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Tax Strategies in Retirement

A few years ago, my father’s wealth advisor retired, selling his practice to a younger advisor. Aspects of the service to my father changed. For example, no longer would his wealth advisor also do his taxes (the retiring advisor was also a tax accountant). Also, the new advisor shifted my father’s investments to a different set of funds, while keeping the asset allocation mostly the same.

Another aspect that changed was the new arrangement came with check writing, enabling my father simply to write checks from his retirement account, without having to take any intermediate step.

Whatever you think about this new convenience, it came at a cost. Either the advisor had not cautioned my father about the tax implications of writing checks from his retirement account or my father, who is hard of hearing, did not understand.

In any case, at some point my father chose to pay for some large purchase not with cash from his personal checking account, where he had enough for the purchase, but from his retirement account. This purchase greatly exceeded his required minimum distribution (RMD)1 for the year, so as a result, my father had to pay much more in income tax for that year than he otherwise would have done.

1 Retirees used to have to take RMDs beginning at age 70½. The age has been pushed back to 73 and is planned to be moved back eventually to 75.  

This post discusses taxes in retirement, strategies retirees might take, and mistakes, such as my father’s, to avoid. Topics include:

  • Tax Implications in Retirement
  • Specific Tax Planning Strategies
  • Tax-Efficient Retirement Withdrawal Strategies
  • Tax-Efficient Contribution Strategies
  • Advanced Strategies

What follows is not meant to be tax advice or regulatory advice or legal advice! It is meant for general informational purposes only and should not be taken as professional counsel, nor should it be relied upon for making any decisions that could have significant legal, financial, or regulatory implications.

Tax Implications in Retirement

For many people, during their working career they pretty much receive one income stream (two for a couple) at a time. Unless you own income producing businesses or properties, your income tax situation may be simply: your paycheck withholds taxes and in the Spring of each year you either pay or receive the difference between your tax liability and what had been withheld.

In retirement, your number of sources of income might mushroom, including income from:

  • Social Security
  • Pensions
  • Annuities
  • Part-time work
  • Retirement plan withdrawals

Most of us receive Social Security retirement benefits at some point. Even someone who never contributed to the Social Security system, so long as they are or used to be married to someone who did, may receive a Spousal benefit based on their spouse’s earnings history.

You might receive a defined benefit pension.

You might receive income from an annuity.

You might work a part-time job.

If you own any qualified retirement accounts, such as an IRA or a 401(k), you will eventually be required to convert those balances to income.

All these sources of income are subject to Federal income taxation. Exactly how much of your Social Security income is taxable depends on your total income.

Not only do you need to attend to Federal income taxation, but you also need to mind state taxes, if applicable.

General Tax Strategies for Retirement

A common principle among tax strategies in retirement is to take advantage of lower tax brackets when they apply to you.

For example, let’s say someone retires in their 60s, so they are not yet subject to RMDs. They live in their own home, which is paid off, so they do not require much to live on. Suppose their income this year puts them in the 12% bracket, but their 401(k) balance is substantial, so if they leave it alone, they will likely be in the 24% bracket once they are subject to RMDs.

Asset Location
Unlike asset allocation, which pertains to what you invest in, asset location pertains to what type of asset should go in what type of account.
Taxable accounts (e.g., brokerage accounts) ought to be where you hold growth assets that pay little or no dividends. When you sell assets that you have held longer than a year and a day, you may have to pay a capital gains tax, but it will be at a lower rate than your marginal income tax rate. Most retirees avoid keeping income producing and interest-generating assets in taxable accounts, except for tax-free bonds.

Since there is no tax disadvantage, you may keep your dividend-paying and interest-bearing assets in tax-deferred accounts (e.g., traditional 401(k) and IRAs).

Although you must withdraw the minimum amount once you are subject to RMDs, tax-deferred accounts permit you to withdraw as early as age 59 ½. This can be useful to supplement your income if you reduce your hours to part-time or find yourself involuntarily retired.

Provided you have followed IRS rules, withdrawals from Roth accounts should not result in income taxes. Should you find your taxable income being lower while you are in your 60s, you might consider a Roth conversion strategy, in which you convert tax-deferred assets to Roth.

Whether a Roth conversion makes sense might require some financial cost-benefit analysis, in which you project the size of your tax-deferred balance to estimate future RMDs and taxes on them and compare that to your marginal tax rate now.

Tax-Loss Harvesting
As much as you might like never to have losses, if assets in a taxable account have losses, you can realize losses to offset some of your income, partly reducing your tax liability for the year.

Should you realize losses, be sure not to run afoul of wash-sale rules. Wash-sales are when you sell and buy identical assets within 30 days. If you do so, you may not claim the loss on your income taxes. Here, “identical” would apply to a common stock and an option on that stock.

The proliferation of ETFs that are similar but not identical would seem to offer plenty of opportunity to remain fully invested while minding the wash-sale rules, but how you apply that observation is up to you and your tax advisor.

Tax-Efficient Retirement Withdrawal Strategies

How you withdraw from your retirement accounts has profound implications on how much you pay in income taxes during retirement.

The Key to Understanding Different Tax Treatments: Tax Policy Perspective
The key to understanding tax treatment of different retirement account types is to understand them from a policy perspective, which is simply: the IRS wants to tax your income, period.

But it allows some flexibility in you paying those taxes. Under certain circumstances it will allow you to delay paying taxes for decades, so long as you pay them eventually and inevitably.

Such is the case with retirement accounts. In the case of Roth accounts, you fund them with after-tax money. Since you have already been taxed, the policy perspective dictates that you may enjoy the subsequent growth and income from these accounts without paying additional taxes.

Thus, with Roth IRAs and the Roth part of your employer account, your eventual withdrawals from them will be income tax-free.

On the other hand, you were not taxed on your contributions to traditional IRAs and employer plans. The policy perspective dictates then that you will have to be taxed when you withdraw.

And just in case you were hoping to get away with never withdrawing, the IRS has stipulated a schedule by which you are required to withdraw from these tax-deferred accounts once you reach your early 70s. This is a schedule of your RMDs, alluded to at the beginning of this post.

A Generic Rationale for Withdrawal Order

For someone not old enough to be subject to RMDs:

  1. Taxable losses
  2. Long-term gains
  3. Short-term gains
  4. Roth
  5. Health Savings Account (HSA)
  6. Tax-deferred

This is a generic rationale. A personalized rationale would compare present marginal tax rates with future ones. This comparison might result in withdrawing from a tax-deferred account ahead of other accounts, to reduce taxes in the future.

Another consideration is when there is a couple. The same income is taxed at a higher rate for a Single filer than for a couple filing jointly. However, when one spouse dies, after a year the survivor becomes a Single filer, and RMDs are now taxed at a higher marginal rate.

So, it might make sense to take tax-deferred withdrawals now in case either spouse faces a future as a survivor paying high marginal taxes on large RMDs.

Tax-Efficient Contribution Strategies

The implication of the tax perspective presents you with choices for minimizing your lifetime income taxes. Two principles emerge:

  • If your marginal tax rate in retirement will be higher than now, contribute to Roth. If lower, contribute to traditional
  • A corollary to this is that very young workers, whose marginal tax rates now are probably as low as they will ever be, should opt for their employer’s Roth option

The challenge with these principles is we do not know the future. Hence, at GuidedChoice, when advising clients whose plan includes a Roth option, we tend to recommend contributing to both traditional and Roth options. When the clients eventually retire, it will be useful for them to have choices.

HSAs are touted for being “triple tax advantaged.” Contributions are not taxed, growth and income are not taxed, and withdrawals are not taxed provided you spend them on qualified medical costs.

HSAs are valuable as a retirement planning vehicle. In the event you are eligible for one, you should contribute the greatest amount permitted for your age.

Treat your HSA as a Roth retirement account. If you can afford to pay healthcare costs out of pocket instead of withdrawing from your HSA, do so. We also recommend investing HSA balances at the same risk level as we advise they do with their retirement savings.

Advanced Considerations

State Taxes
Retirees flock to income tax-free states such as Texas and Florida not only for the climate but also to avoid paying state income taxes. Before you relocate, be sure to understand what you might pay instead in terms of property and sales taxes.
Estate Planning
Estate planning is crucial for tax efficiency, enabling strategic asset transfer to heirs while minimizing estate and inheritance taxes. It involves using trusts, gifting, and beneficiary designations to reduce taxable estate size, ensuring more of your legacy is passed to your beneficiaries instead of being eroded by taxes.

A common consideration is the different tax treatment between taxable assets and inherited retirement accounts. When heirs inherit taxable assets, the cost basis of the assets “step up” to value at the time of inheritance, while inherited retirement accounts must be liquidated per a certain schedule, with those withdrawals treated as taxable income.

By leaving the taxable assets to a person in a high tax bracket and the IRA to a person in a low bracket, such as a student without income, the retiree plans his estate so as to minimize taxes for his heirs.

Health Care Costs
Just as they are while you are working, healthcare costs can be tax-deductible when they exceed 7.5% of adjusted gross income. This includes expenses like insurance premiums, long-term care costs, and out-of-pocket medical expenses.

Leveraging a Health Savings Account (HSA) for tax-free withdrawals for qualified medical expenses further enhances tax efficiency. Strategic planning, like bunching medical expenses in a single year, can optimize deductions, reducing overall taxable income and easing the financial burden of healthcare in retirement.

Changing Laws, Regulations, and Enforcement Policies
Over just the past few years, the rules about RMD ages, RMD liquidation rules, and Roth contributions in qualified employer plans have changed. Some of these changes were so rushed that Congress had to follow up to add detail or correct some of the language.

In at least one instance, the IRS announced it would not even enforce some of the changes for another year or two, presumably because it felt the rule changes did not afford plans and taxpayers enough time to adjust.
Keep abreast of changes in taxes pertaining to retirees. Pay attention to communication from your employer’s (or former employer’s) HR department, and to relevant sources such as AARP.


For Younger People
If you know any young people with lower incomes than they will probably enjoy later in their career, encourage them to save in their employer’s Roth retirement plan.
Look at Your Employer's Plan
If your employer’s plan offers a Roth option (and if it does not yet, it will soon), consider contributing to a mix of traditional and Roth.
Use Your HSA
If you are eligible for an HSA and you can afford to do so, max out your contributions, invest them as you would your retirement account, and avoid spending from this account until you retire.
Consider a Fee-only Planner
If you have both significant retirement account assets and taxable account assets, consider consulting a fee-only planner about how your assets are located.
Be on the Alert for Changes
Keep abreast of changes in taxes pertaining to retirees.

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