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January 11, 2018Income for Life Retirement Series #8: Reduce Taxes on Retirement Accounts
If you hope to maximize the benefits from all your hard-earned retirement savings, you need to protect as much as you can from Uncle Sam. Fortunately, there are plenty of legal ways to do just that. It will take laying some groundwork and understanding exactly what the government looks for in order to reduce taxes on retirement accounts.
Assuming that you have your money allocated to all the correct “buckets”, the first bucket to protect is your taxable brokerage accounts. That is the money you have not invested in tax-deferred accounts like an IRA or alternative retirement accounts. Since you have already paid taxes on this money, you will only be liable for the dividends and interest they earned, along with the capital gains you earn if you sell the asset. The highest long-term capital gains rate is for assets held for over a year is currently 23.8%. However, most people pay 15%. Those in the lowest of tax brackets pay nothing—that means for a married couple that made $75,900 or less this year, their tax rate would 0%. (For updated rates visit https://www.nerdwallet.com/blog/taxes/capital-gains-tax-rates/)
Once you have covered your taxable accounts, turn your focus to your tax-deferred accounts—like 401k plans or IRAs. Those are the account where the balances grow tax-deferred until you begin to utilize the funds. Once you start taking withdrawals, you’ll pay the ordinary income tax rates. As soon as turn 70 1/2 years old, you are must take the what is known as the Required Minimum Distributions (RMDs) every calendar year. That amount is dependent on balances of all your tax-deferred accounts, divided by a life expectancy factor that is determined by the IRS and your age. The only exception to this rule is if you are still working at age 70 1/2 and contributing to the 401(k) plan where you are employed; in this scenario, you do not need to take RMDs from this consideration.
Finally, the last type of account you need to work on protecting is a Roth IRA. It is unlike the other accounts in that you paid taxes on the money before saving it. However, there are rules you need to follow. The first is you must have owned the account for more than five years if you are not over the age of 59 1/2. All withdrawals are tax-free and can be taken at any time with this type of account. It is also possible to never touch the money unlike a Traditional IRA, which has the RMDs as discussed above. That means in the event that you don’t want the cash; it is possible to leave it at the accounts to continue developing for your heirs. This flexibility makes a Roth a necessary tool for retirement—if you qualify for one. Should you require money for a significant expense, it is possible to take a large amount without triggering a tax invoice. Additionally, if you do not want the cash, the accounts will continue growing, unencumbered by taxation.
Most financial professionals suggest that you take from your taxable accounts before you utilize the others—especially if your income is low enough that you are eligible for tax-free capital gains. After that, you would draw from your tax-deferred accounts and lastly turn to your tax-free Roth account. However, as with most anything in the financial world—always is never always and there are exceptions to the rule.
Having large amounts of money stocked away in your IRA or 401(k) could mean your RMDs move you into a higher tax bracket. In that case, it may be wise to take money from your tax-deferred accounts prior to turning 70 1/2 years old. In doing so the balance on your tax-deferred accounts decreases and so does your RMD. Work with your financial professional to protect you from making a wrong move and accumulating more tax debt than necessary and to determine the right move for your situation.
Another approach to reducing taxes in your IRAs and 401(k) plans is to convert a portion of those accounts into a Roth. The drawback to that is that the conversion is going to be taxed as normal income and may bump you into a higher tax bracket in the year that you do so. It is possible to avoid that by rolling a small portion of your IRA into a Roth annually, which will help you keep an eye on how to your taxable income is affected yearly.
You now have a few ideas for ways to reduce taxes on retirement accounts. But the details of the process is far from “financially simple”. Seek out the help of your CPA or CERTIFIED FINANCIAL PLANNER™ before doing anything. If you don’t have a CFP® contact us and we can help. And be sure to subscribe to this blog for more retirement and financial education.