Tax-Efficient Retirement Planning

Determining a baseline for retirement savings in the United States is difficult due in large part to the nation’s diversity. A host of variables, from age and lifestyle to cost of living and income, can influence what constitutes adequate savings.

The median retirement savings for all Americans was $86,000 according to the Federal Reserve’s 2022 Survey of Consumer Finances. The average balances of retirement savings varied significantly across different age groups, with those under 35 having an average balance of only $49,130 and those 75 and older having an average balance of $462,410.

Retirement savings balances don’t dictate annual tax burden; that is determined by taxable income, which may come from a variety of different sources. Social Security benefits, traditional IRA and 401(k) withdrawals, pension income, capital gains and dividends from investments and other income streams are all taxable, even in retirement.

There is always uncertainty in retirement, even for investors with several hundred thousand dollars saved. Healthy Americans in their 70s could live for two or even three more decades. What might have seemed like a lot of money at the outset of retirement could prove inadequate.

Strategies that minimize a retiree’s tax burden can be valuable in the long run and may help savers keep more of their savings intact.

How Income Affects a Retiree’s Tax Burden

Retirement savings tax strategies can be heavily influenced by a person’s income during their career and the sources of their income in retirement. A tax-efficient strategy for someone making less than the Roth IRA income limit throughout their working years and a tax-efficient approach for an above-average earner may look very different.

For higher-income savers, maximizing traditional 401(k) or IRA contributions can be beneficial, even though withdrawals from the account in retirement will be taxed as normal income.

Some workers might also want to look into establishing a backdoor IRA, which entails creating a traditional IRA with after-tax dollars then converting it to a Roth IRA. Although there can be significant tax advantages in a backdoor IRA, retirement savers should be cautious. Any gains in the traditional IRA are taxable in the year of the transfer or transition to a Roth IRA.

Workers who do qualify for a Roth IRA or Roth 401(k) may want to consider using a Roth IRA from the start, or for as long as they can prior to reaching the AGI limit. Savers early in their work life who believe they will earn a higher income once they retire could experience greater tax savings by taking advantage of tax-free Roth IRA or Roth 401(k) withdrawals in the future.

Location of Assets

Higher-income workers who don’t qualify for Roth retirement savings accounts can still strategically invest in assets that generate capital gains rather than regular income. The taxes on long-term capital gains and qualified dividends can be significantly lower than ordinary income tax in retirement.

The same is true for lower-income individuals. Many savers may even qualify for the lower long-term capital gains rate of either zero percent or 15 percent.

The Bucket Strategy

For individuals who have a lower tax rate in retirement as well as Roth accounts with tax-free growth and withdrawals, it often makes sense to adopt a staggered withdrawal strategy. This may mean drawing from taxable accounts first, followed by tax-deferred accounts. This approach allows the investments in Roth accounts to grow tax-free for as long as possible.

Higher-income individuals often benefit from discussing their required minimum distribution timing with a tax professional and retirement investment manager. They may also want to consider utilizing qualified charitable contributions directly from their IRAs to further reduce taxable income.

Capital Gains Harvesting

Retirees with high income from different sources may want to pursue capital gains harvesting during lower-income tax years. This involves selling appreciated assets during years when they’re in a lower tax bracket, which locks in the taxable capital gains at the lower rate, then repurchasing them.

Savers should discuss their options with a tax preparer to find out if they qualify for tax loss harvesting, tax credits or deductions.

Every Retiree’s Situation Is Different

There are many potential tax strategies workers saving for retirement and current retirees may utilize. The strategies that provide the greatest long-term tax advantages depend highly on each person’s or household’s unique situation. If you are interested in receiving personalized analysis from local Phoenix retirement planning professionals, contact Fullerton Financial Planning at (623) 974-0300.