Once a year, I make the mistake of playing a video game with my son, Kevin. “This should be fun!” I think right before being knocked out, dunked on, or hit with a rocket launcher. Years ago, we were playing Mortal Kombat, a game where characters with names like Raiden and Nightwolf fight to the death. I was punching and kicking my heart out when Kevin expertly used a series of moves that resulted in flames erupting from his hands and burning my guy to a crisp. “How the heck did you do that?!” I asked. “Combinations, Dad,” he sighed. “You gotta press the right buttons in the right order to unlock the best combos.”
This memory surfaced recently when I was talking to a couple about how to minimize their taxes in retirement. Through a combination of moves made in the right order, retirees are able to save thousands of dollars in taxes and unlock the full potential of their retirement savings.
1. Plan ahead to reduce expenses in retirement.
The higher your cost of living, the more money you’ll need to withdraw from your taxable retirement accounts. One way to keep costs down is to payoff debts such as your credit cards and mortgages before retirement. If you can avoid a large monthly mortgage payment, you’ll avoid paying it off with taxed funds.
2. Remain in the lowest possible tax bracket.
Most retirement income is taxable and therefore subject to higher taxes in higher tax brackets. The couple I met with is planning on retiring at 65. She has a pension and they both will be collecting social security. As a result, they do not plan to withdraw money from their retirement accounts until they are forced to by the IRS at age 70 1/2. Looking at their projected income, we noted that their tax bracket would be 15% between ages 65 and 70 and then dramatically increase to 28% once they turned 70 1/2. We determined that they could withdraw roughly $20,000/yr over the next 5 years and remain in the 15% bracket for the duration of their retirement. The strategy will save $13,000 and build up cash reserves for traveling and other expenses.
3. Tap your accounts in the correct order.
The order in which you access your retirement accounts can mean the difference of thousands of dollars and is dependent on your specific situation, so it’s important to work with a professional. Generally, income made on appreciated assets is taxed at the capital gains rate, which is a lower rate than income taxes. Selling assets allows your tax-deferred and tax-free retirement accounts to keep growing. Next, many retirees access their tax-deferred accounts such as a pension or 401(k). As discussed in #2, the goal is to strategically withdraw from these while paying the least amount of taxes. If you have a Roth IRA, it is often best to save that account for last because it will have the longest to grow before you withdraw from it tax-free.
4. Take advantage of the Roth IRA.
As we just noted, a Roth IRA is a tax-exempt account that isn’t taxed as ordinary income. This makes it a very flexible account that can be used in a variety of ways to minimize your taxes. Throughout retirement, situations may arise where large sums may be needed to pay medical or home maintenance bills. Withdrawing large amounts from an IRA may bump you into a higher tax bracket, but withdrawing from a Roth won’t trigger a tax liability. Finally, from an estate-planning standpoint, any money inherited by heirs in a Roth usually won’t be taxed.
In my yearly meetings with Kevin through Playstation, he reminds me that it takes more than playing once a year to be an expert “gamer.” We meet with our clients once a year, but use our experience year round to put you in the best situation when you retire. A huge part of how we do this is by helping minimize taxes once you’ve transitioned into the next phase of your life.
Your goals and dreams change. Financial products do not. Clients work with us because we don’t sell products – we create customized plans based on each client’s unique goals, and we continuously reevaluate client plans to ensure they are aligned with changing needs. Our clients rely on us to protect their futures, and we take their trust to heart.
Tim Scannell, CPA, CFP® provides Personal and Business Tax Planning, Estate Planning, Investment Management, and Generational Wealth management to his clients. “Clients work with us because we don’t sell products – we create customized plans based on each client’s unique goals, and we continuously reevaluate client plans to ensure they are aligned with changing needs. Our clients rely on us to protect their futures, and we take their trust to heart.