Certain birthdays are milestones. At 18, you’re eligible to vote. At 21, you’re eligible to drink alcohol. And at 65, you’re eligible to collect Social Security benefits.1
The age of 70½ might not seem like much against such celebrated benchmarks, but it’s hugely significant nonetheless. It’s the age at which retirees face mandatory withdrawals from their retirement accounts—and the taxes that go with them. It’s not uncommon for retirees in a low tax bracket to jump into a higher bracket once they reach 70½.
“Many retirees go through life focused on how much money they need to live comfortably once they stop working,” says Kevin Trisler, CFP®, a financial planner with Schwab’s Wealth Strategies Group in Indianapolis. “But far fewer extend their planning discipline to managing their taxes in retirement. As a result, they end up having to live off less than they were counting on.”
The main challenge is centered on managing income from the required minimum distributions (RMDs) the IRS requires you to take from 401(k)s and SEP, SIMPLE and traditional Individual Retirement Accounts (IRAs) once you reach 70½. (Technically, you have until April 1 of the following year, but 70½ is the trigger, and waiting means you’ll have to take two distributions in the first full year, potentially bumping you into a higher tax bracket.)
In general, your age and account value determine the amount you must withdraw; fail to withdraw the full amount and you’ll be hit with a penalty of 50% of the difference between the distribution amount you did take and the one you should have taken.
“If possible, retirees should try to stay below the 25% tax bracket, given the significant tax advantages,” Kevin says. (See “What’s your tax bracket?” below.) If your income pushes above the 25% bracket, not only do you pay more taxes on your regular income, but you’ll also owe taxes on the long-term capital gains in your nonretirement accounts. That’s because those in the 10% and 15% tax brackets pay no capital gains taxes. Jump into the 25% tax bracket or higher, however, and you’ll be assessed between 15% and 20% on your long-term capital gains.
What’s more, a higher adjusted gross income can increase the taxes on your Social Security benefit, as well as phase out certain exemptions and itemized deductions. It can also increase your Medicare premiums, because those too are based on your income. The solution lies in tax strategies you can employ before and after 70½ that can help you keep more of your hard-earned savings.
Strategy 1: Withdraw before 70½
Once you reach 59½, you can withdraw funds from tax-deferred accounts without paying the 10% early withdrawal penalty. The withdrawals are still taxed as ordinary income, but over time they will reduce the size of your tax-deferred accounts—and hence your RMDs once you reach 70½. (See “Cutting RMDs down to size,” below.) Tapping those funds prior to age 70½ may also help put off your Social Security benefit, which increases in size the later you take it, up to age 70.
Of course, before taking early withdrawals you’ll want to assess your income tax situation at age 59½. If you’re still working, for example, you’ll want to be careful not to withdraw so much that you’re pushed into a higher tax bracket. Your Social Security benefits could also push you into a higher tax bracket once you begin collecting them, but keeping your RMDs low means less of your income would be subject to the higher tax rate.
Strategy 2: Convert to a Roth IRA
Converting a traditional IRA or 401(k) plan into a Roth IRA before you reach 70½ is perhaps the most appealing strategy for reducing the potential tax consequences of RMDs, Kevin says.
That’s because Roth IRAs are funded by after-tax dollars and so are exempt from RMDs during the owner’s lifetime under current tax law. And when you do withdraw the funds, both the principal and earnings are tax-free. (Keep in mind that converting to a Roth IRA is a taxable event, and that you shouldn’t use your IRA or 401(k) funds to pay the conversion taxes.)
There are two situations in which such a conversion makes sense. The first is when you’re certain you’ll be in a higher bracket when you eventually withdraw the money—which is often the case once you factor in RMDs and Social Security, according to Kevin. And the second is when you don’t need the money, you aren’t concerned about paying income taxes, and you’re converting in order to leave your heirs an income–tax–free Roth IRA.
Strategy 3: Make a charitable contribution
If you are considering a full or partial conversion to a Roth IRA, you may be able to reduce the resulting tax hit by making a charitable donation in the same year as the conversion. (The donation has to come from outside your retirement accounts.)
Generally speaking, the deduction for charitable giving is limited to 50% of your adjusted gross income when you donate cash, and 30% when you donate appreciated securities.
Nevertheless, Kevin often advises high-income clients to donate appreciated securities in their non-IRA accounts because they are otherwise subject to capital gains taxes.
Once you reach 70½, however, it may make more sense to simply donate part or all of the RMD (up to $100,000) to reduce your taxable income. The IRA custodian can make a qualified charitable distribution (QCD) directly from your IRA. For the 2016 tax year, if you file a joint return, each spouse can exclude up to $100,000 in QCDs from her or his gross income. “QCDs count toward satisfying any RMD that you would otherwise have to receive from your IRA,” Kevin says, “so they’re a great option if you’re philanthropically minded.”
1You can start receiving reduced Social Security benefits at age 62. Full retirement age is 65 for those born in 1937 or earlier, 66 for those born between 1943 and 1954, and 67 for those born in 1960 or later. Go to ssa.gov for details.