How to Create Tax Advantages for Yourself During Retirement

You’ll likely have several sources of income in retirement that can be taxed, such as IRA distributions and Social Security benefits. But, do you have any after-tax “buckets” that you can use strategically in retirement to help reduce your tax bill?

Let’s take a look.

How Taxes Can Impact Your Retirement Income

First, how much do taxes matter in retirement?

A lot.

Just look at this example.

Connie lives in Oregon, is 66 years old and wants a NET income of $6,000 monthly, $72,000 annually. How much does she need to withdraw from her investment accounts to meet her income goals factoring in taxes?*

*Note that in each of these scenarios, her income remains $72,000.

In example one, Connie draws all of her income from tax-deferred accounts, which causes Social Security to become taxable. As a result, in 20 years, she will pay over $320,000 in taxes—and that’s at today’s rate meaning this calculation doesn’t factor in tax increases!

In example two, Connie combines withdrawals from a tax-free account (her Roth IRA) and a tax-deferred account (her IRA). The taxable withdrawal is positioned under the threshold that triggers taxes on Social Security. As a result, over a 20-year period, Connie will pay $95,300 in taxes, a savings from example one of $225,000!

In the final example, the stars align, and Connie pays $0 in taxes! How? She withdrawals tax-free income from her Roth IRA, which then exempts her Social Security and long-term capital gains from taxes.

In these scenarios, Connie shows us that the more you pay in taxes the more money you need in reserve. So, the question is, how can you achieve tax diversification?

How Can You Achieve Tax Diversification?

When you plan for retirement, you can use tax-deferred accounts such as your 401k strategically to grow your retirement income. Let’s look at how to achieve tax diversification in retirement using a Roth IRA, a Roth IRA conversion and an HSA.

Roth IRAs and Traditional IRAs

Many people contribute pre-tax dollars to a traditional IRA during their working years. When money is distributed, it’s taxed at ordinary income rates. In contrast, a Roth IRA is funded with after-tax dollars. A Roth IRA can be a valuable asset in retirement because qualified distributions are not taxed, unlike distributions from a traditional IRA.[1]

Roth IRA Conversions

Even if you haven’t contributed to a Roth IRA in the past or you’re not eligible to, you may be able to take advantage of the backdoor Roth strategy.

Individuals with income over $144,000 and couples filing jointly with income over $214,000 cannot contribute directly to a Roth IRA. Those who are able to can only contribute up to $6,000 per year if under age 50, or $7,000 per year if over age 50.[2] However, anyone has the option to convert any amount of money from a traditional IRA, 401(k), or similar qualified retirement account into a Roth IRA, regardless of income.

If you convert money from the accounts mentioned above into a Roth IRA, you pay tax on what’s converted and can then withdraw money tax-free later on. Keep in mind that Roth IRA conversions are now irreversible and that money can’t be withdrawn penalty-free until five years after it’s converted, and typically not until age 59 ½.[3]

Health Savings Accounts (HSAs)

Not everyone can contribute to a Health Savings Account (HSA), but if you can through your employer, consider doing so. The benefits of an HSA are:

• Contributions are not taxed
• Funds grow tax-deferred
• Funds can be withdrawn tax-free for qualified medical expenses. Qualifying medical expenses include Medicare Part B and Medicare Advantage plans, prescription drugs, a portion of long-term care insurance premiums, dental and vision care[4]

It’s not uncommon to run into  unexpected taxes in retirement. To offset the impact of your taxable sources of income in retirement, you may consider a Roth IRA or an HSA as two of many potential tax strategies.

We can help you create a long-term tax diversification plan that works with your overall retirement plan.

Interested in chatting? We’re a click away!

[1] https://www.investopedia.com/terms/r/rothira.asp
[2] https://www.investopedia.com/terms/r/rothira.asp
[3] https://www.investopedia.com/terms/r/rothira.asp
[4] https://www.investopedia.com/articles/personal-finance/091615/how-use-your-hsa-retirement.asp

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The content presented is for informational purposes only and is not intended as offering financial, tax, or legal advice, and should not be considered a solicitation for the purchase or sale of any security. Before making any decisions, you should consult a tax or legal professional to discuss your personal situation.