Tax strategies for approaching retirement
When steady income from employment stops, it’s replaced with other sources, such as pensions, Social Security and investments. You can usually control when to start these income sources and — in the case of investments — decide which account to pull money from, as different accounts may have different tax consequences.
This gives you a chance to explore tax strategies that can have a significant effect on your retirement, including the following five ideas.
Zero percent capital gains
When you stop taking a salary, you’re more likely to be eligible to pay zero taxes on your long-term capital gains. Low-income taxpayers (individuals with taxable incomes below $39,375 and couples filing jointly with taxable incomes below $78,750 in 2019) are eligible for this 0 percent long-term capital gains rate.
With advanced planning, even with significant assets you can intentionally find yourself in the lower brackets for the first couple years of retirement and take advantage of the zero percent long-term capital gains tax.
For instance, you can delay taking Social Security for a couple years while you live off your zero percent capital gains. If you need more income, money withdrawn from a Roth IRA would not increase taxable income or affect the zero percent tax rate on the capital gain withdrawal.
Qualified Charitable Distributions
When nearing retirement, planning for charitable gift donations can yield extra tax benefits, too.
Under current tax rules, most people will be taking the standard deduction, preventing them from deducting charitable gifts. However, taking a Qualified Charitable Distribution (QCD) from your IRA could be the ticket to getting the best tax savings on a charitable contribution.
With a QCD, make a charitable contribution up to $100,000 from your pre-tax IRA and the amount is excluded from your income. Not only are you still able to take the standard deduction, you have effectively added the charitable deduction on top of that [because you’ve liquidated a taxable asset and given it away without having to pay the usual taxes on it first]. Plus, a QCD counts toward satisfying your required minimum distribution.
One downside is you have to be over 70½ years old to make a QCD, so those approaching retirement will have to wait.
If you own a traditional IRA, and are able to keep taxable income low, you may want to consider a Roth IRA conversion.
While it’s true that each dollar you convert will add to your taxable income that year, paying the tax now may result in less taxes paid overall [since gains in a Roth account are forever shielded from tax]. Also, money in a Roth is not subject to required minimum distributions at age 70½.
One trick with Roth IRA conversions is to do a partial conversion in an amount that takes you to the top of your current tax bracket. So, if you are in the 12 percent tax bracket, convert enough of the traditional IRA into the Roth to stay in that bracket without moving up to the next one. Doing this over a few years can substantially reduce your overall tax burden.
Net unrealized appreciation
If you are retiring with a 401(k) plan that has company stock in it, you may be able to take advantage of special tax treatment for the net unrealized appreciation (NUA) of the company stock. NUA is the difference between the company’s current stock price and the amount you paid for it.
A common approach to 401(k) distributions is to roll the 401(k) over to an IRA, where withdrawals are taxed at your ordinary income level.
With NUA treatment, the gain in the company stock is taxed at more favorable capital gains rates when sold, with only the cost basis portion being taxed at ordinary income rates. If the NUA makes up most of the account value with a minimal cost basis, this can result in significant tax savings.
Strategic investment withdrawals
Investment accounts can be separated into three tax categories: taxable accounts (investments), tax-deferred accounts (traditional IRAs and 401(k)s), and tax-exempt accounts (Roth IRAs).
Conventional wisdom is to withdraw first from taxable accounts, then tax-deferred accounts, while leaving tax-exempt accounts last.
A better idea is to take strategic withdrawals from whichever account best suits your taxable situation each year.
One example is to tap the tax-deferred accounts in the early years of retirement to avoid large future required minimum distributions that push you into higher tax brackets.
There are many other examples, too, but the idea is to have money in accounts that are taxed differently, allowing you to strategically tap them to minimize taxes through your retirement. This tax diversification also is helpful in responding to any future tax law changes.
This article presents the views of contributing adviser Kevin Webb, CFP, of Kehoe Financial Advisors, not the Kiplinger editorial staff.
© 2019 The Kiplinger Washington Editors, Inc. Distributed by Tribune Content Agency, LLC.