understanding gift tax

Tax Planning for Retirees

Almost half (46 percent) of recent retirees wish they had planned better for handling taxes in retirement, according to a new survey from the Nationwide Retirement Institute. One in four retirees report having paid thousands of dollars more in taxes in retirement than they had expected.

The perfect storm is brewing for retirees.

Retirees can go years with little to no tax liability, only to be hit with a huge tax bill once they hit 70 years old.

A large tax bill can be crippling to your retirement plans. Every dollar you spend on taxes is one less dollar you spend on yourself in retirement. That is less of an inheritance you leave, one less vacation you take, or a less exciting life you get to live.

Pre-retirees are finding out the hard way that there is a tax bomb waiting for them once they get into retirement. What is worse, is that this tax liability can be avoided with the proper planning. To properly plan, you need to know how the tax bomb is created, the tax planning window in which to take the proper steps, and which actions you can take to properly reduce your future tax liability.

Taxes in Retirement

You would think that once you were done working your taxes would naturally decrease. You are no longer bringing home an income so what is triggering the taxes? A majority of retirees have spent a lifetime putting money away for retirement. The issue is that they have put money away in deferred compensation plans like 401ks and traditional IRA accounts. These are great plans, but they are tax deferred plans.

A tax deferred retirement plan kicks the tax can down the road. We avoid paying taxes today, so we can pay taxes in retirement. The hope is that you avoid paying taxes while you actively generating income and are in a higher bracket, so you can pay them later in a lower bracket. In theory, that is exactly how it should work. Unfortunately, theory rarely equates to reality.

Things become problematic when you become forced to take money out of these tax deferred accounts and must pay tax on that money.

Required minimum distributions are set to start when you turn age 70 ½. It is at this time that you are required to withdraw a minimum amount from your account each year. It doesn’t matter if you need this money or not; you are forced to take the money or pay a 50% penalty on the money you don’t withdrawal.

So how do you figure out what your required minimum distributions are?

First, you need to start with all your tax-deferred retirement accounts. If you have multiple traditional IRA accounts, you can group those together and think of them as one account. If you have a 401k or multiple 401ks, these accounts need to be thought of separately. You will be required to take a distribution from each of these accounts. Roth IRA accounts do not have required minimum distributions. You’ve already paid taxes on these accounts, so you are free to leave the money in the account without penalty.

Once you have properly classified your accounts, you need to determine the year-end balance for the previous year. When you have the account balances, you need to determine your age at the end of the current year. Not your current age right now, or on the day you take your required minimum distribution, but the age you will be at the end of the current year.

Look up your age in the Uniform Lifetime Table provided by the IRS to find your divisor. Divide the balance in your account at the end of the year by the divisor to get your required minimum distribution.

For example, if you are 71 years old at the end of the year, and your account balance at the end of last year was $1,000,000, your required minimum distribution will be $37,735. You arrive at that number by dividing $1,000,000 by 26.5, which is your divisor.

Your required minimum distributions are only one part of the income picture that needs to be analyzed. What other taxable income do you have?

If you are currently withdrawing an annuity payment or receiving a pension, you will have to include those amounts in your income.

The real kicker to retirement income is your social security income. You can start your social security payments early at the age of 62. If you wait until after your full retirement age, you can build delayed retirement credits which will increase your social security benefit amount. Once you hit age 70, you will be required to take your social security benefit. As you can see, all these large income sources are turning on at the same time, which can spell t-r-o-u-b-l-e.

What a lot of people fail to consider is the taxation on your social security benefits. Most people believe that social security is received tax-free. For a lot of people this is true, but once you pass some very low income thresholds, they can tax up to 85% of your social security benefits. With the state of social security today, expect this tax amount to increase to 100% sometime in the future.

For single tax filers, the top threshold is set at $34,000 and for married filing joint, that threshold only increases to $44,000. To find out if you reach that threshold, add up all your income sources plus ½ of your social security benefit.

If you are taking required minimum distributions plus social security, you are going to hit that threshold rather quickly and be forced to pay more in taxes. Luckily, with the right planning, there are steps you can take to minimize your future tax burden.

How to Reduce Taxes in Retirement

Reducing taxes in retirement requires planning ahead of time. Once you are already past the age of 70, the ability to reduce taxes greatly diminishes. It is at that age that you are forced to take all this money out of your retirement accounts plus social security, so the opportunity to plan is gone.

Most people do not wait until they are 70 years old to retire, even though that is when you start collecting the most benefits. A lot of people will begin to retire in their 60s, which is great for advanced tax planning.

Once you retire, your yearly income drops significantly, and you drop into a lower tax bracket. Think of a chart of your tax brackets throughout your life. At the beginning of your career you have very little income, so you are in a much lower tax bracket. As your career progresses, your income begins to rise, and so does your tax bracket. In your 40s and 50s, you are beginning to excel in your career and bring in a larger income. This is when your tax bracket is the highest. It may start at 10% in the beginning and slowly rise to 32% throughout your life. At this level, you do not want to do a lot of retirement tax planning because you are paying the most tax in your life. Once you retire, and your income drops, you may fall back into the 12% bracket. Now that you have all these assets and you are in a lower bracket, this is the best time to take advantage of tax planning. This is our tax planning window. Once you hit 70, you are forced to take your retirement money and your tax bracket could rise again.

There are three types of accounts you could put your assets into. You have your always taxable accounts, deferred tax accounts like traditional IRAs and 401k accounts. The next type of account is your never taxable account and that is your Roth IRA. The last type of account is your sometimes-taxable account and that is a standard brokerage account.

Why are brokerage accounts sometimes taxable?

Brokerage accounts are sometimes taxable depending on the investments you hold and your current tax bracket. There are two types of gains in a brokerage account, short-term capital gains and long-term capital gains. A short-term capital gain is a stock you hold for less than 1-year, or less than 365 days. These gains are always taxed at your ordinary income rate, so they will always be taxed. You also have long-term capital gains which are gains for stocks held more than 1-year, or at least 366 days. These gains have a favorable tax rate because the government wants you to buy and hold your stocks. The rates these gains are taxed at are either 0%, 15%, or 20%. The percentage depends on your current tax bracket. For example, if you are in the lower two tax brackets, your capital gains would be taxed at 0%. If you are in the middle four tax brackets, your capital gains would be taxed at 15%. Finally, if you are in the highest tax bracket, your capital gains will be taxed at 20%. The possibility of having your long-term capital gains taxed at 0% is what makes a traditional brokerage account sometimes-taxable.

Now that you understand all the moving parts, you can begin to tax plan for retirement. There are several steps you can take to reduce your taxes; you do not have to do them all.

First, you can begin to convert money from an always taxable account to a never taxable account. This will allow you to pay tax now, while you are in a lower tax bracket. This will also reduce your future required minimum distributions, because they will not be required in your never taxable accounts. Converting money from one type of account to the next has become a lot harder with the new tax laws in place. Before, if you made a mistake you could simply hit the undo button and fix everything. There is no more undo button, so you must do a bit more planning to make this work. Remember, when you take money out of your taxable accounts, it counts as income. If you take too much out, it will push you into a higher tax bracket, and that is not what we want to do.

Let’s work through an example of this concept. If you are single and your income is currently $20,000, you are in the 12% tax bracket. You can convert $18,700 before it bumps you into the 22% tax bracket. Even though the United States has a progressive tax system so only a little bit of your income would be taxed at 22%, it is still a level we want to avoid. The idea is to pay less in taxes, not more.

Converting money from an always taxable account to never taxable account and staying in your lower tax bracket is the first step to plan for taxes in retirement.

The next option is to spend down always taxable accounts first. Be careful, you can’t really convert and spend down assets at the same time. However, if you need the money to live, you have no choice but to start spending down some of your assets. Given the options between an always taxable account, never taxable account, and sometimes taxable account, start with the always taxable account. This is the same basic principle as the conversion step.

Using the example above. Instead of converting $18,700 to a never taxable account, you can withdraw that amount and spend it to live. If you really need $25,000 to live, you can start with $18,700 from a taxable account and get the other $6,300 from a never taxable account. Again, you are converting while keeping your tax bracket low. Or, if you need only $10,000 to live, you could withdraw that money from an always taxable account and convert the other $8,700 to a never taxable account.

The best way to help yourself is to create tax diversification while you are still young. Most people have very large, always taxable accounts because the world defaults to 401k plans. If you are putting money away in a 401k, you should be thinking about opening a Roth IRA account, not a traditional IRA account. If you are already maxing out both, then it’s time to put money away into a sometimes-taxable account. Tax diversification will give you more options in the future by allowing you to withdraw money from different accounts at different times, and it will reduce your required minimum distributions in the future.

To throw a monkey wrench into these strategies, don’t forget to think about social security. There are a few things to think about before claiming social security. For example, what if you have a large always taxable account, but you don’t want to touch it and instead start social security early benefits? It may be better from a tax perspective to let your social security benefits grow by delaying and to begin spending down assets from your always taxable account. If you’ve already started to withdraw social security benefits, then you need to make sure you add them into your income and tax calculations for converting.


A lot of retirees are being surprised with huge tax bills in retirement. Every dollar you send to the government is one less dollar you get to spend living your life in retirement. If you wait too long, you could get stuck with these huge tax bills with no way out.

However, if you plan, you can take advantage of the tax planning window and reduce your future tax burden. Converting accounts from always taxable to never taxable, spending down always taxable accounts, and delaying social security are all valid options for tax planning. Remember you need to keep your current tax bracket and the next tax bracket in mind when making these decisions. The idea is to keep yourself in the lowest tax bracket while you can. The more years you have before you hit age 70, the easier these strategies are to implement.