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Saving enough money for retirement is Americans’ primary concern when it comes to long-term financial planning, but it’s also vital to consider taxes and how they will affect your nest egg.
“Putting money into a 401(k) may not be enough to retire comfortably if the financial plan doesn’t address the impact of taxes on retirement income,” Aditi Javeri Gokhale, chief strategy officer at Northwestern Mutual, said in a news release. “Most people don’t realize that their retirement income may be taxed about 20% or 30% when they withdraw and spend it. When they recognize the impact, it’s often too late for them to adjust.”
A recent Northwestern Mutual study found that only 3 in 10 Americans have a plan to minimize the taxes they pay on their retirement savings.
“A comprehensive financial plan can help people get to and through retirement by minimizing exposure and preventing anyone from paying more in taxes than they should be,” Gokhale said, “potentially preserving thousands of dollars in their nest eggs.”
There are a number of strategies you can use to minimize your taxes in retirement. Here’s a look at the top strategies Americans are utilizing, as identified by the Northwestern Mutual study.
1. Making Strategic Withdrawals To Stay in a Lower Tax Bracket
Among Americans who have a plan to minimize the taxes they pay on their retirement savings, 32% said they plan to make withdrawals strategically from traditional and Roth accounts to remain in a lower tax bracket.
“This can be a great way to manage a tax bracket because distributions from traditional IRAs are generally income taxable to the recipient, whereas money coming out of a Roth is tax-free,” said Ben Glassman, private wealth advisor and director of financial planning at Northwestern Mutual’s Haven Wealth Advisors.
“This allows you to take distributions up to a certain threshold and use tax-free dollars to avoid tripping into a new tax bracket. This method allows individuals to spend down their income-taxable, less efficient legacy dollars with intention.”
2. Using a Mix of Traditional and Roth Retirement Accounts
Thirty percent of Americans who have a plan to minimize the taxes they pay on their retirement savings said they utilize a mix of retirement accounts.
“This is pretty similar to the above, and a great example of why we work with our clients to build tax diversification into their planning,” Glassman said. “By doing the legwork upfront, it gives you the ability to make decisions on which accounts to use in creating a tax-efficient distribution plan.”
3. Making Strategic Charitable Donations
Charitable donations are part of the strategy for 24% of Americans who have considered reducing taxes in retirement. These donations can be used as tax write-offs up to a certain percentage of your adjusted gross income (AGI).
“In addition to cash gifts, you can also gift long-term highly appreciated assets,” Glassman said. “By doing so, you generally avoid the tax on the gains and get a deduction on the fair-market value of the asset (up to applicable AGI limits). It’s important to always consult with a CPA for tax questions.”
4. Using a Tax-Advantaged Healthcare Savings Account
Among Americans who have a plan to minimize the taxes they pay on their retirement savings, 23% said they use a Health Savings Account (HSA) or other tax-advantaged healthcare account.
“This is another great resource, particularly for healthcare expenses,” Glassman said. “Your contributions are made on a pre-tax basis, and you can use the funds to pay for qualifying medical expenses without tax. It’s also worth noting that the HSA can be used after age 65 (not 59 ½) as part of a retirement plan without the IRS imposing a 20% penalty for non-medical expenses.”
5. Using Other Tax-Advantaged Products
Twenty-two percent of those with a plan for minimizing retirement taxes said they use products like permanent life insurance or annuities for the tax benefits. In addition, 13% said they use the basis paid into the cash value of permanent life insurance to remain in a lower tax bracket.
“A well-designed permanent life insurance policy is a tax-efficient way to grow, access and transfer wealth,” Glassman said. “As part of a retirement income plan, you have access to the accumulated values without the impact of taxes. Life insurance uses the FIFO (first in, first out) accounting method, allowing you to pull the basis (your contributions) out without taxes.
“You can also access the gains through a policy loan as an advance against the death benefit,” he continued. “For early retirees, those retiring before 59 ½, there is no 10% early distribution penalty unlike many retirement accounts.”
It’s important to remember that the primary purpose of permanent life insurance is to provide a death benefit, Glassman noted.
“Using permanent life insurance accumulated value to supplement retirement income will reduce the death benefit and may affect other aspects of the policy,” he said.
6. Making Roth Conversions Before Taking RMDs or Social Security
Among Americans who have a plan to minimize the taxes they pay on their retirement savings, 19% said they will make Roth conversions before they start taking Required Minimum Distributions (RMDs) or collecting their Social Security benefits.
“Roth conversions can be a great strategy to address several aspects of a retirement income plan,” Glassman said. “A Roth conversion creates tax-free retirement dollars in the future by pre-paying the tax today, reduces the balance of IRA dollars that would be subject to Required Minimum Distributions (RMDs), and the Roth IRA is a more tax-efficient legacy asset than traditional IRAs, given the tax treatment to the beneficiaries upon withdrawal.”
There are several important considerations when evaluating a Roth conversion within your own planning, Glassman said.
“Do you believe taxes today are higher or lower than they will be in the future? Do you have a long enough time horizon on the money to out-earn the cost of paying the taxes today?,” he said. “The conversion is also an income-taxable event, which could impact [your income-related monthly adjusted amount] IRMAA once you are on Medicare. The importance of where the conversion fits within the context of a financial plan, the timing of the conversion and the amount of the conversion cannot be overstated.”
7. Using Qualified Charitable Distributions From an IRA
Seventeen percent of Americans who have a plan for reducing taxes in retirement said they will utilize Qualified Charitable Distributions from an IRA.
“Qualified Charitable Distributions (QCDs) are a great planning tool, particularly for individuals or households with large qualified balances who are charitably inclined,” Glassman said. “This allows you to make a distribution from your IRA to a charitable organization without realizing the income tax of that distribution. For those with RMDs above their income need, who aren’t relying on those dollars for their own future income planning, this can be a very efficient use of the surplus funds.”
The annual limit is $105,000 per year.
8. Making Contributions to Other Tax-Advantaged Accounts
Among Americans who have a plan to minimize the taxes they pay on their retirement savings, 14% said they are making contributions to other tax-advantaged accounts, like a 529 plan.
“If your state has income tax, you may get a deduction on your state income taxes up to a certain limit,” Glassman said. “The money grows without taxes and can be used without tax for qualifying educational expenses.”
Now, under the Secure Act 2.0, you can use surplus 529 account money to fund a Roth IRA for the beneficiary (up to annual and lifetime limits).
9. Taking Advantage of a Qualified Longevity Annuity Contract
Thirteen percent of Americans with a plan to minimize taxes in retirement said they will take advantage of a Qualified Longevity Annuity Contract (QLAC) to set aside funds for later in retirement.
“This is another strategy that, for the right person, can accomplish several objectives in retirement income planning,” Glassman said. “Funding a QLAC reduces the current balance of your qualified accounts, which lowers future RMDs. Once inside a QLAC, the withdrawal of funds can be deferred up to age 85. And finally, once the withdrawals begin, they come in the form of a lifetime income stream, which creates a stable, predictable income floor for the later years of planning.”
Disclaimer: This is not intended as legal or tax advice. Consult with a tax professional for tax advice that is specific to your situation.
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