Conventional wisdom says retirement savings should be spent with a focus on drawing down taxable accounts early in retirement. Many seniors can slash their lifetime tax bills by ignoring this advice, however, and charting a more considered approach.
The standard advice for retirees has long been to tap savings in taxable brokerage accounts and bank accounts first while not touching tax-deferred accounts such as 401(k)s or traditional individual retirement accounts until required minimum distributions kick in at age 72. This allows assets inside traditional IRAs or 401(k)s the maximum tax-deferred growth.
The problem is that this approach results in many retirees paying almost no tax early in retirement then getting hit with stiff tax bills in their 70s after they start collecting Social Security and begin required distributions from tax-deferred accounts.
“We’ve had clients [in their 60s] come in and say, ‘We paid no taxes the last five years. Isn’t that great?’ ” says wealth manager and certified public accountant Theodore Sarenski in Syracuse, N.Y. “And I say, ‘No, it’s not.’ “
Sarenski says clients instead should be focused on reducing their lifetime taxes. And that often means paying more tax in early retirement to reduce tax later.
By way of example, he notes that a couple over 65 years old with no other taxable income can withdraw $47,700 from a tax-deferred account and pay just $1,990 in taxes, a tax rate of just 4.2%. That same couple can take out $108,850 and pay $9,328 in taxes, an 8.6% tax rate. Either rate is lower than they are likely to pay after they begin collecting Social Security.
Many seniors should therefore consider tapping their tax-deferred accounts earlier in retirement and pay taxes while income is still relatively low, wealth advisors and accountants say.
Some early retirees in low tax brackets can save even more by converting tax-deferred accounts to Roth accounts.
Greg Will, a financial advisor and certified public accountant in Frederick, Md., refers to retirees’ late 60s as their “gap years.” The decisions they make then will affect their taxes for the rest of their lives. Optimally, they will enter their 70s with three buckets of money: an after-tax bucket, a tax-deferred bucket, and tax-free bucket for the Roth IRA, Will said.
Retirees can frequently save money by alternating between different buckets. For example, toward the end of the year, if Will sees his clients are hitting a higher tax bracket, he will advise them to pull money out of an after-tax account instead of tax-deferred account.
“If we have flexibility where we can draw from any of the three accounts, we have a lot more leverage over their future taxes,” Will says.
For many retirees, particularly upper-income ones, Roth conversions early in retirement are the best way to lower their taxes later in retirement. In the simplest type of Roth conversion, investors transfer assets from a tax-deferred account to a Roth account. The value of the assets is taxed at the time of transfer as ordinary income.
Consider the earlier example of a couple with no other taxable income. Instead of spending $109,450 from a tax-deferred account, they could convert $109,450 in assets from tax-deferred account to a Roth IRA account and pay the same $9,328 tax bill. Any money they take out of the Roth for the rest of their lives will be tax-free. Or they could leave it tax-free to their heirs.
Roth conversions make sense for retirees who have enough after-tax money to pay the taxes on the funds being converted. Otherwise, retirees have to pull even more money from their tax-deferred account to cover taxes.
Marianela Collado, a wealth advisor and certified public accountant in Plantation, Fla., analyzes each client’s anticipated future taxes and determines when current Roth conversions make sense to avert higher taxes in the future. A middle-income client might be doing Roth conversions in the 12% tax bracket, whereas an upper-income client may be doing them all the way up to the 24% bracket, she says.
Roth conversions also make sense for wealthy retirees who have estates too large to be covered by the $11.7 million per person lifetime tax exemption, says Bruce Weininger, a Chicago financial advisor and certified public accountant at Kovitz. Wealthy clients like this will probably pay around 40% to do a Roth conversion, reducing the size of their estate and their estate taxes.
But it will be far more costly if they don’t do a Roth conversion. The taxes on their estates will be larger and their heirs eventually will yet pay more taxes when they pull money out of an inherited tax-deferred account.
By contrast, with a Roth conversion, “you get all the tax-free growth from the day you do it until the day the kids take out the money,” Weininger says.
The current low interest rates make deferring taxes less valuable, says economist Laurence Kotlikoff of Boston University. Many early retirees have a lot of their wealth in bonds, which they keep in tax-deferred accounts to escape taxation on the interest.
But bonds are yielding less than inflation, meaning there is no growth in value from letting them sit in a tax-deferred account, Kotlikoff notes.
“If you’re in a period when you’re in a low tax bracket, that’s when you want to take it out of your IRA,” he says. “The real gain from this game is smoothing tax brackets” later in retirement.
That’s not all. Retirees with large tax-deferred accounts frequently get hit with higher Medicare premiums when they begin taking required minimum distributions at 72. The best way to reduce RMDs is to get money out of tax-deferred accounts before they begin.
It must be done with care. If a retiree takes out too much money from a tax-deferred account or does too large a Roth conversion in a particular year, that could also trigger higher Medicare premiums.
Kotlikoff sells software that shows safe ways that individuals can boost their income. He did an analysis on an imaginary 62-year-old retiree with $1 million in tax-deferred assets, $250,000 in a savings account, and $250,000 in a tax-free Roth account. The retiree planned to live off the savings account until age 66, then begin drawing down his tax-deferred account.
If he did this, the retiree would pay no taxes from 62 to 65, then see his taxes soar later in retirement. The analysis found that the retiree could boost his lifetime retirement income by $25,000 by tapping the tax-deferred account earlier.
Part of the gain came spending tax-deferred money at lower tax rates earlier in retirement. But the retiree also was able to dodge higher Medicare premiums down the road by lowering his RMDs.
That’s the math. The reality is that convincing clients to pay more tax in their 60s is often a tough sell, financial advisors say.
David Frisch, a certified public accountant in Melville, N.Y., says most clients come around after he shows how it can lower their lifetime taxes. He had a conversation recently with a client when he told her she needed to take extra money out of her individual retirement account because it would still be taxed at the 12% rate, but would be taxed at a much higher rate later in retirement. He told her that she could lower her future taxes or those of her children if the assets pass to them.
“She basically said,” Frisch recalls ” ‘I paid for my kids’ college. I even paid for my Mother’s Day dinner. Now I have to pay their taxes!’ “
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