A Strategy for Making the Most of Your Retirement Savings
Carefully Managing Your Portfolio Distributions Can Lower Your Tax Burden in Retirement
Most retirees rely on their investment accounts to create income in retirement, and this is a smart move even though investing in the markets comes with a certain level of risk. Since we can’t predict how well the markets will perform, though, it’s smart to make sure you’re making the most of your retirement savings by implementing a strategy to lower your tax burden in retirement.
Read on to learn more about a strategy that allows you to save on taxes, leaving you more money to spend on the things you really enjoy.
The Problem: Higher Taxes
One of the biggest challenges retirees face in retirement is an unexpectedly high jump in their tax burdens. This is because, generally, any contributions that are made to traditional retirement savings accounts such as a 401(k) or an IRA are made using pre-tax dollars and they grow tax-deferred until you begin to take withdrawals in retirement. Once that happens, the IRS treats those withdrawn funds as ordinary income and taxes them accordingly each year. For many, this jump in reported income can lead to a jump in tax bracket and, therefore, an increase in taxes owed.
The Cause: Required Minimum Distributions
One might wonder why anyone would withdraw more money than they reasonably need to support themselves each month. The reality is that the amount you withdraw is largely out of your control due to required minimum distributions (RMDs). By the age of 72 (or, by the age of 70 ½ for those who reached the age of 70 ½ in 2019 or earlier), retirees are required to begin withdrawing a specific amount of money from their tax-deferred retirement accounts or they face steep penalties.
SEE ALSO: Seven Steps for Planning Your Retirement As a Couple
For those with a large amount saved up in their retirement savings account, the RMD can end up being significantly more money than what the retiree needs to support themselves, especially once you take into account any other income sources, such as Social Security. With our current tax code, those withdrawals are taxed at high rates and can significantly raise your tax bill.
The Strategy: Income Smoothing
A strategy to fight against this income jump – and, in turn, tax increases – is called “income smoothing.” The idea is that you can prevent higher income levels from being recognized and therefore avoid being pushed into a higher tax bracket.
Here’s an example of how income smoothing can work to reduce your taxes:
Take a couple who are both 60 years old and are planning to spend around $20,000 each month in retirement. Combined, they have tax-deferred assets of $7 million and taxable assets of nearly $3 million. Following common practice, say they spend their taxable assets first, which entails selling any securities that would be subject to the lower capital-gains tax rate. The result would be that during their first few years of retirement, their taxable income would be quite low and consequently, so would their tax bill.
However, once they hit 72, the RMD mandate would force them to begin withdrawing from their tax-deferred accounts, pushing their income into the highest tax bracket and causing their tax rate to spike.
If they wanted to avoid this spike by smoothing out their income, then the couple could begin taking distributions from their tax-deferred accounts at an earlier age, resulting in lower estimated average tax costs throughout their retirement. This means that they would have more financial resources available to support their other financial goals.
SEE ALSO: Four Ways You Can Avoid Retirement Tax Surprises
Note: One thing to be cautious of when smoothing income, however, is that tax rates change and if tax rates were ever to drop in the future, that could adversely impact the tax efficiency of this strategy. However, if tax rates were to rise – as many economists believe they will – then the tax benefits would be magnified. Of course, no one can predict the future.
Final Thoughts on Making the Most of Your Retirement Dollars
Income smoothing is just one of many strategies retirees can use to maximize their retirement savings and prepare themselves for retirement. One of its biggest perks is that it doesn’t require you to take on any more investment risk than you already are by investing in the first place. When used with other strategies that reduce tax costs or work to increase your flexibility to control the way your income is recognized on a tax return, income smoothing becomes even more ideal.
Utilizing strategies that can maximize your savings is important if you’d like to achieve your retirement goals. It can sometimes be difficult to see the big picture and how various strategies can work together to help you make the most of your money, so it may be beneficial to sit down with a professional that you trust to ensure you’re making the most of all the options available to you.
Whether you’re getting ready to retire or already enjoying retirement, our team of financial advisors can help you determine a retirement savings strategy that works for your unique financial situation. Contact us today to schedule a no-obligation meeting and get started on designing the right retirement plan for you.