Gren Invest: Your Guide to Smart Retirement Tax Planning
It’s never easy when it comes to retirement planning, and one misstep can be catastrophic for one's golden years on the beach. One big, and often neglected, part of that journey is tax planning. The financial choices you make today can affect how much of your hard-earned savings is left for you to keep in your golden years. The key to successful retirement tax planning is not just about how much money you save, but how the rest of your assets and income streams are structured in the most tax effective way possible. That means understanding how your withdrawals are going to be taxed by the IRS reading up on how distributions from a 401(k), Traditional IRA, or Roth IRA are treated. It also includes the tactics to handle capital gains, social security and RMDs for maximum tax-efficient approach. The tens of thousands of dollars in savings during retirement that a good plan can yield make it easier to remain financially independent and concentrate on what really counts.
Taxchambers takes a look at the latest trending in tax law and provide insight on why planning is imperative. “They concentrate so much on trying to build their pot of retirement money and they don’t think about what’s going to happen with the taxes when they stop working,” he says. And this is where the know-how and advice of a reliable partner such as Gren Invest are priceless. We strive to simplify the complex rules of retirement tax, allowing you more control and confidence in your decision making. Since every corner of your financial life is connected, we take a holistic approach and look at everything all-at-once – from investment accounts to estate plans – and piece together a well thought out plan. That includes diving into some complex tactics such as Roth conversions, tax-loss harvesting and charitable giving all with the aim of maximizing your financial situation. By creating a tax-efficient withdrawal strategy, though, you can manage your taxable income in retirement and remain in a lower tax bracket (so that more of your capital stays with you for as long as possible) for your legacy).
Feeling ready to start your retirement tax planning journey can seem daunting, but it doesn’t have to be. The trick is to start young and stay flexible. Your plan should change with your life, whether because of career changes, growing families or new laws. The objective is to establish a flexible construct that conforms to your long-term goals and risk profile. This will require a delicate balance between tax-deferred and tax-free growth in order to have multiple sources of income in retirement with different tax treatments. With proper placement of your assets among the account types, you can create a system that is both financial sound and tax efficient. All in all, understanding your retirement tax plan is one of the single most important things you can do to help ensure that the wealth you’ve worked so hard to create will last through out your retirement years and achieve the kind of retirement experience you’ve always dreamed of.
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Top Questions Answered
One major distinction between a Traditional IRA and Roth IRA is how they’re taxed, which will greatly impact how you plan to save for retirement. For one thing, contributions to a Traditional IRA are often tax-deductible, in which case you have an opportunity to reduce your taxable income now. Tax treatment: Investments in your account grow tax-deferred, but you’ll pay the piper (ordinary income tax) when you withdraw money during retirement. Your contributions to a Roth IRA, by contrast, are with after-tax dollars; there no upfront tax deduction. But your investments will grow entirely tax-free, and you can take qualified withdrawals in retirement as well. That makes the Roth IRA an extremely powerful vehicle for generating a stream of tax-free income after you stop working, and thus managing your future tax bill properly.
How your Social Security benefits are taxed depends on your “combined income,” also known as provisional income. This amount is derived by adding your adjusted gross income (AGI) to any nontaxable interest you’ve earned, and then adding half of your total Social Security benefits for the year. If this total amount is above a certain level, a percentage of your benefits are taxable. For instance, if you file as an individual and your combined income falls between $25,000 and $34,000, you’ll likely owe income tax on up to 50 percent of your benefits. Once your income exceeds $34,000, as much as 85% of your benefit can be taxed, so it’s important to consider strategies for how you generate your overall retirement income.
This is a Required Minimum Distribution, or RMD, and it’s the smallest amount that most people need to take out of their tax-deferred retirement accounts each year, according to the IRS. That includes Traditional IRAs, SEP IRAs, SIMPLE IRAs and 401(k) plans. The rule generally applies when you turn 73 (though that age has been altered in legislation). The precise amount you have to withdraw is based on your account balance and your life expectancy as determined by the IRS. Not taking your full RMD on time can invoke a hefty tax penalty which, more often than not, is equal to 25% of the amount you should have taken but didn’t. This is why planning for RMDs is such an important part of any retirement income strategy.
A Roth conversion is the act of transferring money from a traditional pre-tax retirement account such as a Traditional IRA or 401(k) plan into a Roth IRA. When you convert, you pay income tax on the entire amount being moved in the year of the conversion. The beauty of this approach is that, once the money is in the Roth I.R.A., it can grow entirely tax-free, and all qualified withdrawals are tax-free in retirement, to boot. This can be a shrewd move if you expect to be in a higher tax bracket in the future than you are today or want to lower future RMDs, since Roth IRAs don’t have them for the original owner.
Control over capital gains taxes is vital if you plan to keep your investment returns in retirement. One effective tactic is what’s known as tax-loss harvesting, or selling investments at a loss to help reduce taxes when you’ve sold off some of your winners. You can also strategize over which assets to sell and when. After owning your appreciated assets for more than a year, you might qualify for the lower long-term capital gains tax rates. Another strategy is contributing appreciated stock directly to a charity, which can allow you to take a tax deduction for the full market value of the stock and avoid the capital gains tax you would have had to pay if you sold it first. Asset location is equally important.
Asset location is a tax strategy that entails putting various types of investments in the accounts offering the most favorable tax treatment. It differs from asset allocation, or the mix of assets that you own. Generally speaking, you would invest your least tax-efficient holdings for example corporate bonds or actively traded mutual funds that produce lots of short-term gains inside tax-advantaged accounts (like an I.R.A. or a 401(k). By contrast, your tax-efficient investments index funds or individual stocks you intend to hold for the long term will go into your taxable brokerage accounts. This tactic can reduce the tax burden on your portfolio as a whole and help that wealth grow more efficiently in the long run.
Yes, for the most part, withdrawals from a traditional 401(k) plan are taxed as ordinary income at your marginal tax rate in retirement. The reason is that the money you put into the account over your working years was never taxed and the account’s investments could grow tax deferred. Once you start withdrawing the funds in retirement, all that money including your original contributions and whatever returns it has earned is treated as if it had never been taxed by the government to begin with. If your employer offers a Roth 401(k) option, some contributions are made after-tax and qualified withdrawals from this segment of your account would be tax-free, providing you with an invaluable stream of non-taxable income in retirement.
Health Savings Account (HSA) HSA is one of the most powerful ways to save for retirement because it enjoys a triple tax benefit: money goes in tax-deductible, the funds grow with no taxes, and then you can pull out the cash tax-free for medical expenses all medical costs are qualified. In retirement, an HSA can remain a tax-advantaged piggy bank to pay for all sorts of medical related expenses, like Medicare premiums and deductibles, long-term care insurance and much more. Once you turn age 65, you can also withdraw the money in your H.S.A. for any reason without penalty, and the only cost will be ordinary income taxes that would apply like a Traditional IRA account making it an extremely flexible and valuable retirement vehicle.
A Qualified Charitable Distribution (QCD) is a provision in the tax code that allows those who are 70½ or older to contribute money from their Traditional IRA directly to a charitable organization. You may not donate more than $100,000 per person via a QCD in any year. The big benefit of a QCD is that what goes directly to the charity does not count as part of your AGI for the year. This can be particularly advantageous as it may enable you to meet your RMD for the year without having to take into your taxable income that distribution, which could potentially keep you in a lower tax bracket and allow you time for your investments or accounts to recover.
A tax-efficient withdrawal strategy means figuring out the sequence of retirement accounts to tap in order to minimize your lifetime tax bill. An often-used example is that of a withdrawal plan applied in an ordered sequence. First, you would spend down the money in your taxable brokerage accounts, and prioritize those with a high cost basis. Then you’d draw the money down from your tax-deferred accounts, like a Traditional IRA or 401(k). Finally you would draw down your tax-free Roth accounts last, so they could continue to grow tax free for as long as possible. You can modify this sequence depending on your individual tax situation and the market, but it is always about controlling what you earn annually.
Key Strategies for Effective Retirement Tax Planning
Using various account types for tax diversification The available options induce a certain diversification in order to build a more powerful retirement tax plan. Having only one type of retirement account, such as a pre-tax 401(k), might mean you’ll be facing stiff tax bills down the road. If you diversify across tax-deferred, tax-free and taxable accounts, you'll give yourself important flexibility in how you manage your taxable income when you are retired. Tax-deferred accounts such as Traditional IRAs and 401(k)s are wonderful tools for sheltering income from taxes while you’re in your peak earning years. Contributions are usually pre-tax, and the investments grow without incurring an annual tax. But every dollar taken in retirement is taxed as ordinary income. And to offset that, you can add tax-free accounts the most common being a Roth IRA and Roth 401(k) which are funded with after-tax dollars but allow for tax-free growth and t ax-free withdrawals in retirement. It gives you something to rely on that won’t bring your tax bracket up or change how your Social Security benefits are taxed. And finally, a standard taxable brokerage account, which doesn’t offer upfront tax breaks but does provide liquidity and take advantage of preferential long-term capital gains rates. Diversifying among these three “tax buckets” enables you to carefully withdraw from various sources of income each year, out in front of your tax situation and portfolio lifespan.
One other key tenet of advanced retirement tax planning is around timing income, particularly when it comes to Roth conversions. Roth conversion is where a person moves money from a pre-tax retirement account into a Roth-IRA and pays income tax on the amount converted in the year of the transfer. While this will result in a tax bill up front, it can be an exceedingly useful long-term play. The best time to do conversions is in low-income years (such as after you retire but before taking Social Security and R.M.D.s), when you can control the taxes. In these “gap years,” your income could be much lower so that you would find yourself in a lower tax bracket and the tax cost of converting is less painful. By moving amounts systematically over several years, you can so-called “fill up” the lower tax brackets and effectively pay taxes at a discount to what you might owe in future. Taking this approach depletes your tax-deferred accounts balance so that in the future, you can have a lower RMD and pay less in taxes. In addition, the converted assets can now also enjoy tax-free growth and withdrawal with no RMDs for the original owner, leaving a powerful financial legacy to you or your heirs – since Roth IRAs do not have required minimum distributions (RMDs) for the original account owner.
However, in addition to account structure and flushing of conversions, a comprehensive retirement tax strategy also requires deliberate engagement around all (other) potential streams of income and deductions. That applies to the timing of claiming Social Security, when that makes a big difference in the lifetime payout you would receive and your annual taxable income. It also includes coming up with a strategy for your Required Minimum Distributions (RMDs) well before they kick in at age 73. For those inclined to give back, consider the use of a Qualified Charitable Distribution (QCD) that allows someone 70 and a half year or older to give directly from an IRA to a charity, which not only satisfies their RMD but they don’t have to recognize the distribution as income. In addition, it is imperative to manage the investments in the taxable brokerage. This involves considering holding periods in order to qualify for the favorable long-term capital gains rates and using tactics like tax-loss harvesting to balance out any gains with losses. Align this puzzle of Social Security to RMDs, with charitable gifting and investment management and tax planning becomes less a scramble done in December as it does year-round integration into the fabric of your financial life that joins with you every step ensuring your retirement is not only rewarding but also his tax efficient.