How to Minimize Your Tax Exposure In Retirement
Tax season is here again! If you are recently retired or approaching retirement and haven’t budgeted for taxes, you could be in for a surprise. Many retirees assume their tax liability will go down after they leave the working world, but that’s not always the case. If you don’t prepare for taxes, you could find yourself with less disposable income than you had anticipated.
The good news is there are steps you can take today to help minimize your tax exposure in retirement. Below are three such steps. You also may want to consult with a financial professional to develop action steps that are aligned with your specific needs and goals.
Convert to a Roth IRA
Qualified accounts like IRAs and 401(k) plans are common retirement savings vehicles. They usually offer immediate tax benefits. With a traditional IRA you can take a tax deduction for your contributions, assuming you meet income limitations. Your 401(k) contributions are deducted from your check on a pretax basis, thus reducing your taxable income.
Traditional IRAs and 401(k) plans also offer tax-deferred growth. This means you don’t pay taxes on growth as long as the funds are in the account. However, all distributions from these accounts are taxed as income. That could become problematic if you’re relying on a traditional IRA or 401(k) plan to provide much of your retirement income.
You could consider a Roth conversion to minimize the tax burden. As the name suggests, you may convert a portion of your traditional IRA funds into a Roth account. You will pay taxes on the converted amount, but you won’t pay taxes on future growth or distributions, assuming you wait until age 59½ and until the Roth has been open at least five years before you take a withdrawal. A conversion may create a tax liability today, but it could also eliminate tax exposure in the future.
Pay for Your Medical Expenses with Distributions from an HSA
Health care is often a substantial cost item for retirees. In a recent analysis, Fidelity found that the average retired couple is likely to pay $275,000 for health care expenses in retirement.1 That includes costs such as premiums, deductibles, copays and more. If you take income from your IRA or 401(k) to pay for those costs, you could inflate your taxable income.
Instead, consider using a health savings account (HSA) to pay for those costs. With an HSA, you can make tax-deductible contributions, grow your funds tax-deferred and then take tax-free distributions to pay for qualified health care expenses. That could reduce the amount of taxable withdrawals you have to take from other accounts.
In 2018 you can contribute up to $3,450 to an HSA as an individual or $6,900 as a family. If you’re age 55 or older, you can make an additional $1,000 catch-up contribution.2 Consider maximizing your HSA contributions so you can take advantage of tax-free distributions in retirement.
Donate Your RMDs to Charity
Traditional IRAs and 401(k) plans are popular in part because they allow you to defer your taxes on investment growth. However, you can’t defer those taxes forever. The IRS requires you to take minimum distributions at age 70½. These required minimum distributions (RMDs) are treated as taxable income.
If you’d already planned on giving money to charity, however, you could take advantage of a unique exception to reduce your taxable income. The IRS allows you to donate your RMDs to charity and avoid paying taxes on the distribution. To do so, you’ll have to set up the distribution to transfer directly to the charity without passing through your account first.
Ready to develop your retirement tax strategy? Let’s talk about it! Contact us today for a free financial review. We can help you analyze your needs and develop a plan that suits your specific retirement needs and goals.
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