From Barron’s — By Jonathan I. Shenkman
The core focus of retirement planning is on the accumulation of assets to live out one’s golden years. This includes regularly contributing to retirement accounts and investing those funds appropriately. Although this is unquestionably a crucial first step, an important second consideration that many investors neglect is ways to minimize expenses in retirement, which will allow one’s nest egg to last longer.
One major continuing expense is a client’s tax liability. Despite no longer having a paycheck from an employer, retirees still need to pay taxes on whatever income they generate from their retirement accounts and other forms of income. Following are several strategies that may help advisors work with clients to plan for their continuing taxes in retirement:
Don’t waste low-tax years
It is important to capitalize on years with low or no income. It makes no difference whether it was due to unemployment, a bad year financially, or another reason. The key is to plan for your long-term tax liability and not just focus on the short term. During a low-tax year, investors should consider converting pretax dollars to a Roth IRA. This would require paying taxes on the conversion amount, but the long-term tax deferred growth and the ability to withdraw funds tax free can be beneficial in retirement.
Additionally, an IRA owner can proactively take distributions out of their account in low-tax years. Remember, required minimum distributions (RMDs) are the bare minimum one is required to take. If someone is in an advantageous tax situation, taking more than what is required can minimize taxes on the distributions later.
Consider a dynamic withdrawal strategy
It is common for investors to have multiple accounts with varied tax statuses by the time they retire. Funds should be withdrawn in a way to help minimize one’s tax liability. The rule of thumb is to first withdraw money from a taxable account. Next, withdraw funds from a tax-deferred account like a traditional IRA. Finally, withdraw tax-free funds from a Roth IRA. This process will allow retirees to avoid withdrawing their tax-advantaged funds, allowing those funds to grow longer without paying tax.
However, there are always exceptions to this rule. A dynamic withdrawal strategy allows for modification as one’s personal financial situation changes. For example, if someone is concerned about being bumped up into a higher tax bracket one year, it may make sense to first take funds from a Roth IRA in that year. The key is to evaluate your situation every year to avoid the higher tax bracket.
Qualified charitable distributions (QCDs)
A QCD is a direct transfer of funds from an IRA to a qualified charity. QCDs can be counted toward satisfying one’s RMDs, but, unlike regular withdrawals from an IRA, the donor doesn’t pay tax on these dollars. This will help keep a retiree’s taxable income lower, since the distribution doesn’t count toward adjusted gross income. The maximum annual amount that can qualify for a QCD is $100,000.
Rebalancing using donor-advised funds (DAF)
A DAF is an investment account whose purpose is supporting charitable organizations. A donor is eligible for an immediate tax deduction when contributing cash, securities, or other assets to a DAF. Those funds can then be invested for tax-free growth until the donor decides to distribute them. Grants can be made to any qualified public charity, right away or over time.
A DAF is particularly useful when an investor owns a security with no cost basis or a highly appreciated stock. In these scenarios, a capital-gains tax liability can be avoided by moving the position to a DAF. If you are looking to rebalance a client’s portfolio and they are also charitably inclined, the client can trim a large position, avoid paying capital-gains tax, move it to a DAF, and potentially lock in a tax deduction for the contribution.
Still working exception
The “still working” exception allows RMDs to be delayed for a retirement plan from an employer for whom someone is still employed. Therefore, this doesn’t apply to an old 401(k) at previous employers. Nor does it apply to IRAs, SEPs, and SIMPLE IRAs. When you use the “still working” exception, RMDs begin in the year you separate from service. Your required date to begin taking RMDs will be April 1 of the year after separation from service.
The definition of “still working” has no official specifics from the IRS. Consequently, working part time may be sufficient to take advantage of this strategy. It’s important to note that you can’t use the exception if you own more than 5% of the company for which you are still working.
Geographic arbitrage
Geographic arbitrage is when someone earns money in a part of the country with a high cost of living and high taxes and then retires to a less expensive part of the country with lower taxes. This may allow retirees to get the benefits of a big city income and enable those dollars to last longer in a cheaper and more tax advantageous part of the country. I frequently tell my clients that one of the best ways to save money is by being more thoughtful on where you decide to live. For example, if an individual worked their entire life as a lawyer at a big firm in New York City or San Francisco, they may want to consider taking their lifetime of earnings and moving somewhere with no state income tax like Florida, Texas, or Nevada. This type of relocation can make a meaningful difference in the cash flow of every retiree.
Jonathan I. Shenkman is the president and chief investment officer of ParkBridge Wealth Management based in New York.
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