“Tips for Lowering Taxes in Retirement”

So many financial articles talk about the importance of saving for retirement and how much money you should have saved to retire comfortably. While that is certainly an important topic, considering how these savings will be taxed in retirement, and the timing of these withdrawals, can be just as important. We have seen clients who take advantage of company pensions, social security, and IRA withdrawals early on in their retirement years which means their incomes are high but so are their taxes. What is the right strategy for timing these various savings tools? Additionally, with the age for Required Minimum Distributions moving to 73-75 with the recent SECURE Act 2.0, what is the best way to utilize gap years between retirement and this new RMD age?

What is a Required Minimum Distribution?
For the majority of individuals, their retirement savings are going to be within a company retirement plan (401K, 403B, etc.). When they leave their employer, they will likely roll these savings into a Traditional IRA and that is where the Required Minimum Distribution (RMD) comes into play. The RMD rules state that a minimum amount of money must be withdrawn from your Traditional IRA (or company retirement plan) every year starting when the owner reaches age 73 (Age 75 from 2033 onwards). You can always take more than the RMD every year, but it acts as the minimum that you MUST take, which also means you won’t have as much flexibility with your taxable income from age 73 onwards. They calculate your RMD based on a percentage of your year-end account balance from the previous year and the equation can be found here. So is there a way around the RMD rule? How can I manage these funds prior to age 73?

The Roth IRA Conversion
One common approach that you can take before you reach age 73 and the RMD rules is to consider converting a portion (or all) of your Traditional IRA assets into a Roth IRA. The Roth IRA has many benefits, but beyond being a tax-free vehicle it also does NOT have RMD rules. This means that you have complete control over what age and what amount you take money out of a Roth IRA. In fact, if you NEVER wanted to touch your Roth IRA and leave it to beneficiaries you could do that too. When you decide to convert money from a Traditional IRA to a Roth IRA you will pay taxes in the year you make the conversion, but once the funds are in the Roth IRA they are free and clear of taxes for any gains or withdrawals into the future. This can be a great option for someone to consider if, for example, they retire at 65 and have a 8 year gap before they reach age 73. Performing partial Roth IRA conversions during these years will ultimately mean that their RMD’s from the Traditional IRA (and subsequent taxes) will be significantly lower down the line.

Tax Gain Harvesting
If an individual already feels they have significant assets in a Roth IRA, or a conversion to a Roth doesn’t make sense for them, then tax gain harvesting could be a helpful consideration. Tax gain harvesting applies to non-retirement accounts such as a joint investment account or a simple after-tax brokerage account. Any assets owned in these accounts that have gained value over the years are going to be ripe for incurring capital gains taxes when you sell them. The beauty of the capital gains tax system in the US is that it fluctuates depending on your income. In 2024, for a married couple filing joint taxes, you can actually pay %0 capital gains tax if you make less than $94,050 of income! Yes, a 0% tax! So, before reaching age 73, and before starting social security income, it can be a great strategy to go through some of your non-retirement savings and sell holdings that have significant gains without incurring any taxes. You can then repurchase the exact same asset right away and re-start the clock on any growth from that point. This process can be tricky, and we highly encourage speaking with a CPA or your financial advisor before considering this approach.

Delaying Social Security
A final wrinkle to the above plans can be when you decide to start taking social security benefits in retirement. An individual can begin taking social security anytime from age 62 onwards, but the longer you wait the higher your monthly benefit will be (after age 70, your social security benefits will NOT increase for waiting). In order to reduce taxes on either the Roth IRA conversion strategy or the tax gain harvesting mentioned above, it can be helpful to consider delaying social security benefits in the early years of retirement. Everyone’s situation is different, and your monthly budget might not allow the delay, but not only can waiting provide you a higher monthly benefit, it can also reduce your overall tax burden on the strategies we’ve discussed above.

Retirement years should be a time when you enjoy your hard work and effort in saving. Implementing some of these strategies can make a huge difference in stretching out your money over your lifetime.

Cambridge does not offer tax or legal advice.