Have you heard of the term tax diversification? While most of us tend to think of investing when we hear about diversifying our finances, there are also ways to create diversity in how your assets are taxed in retirement that can help you keep your lifetime tax bill at a minimum.
Here’s what to consider as you build your tax-optimized retirement savings and distribution strategy.
Avoiding a big mistake retirees often make
Before we get into it, we have to share WHY this is an important topic to address.
One mistake we see a lot of retirees making when putting together their retirement distribution plan is that they focus on fitting their expenses into their Social Security payment and/or their pension, while minimizing withdrawals from their 401k and IRAs. It makes sense – the monthly guaranteed income sources feel safer to spend, while your retirement savings accounts feel more like, well, savings. So intuitively we tend to save withdrawals from those sources as special occasions or only when necessary.
However, this could cause major unintended tax consequences in future years, especially once you reach the age of required minimum distributions (RMDs). It’s not unusual for our clients to reach their RMD age and have a huge tax bill due to the large distribution they must take in order to avoid penalty. The good news is, with some tax planning in your 60’s, you can spread the taxation of your pre-tax retirement savings out over many more years and ideally, lower the total tax bill for your lifetime, without necessarily having to spend those dollars before you need them.
We find it simplest to make your plan following these steps. Keep in mind that even if you don’t have all of the types of accounts mentioned, the steps of this plan will give guidance on how to keep your taxes to a minimum regardless.
1: Withdraw from your traditional retirement accounts
Even though you may want to think of your 401k and IRA as untouchable or for your future or your legacy, to optimize your tax planning, it’s a good idea to at least withdraw enough from any pre-tax, aka traditional, retirement accounts up to the amount of the standard deduction (or your anticipated itemized deductions, if higher) for that year.
For example, a married couple in 2024 would target withdrawing up to $29,200, which is the standard deduction for this year. These are technically taxable withdrawals but keeping it to the standard deduction amount or less will mean that none of it is taxed.
Not only does this allow you to withdraw pre-tax money at a low or no tax rate, it also lowers your future requirement minimum distributions if you start practicing this as soon as you are eligible.
2: Withdraw from brokerage accounts with low capital gains
If you have money in a taxable brokerage account that’s invested in stocks, bonds or mutual funds that have grown in value, the next step would be to realize capital gains up to the top of the 0% capital gains tax bracket. For 2024, that limit is $94,050 in total taxable income for married filing joint. In other words, you could make over $64k in the stock market but still pay $0 in capital gains assuming the only other income you have would be from step 1 with taxable withdrawals up to the standard deduction.
3: Spend down cash savings
Most retirees have a decent savings account built up by the time they retire and spending this money does not incur taxes. By balancing any income needs that wouldn’t be covered by your traditional retirement account withdrawals and/or capital gains realized with cash from your savings, you’re still able to keep yourself in that no-tax zone. And with interest rates starting to fall, it’s a good idea to spend down savings rather than claim Social Security until later.
4: Reimburse prior medical expenses from your HSA
If you still need additional income, then look to making tax-free withdrawals from your HSA. You can reimburse yourself for any Medicare premiums you are paying, pay current medical expenses and even reimburse yourself for past expenses that were incurred after you established the HSA but paid from your regular savings at the time the expense was incurred. Just make sure you have a good record of those prior expenses in case the IRS requests proof.
5: Withdraw from Roth IRA or 401k
Your Roth accounts have no required distributions, meaning those should be the last account you tap in your tax-efficient withdrawal plan. The longer you can let this account grow, the more tax-free income you’ll leave yourself later in life. But if you need more money and don’t want to add to your tax bill, this is the place to go next.
6: Fill up the lower tax brackets with taxable withdrawals or Roth IRA conversions
Many people may find themselves skipping right to this step either because they don’t have the other options, or they simply need more income than the above steps will allow. No worries, just be mindful of where you are in your tax bracket so that you don’t unintentionally make higher-taxed withdrawals that could be deferred a year, when the taxable income meter resets.
If you have a sizable amount in your pre-tax 401k or IRA, it’s a good idea to perform Roth IRA conversions each year in order to “fill up” the lower brackets as well. This has the double benefit of lowering RMDs, since Roth IRAs do not have required distributions, while also allowing you to build up your tax-free income bucket should your needs ever exceed your planned withdrawals in the future.
This is definitely a hot topic around our office as current tax rates are set to expire at the end of 2025, so even if it will cost you some taxable income in the coming year or two, we’d love to help you find the sweet spot of performing Roth conversions to lock in lower taxes without pushing you into higher brackets that you may never reach even if rates do go up in the future.
How Social Security fits the plan
One reason this strategy works is that the need to draw down cash savings will eventually be replaced by Social Security. So if you’re able to delay claiming until at least your full retirement age, you’ll lock in a higher payment that will be taxed less than other income like IRA and 401k withdrawals. (more on SS taxation here)
Tax diversification for the win!
The key here is spreading out the taxation of your traditional retirement withdrawals over the years so that you don’t find yourself making very large withdrawals in your 70’s to satisfy your required minimum distributions, even when you don’t need the money. The IRA/401k money that you don’t need to pay your bills in the years you withdraw it can be used to build your cash savings back up, in case of emergency, or invested in municipal bonds, which can pay tax-free income in a less-risky way than investing in stocks.
Having multiple retirement income sources that are each taxed in a different manner can help you legally use the complicated IRS tax code to your advantage. The key to proper tax-distribution planning in retirement is being mindful of your tax brackets as well as being aware of how your different savings buckets are taxed.
Not sure how to best do this with your unique situation? We’d love to help! Give us a call or set up a time so we can get started on making sure you’re not paying a dime more than you absolutely need to in taxes throughout your retirement.