Tax Planning for New Retirees

Written By: Brian Ellenbecker, CFP®, EA, CPWA®, CIMA®, CLTC®

As you enter retirement, it’s likely your income and resulting tax picture will change—sometimes dramatically. Changes in your tax rate can present planning opportunities. Maximizing the tax opportunities available can help extend the life of your portfolio to help meet your needs throughout retirement. Doing so likely requires multi-year tax planning.

Let’s look at some of the most common tax-related planning items to consider as you approach retirement.

Project Your Income and Expenses

The first step is to spend some time developing a budget, which should include cash flow projections covering at least the first few years of retirement. Understanding your different sources of income, how they may change as you transition into retirement, and what your expenses will look like are all critical steps.

You may be tempted to use an income replacement rule-of-thumb, which typically says you’ll need 75% to 80% of your pre-retirement income. In other words, if you made $100,000 shortly before retirement, you’ll need $75,000 to $80,000 a year to live on in retirement. Beware rules-of-thumb—they should only be used as a rough guide until you dive deeper into your situation. Many of our clients will see their spending at or even above what it was prior to retirement, especially for those that now have more time to do the things they love like travelling, playing more of your favorite sport (golf, tennis, pickleball, etc.), or dining at your favorite restaurants. Over time, spending does tend to decline, though. Estimating when that decline might start and to what extent is important in projecting how long your money might last.

Some of your income went toward saving for retirement and paying payroll taxes on your employment income—two items which aren’t necessary anymore. These items are the ones most likely to contribute to a drop in spending during retirement, at least early on.

Planning for your expenses, including any big-ticket items, will help determine how much income you need in a given year.

Having an income and expense roadmap will help you estimate what your income and tax liability will be over time. Knowing this can help you identify windows where tax planning opportunities exist and will help you be better prepared when the time comes.

Do You Have Retirement Payments Coming From Your Employer?

Most people have a retirement account, like a 401(k), 403(b), 457, etc., but it’s also possible you will be entitled to certain retirement income benefits. The most common forms of income are pensions, deferred comp payments, employer equity (stock options, restricted stock, ESOPs, ESPP, etc.), accrued vacation days or sick day payout.

Some of the income streams may last for your lifetime, like a pension. Others are likely to be front loaded, either as a lump sum or within the first few years of retirement.

Factor in the timing and duration of each of these income streams. If you have income streams that will only last for a short period at the beginning of retirement, perhaps consider delaying the start of Social Security or your pension, assuming you don’t need them to meet current expenses. Doing so can help spread the income and resulting tax out over a longer period, possibly resulting in a lower tax liability over time. It could also result in receiving more income over time, as the monthly payment for Social Security and most pensions increase if you delay taking them.

Social Security and Medicare

While Social Security and Medicare are two distinct programs, many people view them in the same bucket. While Social Security provides income and Medicare provides health care coverage for retirees, the programs are tied together in several ways.

One of the most common questions we get asked is when should I start receiving Social Security benefits? There are numerous factors to consider, including life expectancy, marital status, investment accounts, other retirement income sources and taxes.

From a tax standpoint, Social Security is a tax-advantaged income source, with only 85% of the benefit being subject to tax for most people. That percentage is even lower if your gross income is below $44,000 married/$34,000 single. Taking taxes into account when deciding the right time to start your benefit is one of the numerous factors to consider.

The Social Security Administration handles all aspects of Social Security, along with Medicare enrollment. It also handles premium payments, including the Income-Related Monthly Adjustment Amount or IRMAA. Once your Modified Adjusted Gross Income (MAGI) reaches a certain level, your Medicare Part B and D premiums start to increase. Managing your retirement income and the timing of certain expenses might help you avoid paying higher premiums in one or more years. For more information on how your income impacts Medicare premiums, click here.

Account Distributions

Most people will need to supplement their fixed income sources by withdrawing money from their investments. How you access that income can have a big impact on how long your money lasts. There are many strategies you can use to draw income from your portfolio. You will need to decide which accounts to pull money from (taxable, tax-deferred, or tax-free) and when and how often you want to withdraw money (regularly or as needed)—all while managing your asset allocation.

The ultimate goal should be to choose a strategy that provides you with the income you need, while also keeping taxes and estate planning goals in mind. Making withdrawals from the proper account type each year can minimize your tax liability both now and in the future. Also consider longer–term tax minimization strategies like harvesting capital losses, Roth IRA Conversions and realizing capital gains at the 0% tax rate, to name a few.

Required Minimum Distributions (RMDs)

Once you reach a certain age, you will be required to take distributions from your retirement accounts. When you need to start taking distributions depends on the year you were born. The recently passed SECURE Act 2.0 pushed out the RMD age for people that were not yet required to take distributions.

If you anticipate that your RMD will be larger than what you need to spend in that year, you may want to consider strategies for potentially reducing that distribution and the income tax you are forced to pay on it. Taking withdrawals from your retirement account prior to the RMD start age might help you spread out the tax liability over a longer period of time, potentially allowing you to pay tax at a lower rate. Doing so also reduces the balance in your retirement account, which will lower the required distribution amount. This strategy is particularly effective if you expect your tax liability to be lower from the time you retire until you’re required to start taking distributions. The most common strategy to implement is a Roth IRA Conversion.

Roth IRA Conversions

A Roth Conversion allows you to shift retirement dollars from your pre-tax retirement account to a Roth retirement account. The conversion amount is taxed as ordinary income in the year of the conversion.  However, earnings in the Roth are then tax-free. The goal of a conversion is to pay tax sooner, but at a lower rate than you otherwise would when you take a distribution later in retirement.

Pulling It All Together

The items discussed above only scratch the surface. Your Shakespeare Financial Advisor, along with your tax preparer, can help you with all your tax planning needs. Please reach out if you would like to discuss your situation in more detail. We are here to be your partner and provide peace of mind.