By Jason Coleman

Regardless of your politics, many retirees (and non-retirees) will benefit from lower taxes due to the Tax Cuts and Jobs Act put into effect in January of 2018. With the increase in the standard deduction and lower tax rates, taking income from your retirement accounts could cost you less in taxes than in previous years. This gives retirees an opportunity to do some strategic income and tax planning in the early years of retirement before you have to start taking required minimum distributions (RMDs) from your qualified retirement accounts.

First, it's important to look at some of the significant tax changes that came with the Tax Cuts and Jobs Act. The standard deduction for 2019 has increased to $12,200 for single filers and $24,400 for joint filers. For married couples over the age of 65, they also will have an additional $1,300 deduction each. Add that all up and joint filers who are both at least age 65 will have a standard deduction of $27,000. That means that your first $27,000 of income will be federal income tax free.

Additionally, the new tax laws have reduced the 15% tax bracket rate to 12%. For married filing jointly, the top of the 12% tax bracket for 2019 is $78,950. That means that retirees age 65 and older could potentially have up to $105,950 of gross income and still remain in the lowest tax bracket.

Understanding the tax laws along with taking money from the right accounts at the right time could help to reduce your future taxes all through retirement and to reduce taxes significantly for your heirs.

Tax Strategies for Retirees

Roth conversions: If you're like most retirees, you do not have substantial assets in your Roth IRA, if you even have one at all. With income limits on Roth contributions and clients preferring to save in tax deductible accounts first, many older taxpayers never opened Roth IRAs. The early part of retirement gives you an opportunity to strategically take money from your IRA and convert it to a Roth IRA. There is no income limit or even minimum dollar amount requirements to do Roth conversions, but you have to be aware that pulling money from your traditional IRA and moving to your Roth IRA is a taxable event.

By understanding your tax situation in retirement you can move money into your Roth IRA and pay tax at lower rates than you potentially would later in retirement while building tax free assets and reducing your future RMDs.

Common sense would tell you to try and take income and pay the least amount of taxes possible. This is prudent, but a lot of retirees either forget about or don't truly understand their future RMDs and their impact to taxes in the future.

With RMDs on qualified retirement accounts, at age 70½ many retirees will be forced to withdraw more money from their qualified retirement accounts than they need and will have to pay taxes on those distributions. You are able to take money strategically out of these qualified retirement accounts and convert the funds to Roth IRA accounts that do not have minimum distributions at 70½. This in turn will reduce the values in your qualified retirement accounts, reducing your future RMDs and giving you more tax free assets to use in retirement or to pass on to your heirs.

Here is an example of a basic client situation:

 

John

Cindy

Totals

Age

64

64

 

Taxable Assets

$500,000

$500,000

$1,000,000

IRA Assets

$1,000,000

$500,000

$1,500,000

FRA* Social Security

$24,000

$12,000

$36,000

*Full Retirement Age

John and Cindy are now ready to retire at age 64 with a desired retirement income of $100,000. Typically, it would be suggested that they take their Social Security at their full retirement age of 66 and use their taxable brokerage account for retirement income, delaying withdrawals from their IRAs until age 70½. In this scenario, their taxes could be minimal as 85% or less of their Social Security would be taxed and with a standard deduction of $27,000, their federal income taxes would be only a couple thousand dollars or less depending on the capital gains they realized.

What is not being considered is that with just a modest growth rate on their qualified retirement accounts of 6%, when they reach age 70½ they could have an RMD of $85,000 to $90,000, giving them much more income than they really need.

If they were to delay taking Social Security to age 70 and do a Roth conversion of $60,000 per year to top out their 12% tax bracket from ages 64 through 69, they could reduce their future RMDs to be more in line with their retirement income needs, reducing their future taxes and building a substantial tax free Roth IRA. In addition, they would also benefit with the delay in Social Security, giving them their maximum benefit assuming they have good longevity.

Base Scenario, no Roth conversions, Social Security at age 66

Age

Total RMDs

Total Federal Income Taxes Paid

Taxable Account

IRA Assets

Total Assets

64

 

 

$1,000,000

$1,500,000

$2,500,000

90

$2,859,393

$551,045

$2,247,003

$2,272,940

$4,519,943

(Assumptions: Annual rate of return of 6.0% with a $100,000 per year income adjusted for inflation at 2.58% per year. Social Security income uses a 1% COLA)

Utilizing Roth conversion strategy, $60,000 converted annually, Social Security at age 70½

Age

Total RMDs

Total Federal Income Taxes Paid

Taxable Account

IRA Assets

Roth IRA Assets

Total Assets

64

 

 

$1,000,000

$1,500,000

 

$2,500,000

90

$2,326,151

$458,429

$1,485,697

$1,849,063

$1,348,960

$4,683,720

(Assumptions: Annual rate of return of 6.0% with a $100,000 per year income adjusted for inflation at 2.58% per year. Social Security income uses a 1% COLA)

Harvesting tax gains: For clients like those above who have also been able to save in qualified retirement accounts as well as brokerage accounts, there may be an opportunity to harvest taxable gains in the first years of retirement as well. One other advantage of the 12% (formally 15%) tax bracket is that capital gains realized up to the top of the 12% bracket are not taxable to the account owner.

For retirees that have brokerage accounts, this gives you an opportunity to sell stocks or mutual funds that you have held for a long time with large gains in them. You are then able to use these highly appreciated funds for income in retirement or to simply rebalance your brokerage account to reduce risk and future taxes.

Combining the two strategies would create multiple advantages. By using the assets in your brokerage account for income in the first years while converting IRA assets to a Roth IRA, you can potentially convert more money to a Roth IRA while still staying in the 12% tax bracket. You will have to be aware of the amount of long term capital gains you realize as the combination of those gains and your conversions could put some of your taxable income over the 12% tax bracket threshold.

Optimizing withdrawals in retirement is a complex process that requires a firm understanding of tax situations, financial goals, and how accounts are structured. However, the two simple strategies highlighted here could potentially help reduce the amount of tax due in retirement.

It's important to take the time to think about taxes and make a plan to manage withdrawals. Be sure to consult with a tax and financial adviser to determine the course of action that makes sense for you.

About the author: Jason Coleman made his way to Ann Arbor after graduating from the University of Notre Dame with a BBA in accounting and a graduate degree from the School for Environment and Sustainability at Michigan. He combines two of his favorite activities: working with people to help them achieve financial their goals, and doing so with a focus on sustainable, positive actions and investments. Jason's investment interests include Socially Responsible Investing (SRI), tax-efficient and low-cost diversification strategies, and planning for charitable giving. Keep in mind that there is no assurance that any strategy will ultimately be successful or profitable nor protect against a loss. You should discuss any tax or legal matters with the appropriate professional. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. The above situations described are hypothetical in nature. Any opinions are those of Jason Coleman and not necessarily those of Raymond James.