical to consider tax efficiency carefully. Although saving and investing for retirement is crucial, it is just as vital to develop strategies that minimize your tax liability throughout your golden years. By adopting tax-efficient approaches, you can potentially increase the worth of your retirement savings and experience a more financially stable future.
Understanding Tax Efficiency
Tax efficiency in retirement refers to the optimization of your financial decisions to minimize tax liabilities and maximize after-tax income. By employing tax-efficient strategies, you can preserve more of your hard-earned money, allowing it to grow and sustain your retirement lifestyle.
Why Tax Efficiency Matters in Retirement
- Preserving Your Savings: As a retiree, you’ll likely rely on your savings and investment income to cover living expenses. Minimizing your tax obligations means you potentially get to keep more of your money, helping your savings last longer and providing a more stable financial foundation.
- Enhancing Investment Returns: Taxes can erode your investment returns over time. By strategically managing your investments and utilizing tax-efficient investment vehicles, you can minimize the impact of taxes on your investment gains. This enables your retirement portfolio to grow more effectively.
- Balancing Income Streams: During retirement, you may have various sources of income, such as Social Security benefits, pension payments and withdrawals from retirement accounts. Optimizing the timing and amounts of these income streams can help you avoid unnecessary tax burdens and reduce the likelihood of moving into higher tax brackets.
Strategies for Tax Efficiency in Retirement
Utilize Retirement Accounts with Tax Advantages
Traditional retirement accounts offer tax-deferred growth, which includes 401(k)s, 403(b)s, and traditional IRAs—but withdrawals are subject to ordinary income tax rates. Roth accounts, on the other hand, are funded with after-tax dollars, allowing for tax-free withdrawals during retirement.
Roth IRAs are exempt from RMDs (unless you inherit them). A Roth 401(k) is not, although if you retire in 2023, you can still avoid RMDs by rolling it into a Roth IRA. SECURE Act 2.0 does away with Roth 401(k) RMDs starting in 2024.
Consider Capital Gains / Taxable Income
Consider tax-efficient investment strategies, such as ETFs. Unlike mutual funds, ETFs are not required to distribute capital gains to shareholders. ETFs are structured as open-ended investment companies or unit investment trusts, which allows them to be exempt from paying capital gains taxes when securities are bought or sold within the fund. Instead, ETF investors may be subject to capital gains taxes when they sell their ETF shares, similar to individual stocks. This structure helps prevent the realization of capital gains within the fund, reducing the likelihood of taxable distributions.
Municipal bonds, often referred to as “munis,” are debt securities issued by state and local governments and their agencies, municipalities, and other government entities. One of the key advantages of investing in municipal bonds is their potential for tax-free income.
- Federal tax exemption: The interest earned from most municipal bonds is exempt from federal income taxes. This means that the income generated by holding municipal bonds is not subject to federal income tax, which can be a significant advantage for investors in higher tax brackets. However, certain types of municipal bonds, such as private activity bonds, may be subject to federal taxes.
- State and local tax exemption: In addition to federal tax benefits, municipal bonds can also offer tax advantages at the state and local levels. If you purchase municipal bonds issued by your own state or municipality, the interest income is also usually exempt from state and local income taxes. This exemption can vary depending on the laws and regulations of the specific state or municipality, so it’s important to check the rules in your state.
- Tax-free capital gains: When selling a municipal bond, any capital gains realized from the sale may be tax-free as well. If you sell a muni bond at a higher price than what you paid for it, the capital appreciation is generally not subject to federal taxes. However, if you sell a bond at a loss, you may not be able to claim a tax deduction for the loss.
Determine Your Social Security Strategy
There are many factors to consider when deciding if and when you start taking Social Security payments. You need to weigh your cash needs, your life expectancy, marital status and employment status. If you are still working and making enough income to impact the taxability of your benefits, it can be wise to consider waiting.
Married couples have the opportunity to optimize Social Security benefits by coordinating spousal benefits. Understanding the various claiming strategies can help maximize the combined benefits while minimizing the tax implications. The land of Social Security is very complex, and I highly recommend seeking advice from a professional before taking or delaying benefits.
- Taxation of Social Security Benefits: If your provisional income exceeds the applicable base amount of $25,000 for single filers and $32,000 for married, a portion of your Social Security benefits may become taxable. The specific amount that is subject to taxation is based on a formula provided by the IRS. Generally, up to 50% of your Social Security benefits can be taxed if your provisional income is between the base amount and the upper threshold.
- If your provisional income exceeds the upper threshold, $34,000 for single filers and $44,000 for married, up to 85% of your benefits may be subject to taxation.
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“When planning to take Social Security benefits, I first look at all income sources and if it is possible to manipulate your income stream so that your provisional income stays below the thresholds listed above, says Andrew Barnes, Wealth Advisor and Shareholder for Wymer Brownlee Wealth Strategies. “We may do this by using primarily after-tax sources of income and taxable sources right up to limits.”
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Give in a Smarter Way
A popular tax-saving strategy called qualified charitable distributions (QCD) is beneficial if you’re planning to withdraw from your IRA and looking to make charitable donations, but it will depend on your unique financial situation. A QCD lets you directly transfer up to $100,000 in tax-deferred retirement savings to the qualified charity of your choice tax-free. So, instead of liquidating the assets, paying taxes and then donating the proceeds—a transaction that must be included in adjusted gross income (AGI)—you donate the money directly and avoid a taxable event.
A Donor-Advised Fund is a charitable giving vehicle that allows individuals, families, and organizations to make tax-deductible contributions to a fund, receive an immediate tax benefit, and then recommend grants from the fund to support charitable organizations over time. When you contribute to a Donor-Advised Fund, you are generally eligible for an immediate tax deduction for the full value of the donation, subject to certain limitations and rules set by tax laws. This allows you to reduce your taxable income in the year of the contribution, potentially providing significant tax benefits.
The Big Picture
One of the best ways to help you stay on track for retirement is to develop a long-term financial strategy that takes into account your current financial circumstances and future goals. At Wymer Brownlee, we believe in a holistic approach that aims to help you map out important milestones—like a house purchase, a child’s college expenses, or your future retirement—and ensure that you are putting enough away for future goals. If you’re looking to talk with an advisor or want a complimentary, no-obligation review of your current retirement accounts, I’m just a phone call away.
Andrew Barnes
Wealth Advisor & Shareholder
Category: Financial Service Team
