If your employer provides a 401(K) or other qualified retirement plan, you've had the opportunity to contribute pre-tax money in a vehicle that has allowed you to defer taxes on gains and dividend income until you begin to take distributions from the plan.
Whether because you're in retirement and need money for lifestyle or because you're over the age of 70.5 and eligible for required minimum distributions, you're now faced with a looming tax bill on the money you're going to withdraw. The common question we hear people ask is how they can reduce-or even eliminate-taxes on withdrawals on tax-deferred savings.
The reality is that you're likely going to be paying some tax on that money. Remember, you got a tax deduction and years of tax-deferred investment growth. These are both great deals for investors, but at the end of the day, there is still a tax that needs to be paid.
So while we don't have a silver bullet that will eliminate your taxes altogether, we do have a couple of suggestions to help you be more efficient from a tax perspective.
Take advantage of the qualified charitable distribution on IRA savings.
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If you have additional assets in a traditional, tax-deferred IRA and are eligible for required minimum distributions by being at least 70.5 years old, you may be able to utilize a strategy known as the qualified charitable distribution. The qualified charitable distribution provision allows you to take a distribution from your IRA and contribute that amount directly to charity.
This allows you to do two things. First, the amount contributed via the qualified charitable distribution provision reduces your annual required minimum distributions requirement. Second, the amount contributed isn't included in your adjusted gross income on your tax return. This means that, if your income is high enough to be subject to itemized deduction phase outs, you'll be less likely to reach those phase out thresholds by keeping the money out of your adjusted gross income altogether.
Limit future taxes by making a Roth conversion.
Our second thought may not provide immediate tax benefits, but it does offer potential longer-term benefits. A Roth conversion simply means moving tax-deferred assets to a tax-advantaged Roth IRA. The downside to this transaction is that you will have to pay income taxes on the amount converted. Because of these income tax implications, it's important to analyze a Roth conversion within the confines of your entire financial plan.
Converting too much in a given year could cause some negative ripple effects, including creeping into a higher tax bracket or increase the amount of your Medicare premiums.
The upside to proactively paying the tax on your tax-deferred income and making a Roth
conversion is that it gives you a source of tax-free income down the road. In our experience, the people who have the most difficulty with taxes on their retirement income are those that have the overwhelming majority of their income in a single tax bucket. By diversifying your retirement income among multiple tax buckets, a greater number of planning strategies are open to you.
Just because there can be some income tax implications in retirement shouldn't dissuade you from utilizing tax-deferred savings options during your working years. The key to limiting tax consequences is to have a plan for that tax-deferred income before retiring.
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This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax adviser.
