Plan ahead to optimize your tax strategy in retirement

Let's look at 3 decisions that can influence how much tax you'll pay over the years.

1. Timing your Social Security benefits. Deciding when to start taking Social Security benefits depends on your personal and family circumstances. You can start drawing your retirement benefit at age 62 and get about 70% of your full benefit. You can wait until full retirement age* to receive 100% of your benefit. Or you can choose to defer for a few more years and add 8% to your benefit each year, up to age 70. (Note: This only applies to your earned income benefit—if you're collecting survivor or dependent benefits, those won't increase after you reach full retirement age.)

Among the questions you'll want to ask yourself: 

• Do you have other sources of income to draw upon in retirement? 
• Do you have a spousal benefit to consider?
• Are there health issues that may impact your timing?
• Do you plan to keep working in retirement?

The good news is that no matter how much you earn, 15% of your Social Security benefits are tax-exempt. Retirees with moderate or higher incomes will likely pay federal taxes on some portion of their benefits. And 13 states currently impose a state income tax on Social Security benefits.** 

Social Security benefits get favorable tax treatment compared to retirement income from other sources, like traditional 401(k)s or traditional IRAs, where your withdrawals are taxed as ordinary income. (The exception here is the Roth IRA, where contributions are made with after-tax dollars but withdrawals are tax-free.) You'll want to factor this in when considering whether or how long to delay claiming Social Security benefits. If you can draw down from tax-deferred assets like a traditional 401(k) or traditional IRA before you start collecting Social Security, this can help you balance out current and future taxes.  

Keep in mind that Social Security is a government-backed, cost-of-living-adjusted income that will last as long as you live. Can you afford to spend from other accounts while you let your benefit grow?  

You can estimate your retirement benefits, and how changes in timing might impact them, on the Social Security Administration website.

2. Considering your asset location.  If your income today is higher than what you expect it to be in retirement, it's a good idea use tax-advantaged accounts like traditional IRA and 401(k) accounts. These allow you to take a tax deduction each year you contribute and defer those taxes until retirement. Roth IRAs and Roth accounts within employer plans offer a different tax advantage, in that you pay taxes on contributions today so you can enjoy tax-free withdrawals in the future (provided you follow a few basic rules).   

If you're invested in traditional tax-deferred accounts and retire at a much lower tax bracket, this works out to your advantage. But if you end up in the same or a higher tax bracket in retirement, you've simply delayed your tax bill—and possibly increased it, should tax levels increase in the future. And if all your savings are in tax-deferred investments, you're stuck with that bill as a retiree. 

That's why Lobel stresses the importance of what's known as asset location when working with his clients.  “It's important to diversify from a tax standpoint almost as much as it is from an asset standpoint,” he explains. When you have assets invested in diverse locations, or account types, with different tax rules that apply, you have greater flexibility in drawing your retirement income—and more control over how much tax you'll pay from year to year. 

Converting assets to a Roth IRA can help diversify your income streams in retirement—while reducing future RMD amounts. And if you're nearing retirement, converting some of your existing assets may be a better move than contributing new money into a Roth IRA. When you convert to a Roth, you'll owe ordinary income tax on the pre-tax assets you roll over, so you'll want to make sure you have money available (outside of your retirement accounts) to cover that amount. Given the tax implications, consider how much "ceiling" you have to increase your taxable income and still stay within your current bracket, or a bracket that's affordable for you. You may decide to convert only a portion of the traditional IRA to start with and convert the rest over the next few years.

You should also be aware of 2 "tax traps" conversions can trigger:

• Taxes on Social Security benefits: When you covert to a Roth IRA, you'll pay taxes on the event itself—but be aware that the additional income from the conversion could also subject a higher percentage of your Social Security benefits to taxes. If you're already past the income thresholds and are paying tax on 85% of your benefit, this isn't an issue.
• Medicare IRMAA surcharges: If you're on Medicare, or planning to start within 2 years, going even $1 over the income threshold could mean hundreds of dollars in additional premiums, through their "income-related monthly adjustment amount" (IRMAA). This is assessed annually, so it's not permanent.  

Bottom line: Converting assets to a Roth IRA can be a great tool for balancing out your tax burden over the years. Just be mindful of how much is the right amount for you to convert. If you're too aggressive, you might end up incurring higher taxes now, when you could have cut your lifetime tax bill substantially by following a long-term plan.

3. Planning your withdrawal strategy, including RMDs. Deciding which of your accounts to tap into, and in what order, means putting all these pieces together, while also factoring in your RMDs. These are the amounts you're required to withdraw from certain tax-advantaged accounts, including all employer-sponsored retirement plans and traditional IRAs, starting when you reach age 73***.

The IRS has worksheets to help you calculate your amounts, but the key thing to know is that your RMDs will increase if you maintain high balances in tax-deferred accounts. That's something to consider before you reach RMD age, Lobel advises, when you'll have more ways to optimize your tax approach.  

By spreading out your withdrawals and choosing to pull money from both taxable and non-taxable sources before you’re required to start taking RMDs, you can reduce your taxable income each year. If you can remain in the 12% bracket as opposed to 22% tax bracket for a few years, it could potentially save you thousands of dollars.

For example, an investor who saved money in a pre-tax account, such as a 401(k) plan, may have also invested in taxable assets that offer tax-advantaged income such as qualified dividends (or in some cases tax-exempt municipal bond interest). Withdrawals from the 401(k) account are taxed as ordinary income, but qualified dividends (like long-term capital gains) are taxed at lower rates. If they also have a Roth IRA, they can take tax-free distributions from that account as long as they followed the rules.

With a diverse menu of options, this investor can afford to be “tax nimble” when drawing their retirement income—keeping an eye on their taxable income level from year to year and adjusting their withdrawal strategy as needed.