Guide To Tax Planning In Retirement

Tax planning is important because it affects your ability to give, spend, and how much you leave to your beneficiaries. With the right strategies, retirees can save thousands of dollars per year on their taxes while securing their financial future. By understanding the rules and available strategies or tactics you can utilize, you can potentially keep more of what you’ve earned and disinherit the IRS.  

In this guide, we’ll cover (most) everything you need to know about tax planning in retirement.

  We’ll explain the strategies available so you can achieve the best possible result for your situation. Remember, you don’t need to use every strategy listed here.   Instead, choose the ones that make sense for your financial situation, and don’t be afraid to focus on just the ones that are right for you. Fortunately, by implementing even a few of these over time, you can save money and reduce your taxes throughout retirement. And by learning more about the various tax strategies available and taking advantage of those that work for you, you can be on your way to a happy, healthy, and financially secure retirement.

Section 1: Exploring The Benefits Of Asset Location.

What is asset location?

Asset location is a tax strategy that refers to where you position your different investments across your various account types in order to minimize taxes. In other words, it’s a way to potentially minimize your tax bill by putting investments that will generate lots of tax inside your retirement accounts while putting investments that won’t generate much tax inside your brokerage account.   For example, keeping your bond investments inside your pre-tax retirement accounts, your highest-returning stock investments inside your Roth IRA, and your most tax-efficient stock investments (such as index funds) inside your taxable brokerage account. Those just a couple of ways to use asset location to your advantage. How else can you use asset location to your advantage? When using asset location to minimize your taxes, here are some common strategies to consider:  

1. Use Traditional retirement accounts for high-income but low to moderate-growth assets:

   Traditional retirement accounts like Traditional IRAs or 401(k)s can be a great place to store high-income-producing assets like REITs or bonds. Both of these assets can be an important part of your overall portfolio, but they both generate above-average amounts of taxable income in the form of dividends and interest. So, holding them in a tax-deferred account can be a major bonus, as none of the dividends and interest will be taxable until withdrawn during retirement. In addition, especially for bonds, their overall growth potential is typically lower than stocks, making them a great option for a Traditional IRA, which will have taxes on the withdrawals during retirement. So, lower overall growth leads to lower overall taxes during retirement.

 

2. Next, use Roth retirement accounts for high-income or high-growth assets:

   Next, your Roth accounts can be a great option for high-income or high-growth assets. Like a Traditional retirement account, none of the dividends, interest, or capital gains will be taxed inside your Roth account. But, unlike your Traditional account, Roth withdrawals will not be taxed during retirement, so it could be wise to prioritize putting your highest growth assets inside your Roth accounts and maximizing the benefit of tax-free withdrawals during retirement.

 

3. Lastly, use Taxable brokerage accounts for tax-efficient or “forever” stocks and funds:

   Your taxable brokerage accounts will not receive any special tax treatment, so it can be wise to hold your most tax-efficient assets in these accounts. For example, avoid holding REITs or bonds because the interest and dividends they generate will be taxable each year. In addition, any active mutual funds with high turnover can create capital gains each year, making them a poor fit for your taxable brokerage account. So, as you identify which assets to hold in your taxable account, consider individual stocks or index funds that you plan to hold for the long-run and tax-managed mutual funds that are designed to limit taxable income each year. That way, you can keep your most tax-efficient assets in the accounts with the least tax benefits.

  To summarize, you want to hold high-growth or tax-inefficient assets in your retirement accounts while putting your most tax-efficient assets in your taxable accounts. This can be a simple but effective way to save money in taxes each year during retirement.

What is the impact of this strategy?

As you evaluate the various tax strategies available, it’s important to consider how much you stand to benefit. In other words, you want to make sure the juice is worth the squeeze.   And according to Vanguard’s Advisor Alpha Study, it is.   They found that by utilizing an asset location strategy, you can save up to .6% per year of your portfolio value in taxes. So, a retiree with a $1,000,000 portfolio could save up to $6,000 per year, or $500 per month, by employing an asset location strategy.   Ultimately, asset location can be a powerful strategy to help you maximize your tax efficiency in retirement and keep as much money on your side of the tax ledger as possible. And while it can seem complicated at the outset, there are specific rules or guidelines you can use to help you identify which assets to hold in which accounts. If you want to utilize this strategy but don’t feel confident doing it on your own, consider working with a CFP® professional to help you design and implement an asset location strategy that’s tailored to your unique retirement situation.

Section 2: Be Aware of RMDs and Create a Plan

What are RMDs?

Required Minimum Distributions (RMDs) are regular distributions that certain retirement plan owners must begin taking out of their accounts once they turn a certain age. This is a way for the IRS to ensure that you pay taxes on your retirement funds eventually rather than attempting to pass the funds from generation to generation without paying taxes.   All Traditional retirement accounts (pre-tax) will have RMDs, including 401(k)s, 457s, 403(b)s, Traditional IRAs, SEPs, SIMPLE IRAs, and more. Notably, Roth retirement accounts do not have RMDs.   But, while RMDs are a staple of retirement income distributions, it’s essential to understand the impact they can have on your tax situation, especially for high-net-worth families or individuals.  That’s because RMDs can create a tax trap for retirees as they can force you to take more income than you need and drive your marginal tax bracket up during retirement. So, it’s essential to create a plan to manage your RMDs and avoid being pushed into a higher marginal tax bracket if possible.

First, when do RMDs start?

The starting age for RMDs has changed over time, so it’s best to check the IRS website for the most up-to-date information. At the time of writing, these are the current RMD starting ages:  

• Those born before 1951 must start RMDs by age 70.5 or 72.
  • 70.5 for anyone who turned 70.5 in 2019 or sooner.
  • 72 for those who turned 70.5 in 2020 or later. 
• For anyone born between 1951 and 1959, RMDs begin at age 73.
• And for anyone born in 1960 or later, RMDs begin at age 75.

  When you reach RMD age, you must take your first RMD by April 1st of the following year and by December 31st of every year after that. In addition, if you’re still working when you reach RMD age, you can delay RMDs for your employer-sponsored retirement account until you retire, assuming you are not a 5% owner. And when you’re planning for RMDs, it’s important to note that failing to take an RMD could result in paying a hefty 25% penalty on the missed RMD amount.

How are RMDs calculated?

The amount of your RMD is determined by an IRS formula based on the account balance of your Traditional retirement accounts at the end of the prior year and your life expectancy.   An easy and effective way to calculate your RMD is to use a free online calculator that will ask for your age and account balance. Essentially, the younger you are, the higher your remaining life expectancy, so the smaller your total RMD percentage will be each year. But, as you get older, your remaining life expectancy gets smaller, which can drive your RMD percentage amount up. That said, if your account balance is shrinking through retirement, a smaller account balance can also lead to a smaller RMD over time.

How are RMDs taxed?

One of the biggest reasons you must be aware of RMDs and create a plan to manage them is because RMDs are taxed as ordinary income at your highest marginal tax bracket.   This means they do not benefit from favorable long-term capital gains treatment and have the ability to significantly impact your tax situation each year. So, without a proper plan, RMDs can potentially push you into a much higher tax bracket than you want or need.   That’s why it’s critical to plan ahead and create a strategy to manage your RMDs through retirement. How can you plan for RMDs? When planning for RMDs, there are a handful of strategies and aspects to consider. Here are a few to consider:  

1. You can use Roth conversions to help lower your overall lifetime tax bill before RMDs start.

   Roth conversions can be a powerful strategy to help you lower your overall lifetime tax bill. At a high level, Roth conversions are a strategy where you convert pre-tax funds to Roth funds and pay ordinary income taxes on the full conversion amount. Then, the amounts you have in Roth funds will not be subject to RMDs and can grow tax-free. They can also be distributed tax free as long as you avoid the 5-year rule.

  But how can that help you save money in taxes? By converting pre-tax funds to Roth today at a lower tax rate than you would be paying in the future, you lower your total tax bill.   So, if you have lower income years before RMDs start, you may be able to shift money out of your pre-tax accounts at more favorable tax rates than you would get once RMDs begin. This is often a perfect strategy for early retirees who have a handful of low income years before RMDs start.   For example, if you can Roth convert funds at the 12 or 22% tax brackets that would have otherwise landed in the 24 or 32% tax bracket with future RMDs, you have effectively lowered your lifetime tax bill.   This strategy can be especially powerful for anyone with lower income years before RMDs start and high pre-tax retirement account balances. Additionally, the Tax Cuts and Jobs Act lowered most marginal tax brackets but is set to expire at the end of 2025 unless additional legislation is passed. So, it could be wise to take advantage of these lower tax rate years before they expire.  

2. Qualified charitable distributions (QCDs) can be a great option for charitably inclined individuals.

   Second, if you are charitably inclined, you may consider using QCDs to help reduce your annual tax bill. QCDs are a direct transfer from your retirement account to a qualified charity you can begin making at age 70.5 or older. But, the real power of QCDs is that they satisfy your RMD requirement while creating a powerful tax deduction. So, if you want to donate to charity and have an RMD, consider donating directly from your RMD because that will reduce your taxable income by the amount of your donation. But, there are specific rules and limitations to consider. Currently, there is a $100,000 annual limit for QCDs per individual, but starting in 2024, the annual limit for QCDs will increase with inflation, so be sure to check the IRS website for the most up-to-date information.

 

3. Make sure you avoid penalties by withdrawing the correct amount each year.

   One of the biggest taxes or penalties to avoid is the penalty for missed RMDs. Essentially, if you fail to take the full amount of your RMD for the year, you may face a 25% penalty on the missed amount (50% penalty for years before 2023.) So, if your RMD was supposed to be $100,000, but you only took $50,000, you would face a $12,500 penalty. ($50,000 missed RMD x .25 = $12,500)

 

4. Lastly, understand the impacts of SECURE 2.0.

   Lastly, SECURE 2.0, which passed in 2022, brought some significant changes to RMDs. Most importantly, it pushed the starting age for RMDs back to 73 for some and 75 for others. On the one hand, this is great as you have more time to shift assets to Roth before RMDs begin and more time for your wealth to grow and compound inside tax-advantaged accounts. But, it also compresses your RMDs into fewer years, creating the possibility of a major tax crunch as your RMDs get larger. So, effective RMD planning is more important than ever with the updated rules.

  In the end, RMDs are a big piece of the retirement tax puzzle, and it’s important to use every strategy available to avoid a major tax crunch.   By focusing on Roth conversions in lower income or lower tax years, utilizing the power of QCDs, avoiding any penalties, and understanding the impacts of SECURE 2.0, you can effectively lower your lifetime tax bill by optimizing your RMDs.

Section 3: How to Withdraw Money from your Portfolio in way that Minimizes Your Taxes

What is a tax-optimized portfolio withdrawal strategy?

A withdrawal strategy informs you which account(s) to draw from, when, and in what quantity. For example, a tax strategy might be to pull one half of your withdrawals from your brokerage account and one half from your 401k, while converting $40,000 per year from your 401k into Roth IRA.

How do you create a tax-optimized portfolio withdrawal strategy?

At a high level, to tax-optimize your portfolio withdrawal strategy, you want to pull income from various account types in a way that will minimize your effective tax rate over time.   To use an analogy, imagine that your retirement income is like water. To access it, you must pour it into different government tax cups throughout the year. These cups represent the different tax brackets.

Try to stay in lower tax brackets by spreading income out over time.

First, water goes into the 10% cup until it’s full. Then the rest goes into the 12% cup until it’s full. So on and so forth until you’ve taken in all the water that you will for the year. Ideally, with your retirement income, you want to fill up the low-rate cups each year without pushing into the higher-rate cups like the 35% or 37%.   So, it’s essential to understand your current tax rates for the year and where your income will land. Then, you can decide which income sources to prioritize and which to avoid throughout the year. And generally, it’s better to take small voluntary tax hits now than it is to take large mandatory tax hits later for a couple of reasons:  

1. The US has a progressive tax system.

   The way the US tax system is designed means that the higher your income, the higher your marginal tax rate. So, there’s a big incentive to avoid having a very high-income year because that could push you up into much higher marginal tax brackets. So, retirees should aim to smooth income out over the years to avoid a spike in tax rates.

 

2. RMDs get larger as a percentage of your account value over time.

   Next, because RMDs get larger as a percentage of your account value over time, you could end up having to take large distributions from your retirement accounts in future years. So, any amounts that you can distribute now at lower tax rates could save you significant money in taxes. For example, if you were to live to 100, you could be required to withdraw 15.8 percent of your holdings in one year. So, if you had a $3 million IRA account at age 100, the government would require you to withdraw $474,000 in income that year and pay very high marginal tax rates on most of that income.

  So, as you attempt to create a tax-optimized portfolio withdrawal strategy, remember that filling up the lower cups each year can be a powerful strategy, and smoothing out your income over time is often better than taking big lump sums in any given year. Next, identify the different portfolio levers you can use to smooth out your income. As you work to smooth out your income and fill the lower cups, it’s essential to understand the different levers at your disposal. To do that, it helps to understand how your different accounts are taxed. Here are some things to consider:  

• RMDs and distributions from Traditional retirement accounts like Traditional IRAs or Traditional 401(k)s are taxed as ordinary income at your highest marginal tax bracket.

 

• Qualified Distributions from Roth retirement accounts like Roth IRAs or Roth 401(k)s are tax-free.

 

• Distributions from taxable brokerage accounts could be long-term capital gains if you held the assets for over a year or short-term capital gains if a year or less. Long-term capital gains get more favorable tax treatment, while short-term capital gains are taxed as ordinary income at your highest marginal tax bracket. In addition, you may have interest or dividends from your taxable account. Interest is taxed as ordinary income, and dividends can either be ordinary income tax rates or qualified dividends, which receive lower capital gains rates.

  So, as you try to optimize your withdrawal strategy, here are some potential guidelines to consider.   First, you could focus on taking distributions from Traditional accounts when you have a low income for the year. This allows you to withdraw income at lower rates by filling up the “lower rate cups.”   Using our previous analogy, after filling the 10 and 12% cups with ordinary income from Traditional accounts, you may consider taking long-term capital gains from your taxable brokerage account, which will be taxed at 15% for most people.   After taking some capital gains, you may find yourself in the 24% bracket for any additional income, which is where you can make another critical decision.   If you believe you’ll make it to the 32% or higher tax bracket in the future when you have RMDs, you may consider using the 24% bracket now for Roth conversions. This could help you get money out of your pre-tax accounts at favorable rates. But, you should only consider this strategy if you expect to be in a higher tax bracket in the future.   Alternatively, if you’re in a high tax bracket for the year but need additional income, you can consider withdrawing from your Roth account to avoid distributing any more income at high rates.

What is the potential value of creating a tax-optimized portfolio withdrawal strategy?

When deciding whether to utilize a tax-optimized portfolio withdrawal strategy, consider the potential benefits.   According to Vanguard’s Advisor Alpha Study, you can save up to 1.2% of your portfolio’s value each year by optimizing your withdrawal strategy. To put that in perspective, for someone with a $1,000,000 portfolio, that’s up to $12,000 of savings per year.   Ultimately, the order in which you distribute funds during retirement can have a major impact on your tax situation each year. So, start by understanding the various income sources and account types you have and the tax treatment for each. Then, identify which levers you can pull each year to limit your tax bill. But, while this is a powerful strategy to optimize your situation, it can be complicated to implement, so consider using the help of a fiduciary financial advisor who specializes in retirement tax planning.

Section 4: Don’t Miss Out On The 0% Capital Gains Opportunity.

What is the 0% capital gains opportunity?

The 0% capital gains opportunity is a unique opportunity within the US tax code for investors with long-term capital gains.   Here’s how it works: For 2023, a single person can have up to $44,625 in income while staying in the 0% capital gains bracket. For a married couple, that amount jumps to $89,250. So, assuming you are a married couple and your only income for the year is long-term capital gains, you could have up to $89,250 in taxable long-term gains without paying anything in taxes. For retirees with significant savings in a taxable brokerage account, this can be a powerful opportunity.

Here’s how retirees can take advantage of this opportunity.

If you have a taxable brokerage account with long-term gains, you may be able to take advantage of the 0% capital gains bracket.   To take advantage of this strategy, determine what your total taxable income is each year before December 31st. Then, subtract your taxable income for the year from the $89,250 limit ($44,625 for single filers.) Whatever is leftover is the amount of long-term capital gains you can realize for the year without paying any additional tax.   For example, assume you invested $89,000 into an index fund that doubled in value to $178,000. After more than a year, you decide to sell $89,000 worth, keeping your principal of $89,000 intact. The IRS treats half your proceeds as gain and half as cost-basis. So, the taxable gain you report is only $44,500, which is taxed at 0% based on your taxable income for the year. That’s tax-free income!   The 0% capital gains bracket is a unique opportunity for retirees with significant savings in a taxable account. If it’s an option, retirees should ensure they take advantage of this strategy any chance they get by checking their taxable income before the end of each year, then taking long-term gains to fill the remainder of the 0% bracket.

Section 5: Maximizing Your Legacy For The Next Generation.

Lastly, as you consider the various tax planning strategies available during retirement, there are additional steps you can take to maximize your legacy for the next generation. This can be a win-win for retirees looking to save money in taxes while leaving a legacy of financial stewardship for generations to come.

First, understand the cost-basis step-up.

One of the most powerful ways to maximize inherited wealth for the next generation is by understanding the step-up in basis rules.   Essentially, after you and your spouse pass away, your heirs will receive a step-up in basis on any taxable assets they inherit from you. This is like hitting the reset button on how much tax you have to pay when selling a price-appreciated asset.   For example, if you purchased a stock for $100 per share, and the value increased to $200 per share, and you sold it, normally, you would have to pay taxes on the difference between the price you paid and the price you sold, also known as your gain. But, if your heirs inherit that stock and receive a step up in basis, their new cost basis (the price you paid) becomes the fair market value of the stock at the date of your death. So, if the stock was worth $200 when you passed away, then your heir’s basis would be “stepped up” to $200. Then, they could sell the stock immediately for $200 and pay zero tax.   This rule applies to all taxable assets, including stocks, bonds, real estate, and more. But, this does not apply to assets held within retirement accounts.   So, if you’re considering leaving an inheritance to the next generation, it could be wise to leave them taxable assets that will receive a step-up in basis at the time of your death. Doing so can result in less taxes for Uncle Sam and more wealth staying within your family.

Next, understand the annual gift tax exclusion.

What is the annual gift tax exclusion?

The annual gift tax exclusion is an amount of money you can give away to another person in a given year without having to pay any federal gift tax. The 2023 annual exclusion amount established by the IRS is $17,000 per person per calendar year, which means you may give up to $17,000 in cash or other gifts to each recipient without incurring a federal gift tax liability. Additionally, spouses may combine their individual exclusions and give up to $34,000 per recipient without incurring any gift tax.   For example, if you and your spouse decide to give a gift to your daughter in 2023, you can give her $34,000 combined without triggering any federal or state gift tax. This can be a great strategy for anyone with significant assets that’s interested in gifting to their children while they are alive without counting against their total lifetime exclusion.

Then, understand the lifetime exclusion amount.

The total lifetime exclusion or “estate exclusion amount” is a set amount of money you can give to your heirs during your lifetime without triggering any estate taxes. And if you’re planning to leave a sizable inheritance to your heirs, it’s essential to understand this rule.   For 2023, the total amount you can give to your heirs during your lifetime is $12.92 million or $25.84 million per married couple. That said, the lifetime exclusion amount can change over time with new legislation, so be sure to research and find the most up-to-date information. Also, it’s important to note that unless additional legislation is passed, the lifetime gift and estate tax exclusion amount will drop by roughly 50% at the end of 2025 to an estimated $6.2 million per individual or $12.4 million per married couple.   So, any gifts during your lifetime that exceed the annual gift tax exclusion amount ($17,000 in 2023) will count towards your total lifetime limit of $12.92 million. Then, if the total amount of your lifetime gifts exceed the lifetime limit, the excess will be charged estate taxes.

Lastly, consider the tax impact of leaving an IRA to your heirs.

Finally, when optimizing your taxes during retirement and leaving an inheritance to the next generation, consider the different rules around inherited IRAs.   For both Traditional and Roth IRAs, your heirs must distribute the full amount of the account within ten years.    But, all of the income distributed from a Traditional IRA will be taxed as ordinary income, while all the income distributed from a Roth IRA will be tax-free. So, if your heirs are in their high-earning years and already in a high marginal tax bracket, inheriting a Traditional IRA could push their tax rates even higher. Alternatively, if they inherit a Roth IRA, they can pull funds from the account without impacting their tax situation.   So, depending on your situation, it may be better from a tax perspective to pass a Roth IRA to your heirs than a Traditional IRA.   Ultimately, if you want to maximize your legacy for the next generation, consider the strategies above to help you limit the impact of taxes and keep more money within your family by sending less to Uncle Sam.   And in the end, tax planning during retirement can be complex, but it can save you big if you can get it right.    For example, by just utilizing asset location strategies and creating a tax-optimized portfolio withdrawal strategy, you could save up to 1.8% of your account value per year. To put it in perspective, for a $1,000,000 portfolio, that’s $18,000 in savings each year. But, both of these strategies can be nuanced and may warrant the help of a financial planning professional.   In addition, by creating a plan for your RMDs, taking advantage of the 0% capital gains opportunity each year, and taking steps to maximize your legacy for the next generation, you can ensure that you optimize your taxes during retirement to reach all your financial goals and more.   We hope this guide has served you well and invite you to share it with others retirees that can benefit from this information. In addition, feel free to save it as a reference in the future so you can refer back to it as needed. Remember to reference the tax brackets that are applicable for the calendar year that you’re in.