Retirement is one of life’s major transitions. Having adequate financial resources is important, but so is making those resources last. Taxes in retirement can be just as significant as investment earnings. If you do not have a good plan in place, federal taxes can significantly impact your retirement savings.
Dallas retirees do have one thing going for them: Texas has no state income tax. But federal taxes are still due on retirement withdrawals, Social Security, and investment earnings. If you want to meet these challenges and make the most of your retirement dollars, general advice may not be enough. You need a CPA with a specialty in retirement tax planning to help reduce your tax burden and make your savings last.
Planning Withdrawals from Retirement Accounts
One major component of any retirement tax planning strategy is determining from which retirement accounts you will be withdrawing your funds, in what order, and when. Most retirees have a combination of three main types of accounts: taxable investment accounts, tax-deferred retirement accounts (IRAs and 401(k) plans), and tax-free retirement accounts (Roth IRAs). By varying your withdrawals between these accounts each year, you can better control your taxable income and tax bracket.
What Is Tax Diversification?
The practice of spreading your assets across different types of retirement accounts with different tax treatment is called tax diversification. There are three main types of accounts you should be aware of:
- Taxable Accounts: Income in these accounts, earned through the sale of appreciated investments, is subject to capital gains tax.
- Tax-Deferred Accounts: Withdrawals are taxed as regular income, at ordinary income tax rates up to 37 percent.
- Tax-Free Accounts: Qualified withdrawals from Roth IRAs are tax-free.
Spreading your money across these three types of accounts allows you and your CPA to vary which accounts you pull from each year to help control your tax bracket.
How to Withdraw Strategically?
A common rule of thumb for retirees is to first draw down taxable investment accounts, then tax-deferred accounts and lastly tax-free accounts such as Roth IRAs. This makes sense but is not necessarily the most tax-efficient strategy for all retirees. An experienced CPA in Dallas, TX, can help you create a customized withdrawal strategy that is tailored to your situation. For example, if you have a year where your expenses are unusually high, you could pull from your Roth IRA, rather than selling a stock that has declined in value or going into a higher tax bracket by increasing your taxable income. Alternatively, if there are years with lower income in retirement, it may be possible to take withdrawals from tax-deferred accounts at a lower tax rate. Careful planning over the long term can set up an order of account withdrawals that is intended to help maximize net after-tax income.
How to Handle Required Minimum Distributions (RMDs)?
Once you reach age 73, you must begin taking minimum distributions from your tax-deferred retirement accounts annually, as calculated by IRS formulas. The funds are taxed as regular income and can even result in increased Medicare premiums if you are not careful. But by planning ahead with your CPA, you can minimize the impact of RMDs. For example, you may be able to make Qualified Charitable Distributions (QCDs) that allow you to donate directly from your IRA to a qualified charity. You may also be able to convert to a Roth IRA via a series of Roth conversions, before RMDs begin.
Looking at Roth Conversions
By performing a Roth conversion, you can transfer your assets from a Traditional IRA or 401(k) into a Roth IRA, so that they benefit from future tax-free growth. The catch is you will pay taxes on the amount you convert this year, so there is an up-front tax bill for this transaction. Roth conversions can be a powerful tool in the right situations. If you expect tax rates to be higher later, a Roth conversion allows you to pay taxes now with current rates. If you are experiencing a low-income year for any reason, that is a good time to consider a Roth conversion as well.
How Roth Conversions Work
When considering a Roth conversion, you start by estimating how much traditional (pre-tax) retirement money you want to convert to Roth status. Remember that the amount you convert will count as income this year and you don’t want to accidentally get pushed into a much higher tax bracket. Your CPA in Dallas can model different scenarios and space out conversions over multiple years if needed.
Best Time to Do a Roth Conversion
The main “sweet spot” for Roth conversions is in the years before you start taking Social Security or RMDs, because for many people those are the years with the lowest income. Timing is important when doing Roth conversions. If you spread out conversions over several years when your income is relatively low, you’ll likely pay a smaller total tax bill than if you converted it all in one year.
The “Backdoor Roth” Workaround
If you are a high-earning Dallas professional who makes too much money to contribute directly to a Roth IRA, your CPA may be able to help you explore alternative contribution strategies. This is called a “Backdoor Roth” and it involves first putting after-tax money into a Traditional IRA, then immediately converting that to a Roth. There are IRS rules governing “backdoor Roths,” but a Dallas CPA can help you safely navigate the most common pitfalls.
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Tax Efficiency with Social Security Benefits
Many people are surprised to discover that the IRS can tax your Social Security income. The government defines a formula known as “provisional income” to calculate whether your Social Security benefits are taxable. Provisional income is calculated by adding your adjusted gross income, tax-exempt interest, and 50% of your Social Security benefits. If your provisional income exceeds IRS thresholds, you could pay taxes on up to 85 percent of your benefits.
What Affects Your Provisional Income?
The IRS has set these thresholds fairly low, particularly if you are a married couple filing jointly. Due to this, many Dallas-area retirees face tax on the majority of their Social Security benefits.
How Can You Reduce the Taxable Portion of Social Security?
Working with a CPA, you can develop an income strategy that results in lower provisional income. For instance, you can take distributions from a Roth IRA, rather than taxable accounts, and it will not be counted toward the IRS thresholds. With careful planning, you can help more of your Social Security income go further, and you may also reduce taxes on other income sources.
Retirement Planning for your Legacy
Retirement planning is often focused on leaving something for your family, not just on providing for yourself. As part of this estate planning, minimizing future tax liabilities is an important consideration. up on the right schedule and amounts.
The Value of “Step-Up in Basis”
If your beneficiaries inherit assets like stocks or real estate, they receive a “step-up in basis” to the value of the asset on the day you pass away, instead of its original value. In most cases, this means your heirs will not have to pay capital gains tax on the appreciation in value that occurred during your lifetime. A trusted CPA can advise you on which assets are better to spend in retirement and which to pass along, maximizing what your family inherits.
Do You Need Trusts or Gifting to Reduce Taxes?
High-net-worth families in Dallas should also consider the federal estate tax exemption. Your CPA will often work in conjunction with your attorney to create trusts or annual gifting strategies that will reduce what your estate is responsible for paying. You can rest easy knowing that the legacy you leave behind will provide for your loved ones instead of the IRS.
Secure Your Financial Future
Smart retirement tax planning involves far more than simply setting aside money for your later years. It is also about smart decisions on what to do with your money in retirement. By understanding tax strategies, you can pay less tax, make your savings last longer, and leave something for your family when the time is right.
Tax rules are complicated, and working with a knowledgeable CPA can make a big difference in your financial future. If you are looking for a retirement plan that will thrive in the Texas economy and Dallas’s tax-friendly environment, contact Syd The CPA. We have specialized knowledge in retirement tax planning for Dallas-area residents and can help you craft a retirement plan that fits your goals and your family. Contact us today and let’s see how your retirement plan can work as hard as you do.