Nobody likes to pay taxes. For many, paying taxes triggers an intense gut reaction ranging from euphoria on the news of a large refund to downright anger if a check needs to be cut to the IRS. This tendency toward emotional responses at the mere thought of sharing one’s hard earned wages with the government can lead to poor financial choices.
Often, we become too focused on reducing our current year tax liabilities, which may actually cause us to pay more to Uncle Sam down the road. While this is true at every stage of life, for those heading into or already in retirement, taking a multi-year view on taxes is especially important because of the complexities that can arise from the rules regarding taxability of Social Security, Medicare premium surcharges, and the so-called “widow’s penalty.” Knowing how and when these factors come into play will help you devise a strategy for reducing the tax you and your heirs pay over your lifetimes.
The fact tax rates can and do change periodically adds to the complexity of devising an “optimal” tax strategy for retirement. When deciding between traditional IRAs, Roth IRAs or taxable accounts as the best vehicles for retirement savings, the key is whether tax rates will be higher or lower in retirement. Higher rates now give traditional IRAs an edge. Higher rates in retirement tilt the scale toward Roth. Both will beat a taxable account over time, assuming they are invested the same. The problem is that, because Congress can change the rates, what looked like the right choice in the beginning can turn out wrong. This uncertainty makes it wise to build a tax-diversified retirement portfolio by including all three account types in the mix to provide more tax bracket management opportunities in retirement.
Because traditional IRAs are much older than Roth IRAs, they are often a retiree’s largest source of retirement savings. They are also a large untaxed income pool that must eventually be tapped, starting at age 70½. These Required Minimum Distributions (RMDs) can have negative tax consequences. They can interact with the rules regarding taxability of social security benefits causing an unexpected increase in taxable income. For married couples, 50% of social security is taxable when “combined income” (half of social security plus all other income) is more than $32,000. Once combined income exceeds $44,000, 85% of social security income is taxable. RMDs may also push a retiree into a higher tax bracket, assuming the required withdrawal amount is more than what is needed for living expenses. Furthermore, retirees on Medicare can see a bump in their premiums due to the start of RMDs if the RMD pushes their adjusted gross income over $170,000.
RMDs can be minimized by converting traditional IRA funds to Roth IRAs since Roth IRAs are not subject to RMDs. However, amounts converted add to taxable income in the conversion year and may trigger the same issues. That is, for retirees already on Medicare and collecting social security, the effective tax rate on a Roth conversion must account for the potential change in taxable income due to taxation of social security, and possibly Medicare surcharges, in addition to the marginal tax bracket that applies to the conversion. Still, given that today’s relatively low tax rates are set to disappear in 2025, Roth conversions may still make sense.
Taking advantage of this tax cut window may be particularly beneficial if retirees expect to leave some IRA assets to children. Here, the beneficiary’s expected marginal tax rate should be factored in. It may make sense for parents to convert traditional IRAs that will go to children in high tax brackets to Roth IRAs, having the tax paid at the parents’ relatively low current rate. Alternatively, it may make sense to change the IRA beneficiary designation to grandchildren who will be able to withdraw the funds at a lower tax rate over their lifetimes (assuming the SECURE Act does not go into effect and the “stretch IRA” is preserved for non-spouse beneficiaries).
It also pays to consider the fact one spouse will likely pre-decease the other, leaving the survivor filing using single tax brackets, rather than married filing jointly. This “widow’s penalty” can trigger a higher marginal tax rate, increase taxable amount of social security and higher Medicare premiums for the survivor.
David T. Mayes is a Certified Financial Planner professional and IRS Enrolled Agent at Bearing Point Wealth Partners, Inc., a fiduciary financial planning firm in Hampton. He can be reached at (603) 926-1775 or firstname.lastname@example.org.