Here's a sad story that affects many, if not most retirees. You do the right thing during your working years by contributing to retirement savings plans. Then you're walloped with taxes when you start withdrawing them after retirement. But there may be some ways to control your taxes, particularly if you have money both inside and outside retirement plans.
If all or most of your money is in retirement plans. If all or most of your money is in retirement accounts, there's not much you can do to avoid the tax bite. Don't feel badly, though, because you did the right thing during your working years by putting as much money as possible into tax-advantaged retirement plans. There may be a couple of tax-reducing opportunities, however.
- Because most of your income will be taxable, be assiduous in identifying any and all tax deductions for which you qualify.
- Be particularly careful about your income tax bracket. If you find that your planned withdrawals from traditional IRAs will put you into a higher tax bracket (from the 15% to the 25% bracket, for example), look for ways to avoid a late year IRA withdrawal to keep you in the lower bracket. You could use credit cards toward the end of the year, but you'll want to repay them early in the following year. If your end-of-year expenses are particularly high, perhaps you're buying me a particularly expensive holiday gift, you can borrow from your IRA. So long as you replenish the amount withdrawn within 60 days of withdrawal, you don't have to pay taxes on the borrowed money. (This is available once per year per IRA account.) If you have a Roth IRA, you could withdraw from that account rather than a traditional IRA to avoid moving into a higher income tax bracket as well.
If you have money both inside and outside retirement plans. More tax planning opportunities inure to those who have both retirement plans and money in non retirement accounts (brokerage accounts and bank accounts, for example).
- You'll probably be able to reduce your taxes – perhaps considerably – in your early years of retirement simply by withdrawing money from your non retirement accounts before tapping into your retirement accounts. The math is simple, and compelling. If you need $24,000 per year for living expenses and you're in the 25% income tax bracket, you'll need to withdraw $32,000 from retirement accounts in order to have $24,000 left over after taxes. Withdrawals from non retirement accounts, on the other hand, are subject to much lower taxes, if any. For example, you would need to withdraw only $24,000 from a money market fund – or slightly more to account for taxes on the interest – to net the needed $24,000. So the rule of thumb is:
Withdraw already-taxed (non-retirement) money first. Following this strategy may place you in a position of owing little or not income taxes. Therefore, there is one exception to this rule: If you come up to the end of the tax year and find that you're due to pay zero tax or you're in the lowest tax bracket, take advantage of your low bracket by withdrawing enough money from your retirement account to have it taxed at the lowest tax rate.
- If you have abundant money outside retirement plans and you're in a low income tax bracket, consider converting some of your traditional IRAs into Roth IRAs, using the non retirement money to pay the income taxes. If you qualify, Roth conversions are often very advantageous, even for retirees.
- If you still have considerable non retirement money once you reach age 70½ and have to begin withdrawing from your retirement accounts, strive to make only minimum required distributions (MRDs). This will allow the money in your retirement accounts to continue to grow tax deferred. While we don't want to contemplate your demise, current tax rules are very favorable for transferring retirement accounts to younger generation family members.