After years of accumulating retirement assets, the time will come to decide how you will take retirement income. Of course, you want to make sure you don’t outlive your assets, and one of the best ways to do this is to minimize the taxes you pay on retirement income.
Ready to get started? Consider these three tax minimization strategies.
Strategy #1: Convert to a Roth IRA
Because you make Roth IRA contributions with after-tax dollars, the federal government does not tax Roth IRA account earnings and distributions. This gives you complete control over when you take distributions. Better yet, you may convert up to 30 percent of your traditional IRA balance to a Roth IRA every year. However, there is one catch: You must be at least 59 1/2 years old when you convert to avoid a 10 percent penalty tax.
You will have to pay taxes on the amount you convert from the traditional IRA, but earnings and distributions are tax-free for the new Roth IRA. The tax due on the conversion is based on your taxable income in the year you convert, so it’s important to time your conversion carefully. For example, one year you may have itemized medical expenses that reduce your taxable income, putting you in a lower income tax bracket. That may be a good year to plan to execute a Roth conversion. Conversely, if you have very strong earnings this year, you may want to postpone your conversion until next year if you expect next year’s income to be less.
Another advantage to a Roth IRA is that there is no minimum distribution requirement as there is with a traditional IRA. Additionally, Roth IRA distributions are not counted as part of your provisional income for Social Security purposes, as we will cover in point #2.
Strategy #2: Reduce taxes on Social Security
Up to 85 percent of your Social Security benefit may be taxable depending on your provisional income. Provisional income is the sum of wages, taxable and non-taxable interest, dividends, pensions, self-employment and other taxable income plus 50 percent of your Social Security benefit. If the sum exceeds the annual IRS limits of $25,000 for single filers and $32,000 for couples, 50 percent of your benefit will be subject to federal income tax. As much as 85 percent of the benefit is taxable if the provisional income is more than $34,000 for singles and $44,000 for married couples.
Reducing your provisional income (also called combined income) will reduce the taxable portion of your benefit. One way to reduce the provisional income is to take distributions from a Roth IRA. Distributions from a Roth IRA are not included as income in the provisional income calculation. This is yet another good reason to convert a traditional IRA to a Roth IRA as discussed in strategy #1.
Loans from a cash value life insurance policy are also not included in the provisional income calculation. With this in mind, borrowing the cash value of a life insurance policy can, in some cases, be a better financial decision than taking taxable distributions from a traditional IRA. This approach helps maintain adequate retirement income while reducing taxes on Social Security benefits.
Strategy #3: Donate an annuity
Purchase and donate an annuity to a non-profit organization. A Charitable Gift Annuity allows the donor to take a charitable income tax deduction, and at the same time guarantee a lifetime income stream. Working with a financial professional, you purchase an annuity and donate it to your charity. The charity, in turn, agrees to pay you a lifetime income from the annuity. After your death, the charity retains the remaining value of the annuity contract. The value of the annuity is not considered part of your estate, thus reducing your asset base. It’s a win-win for you and the charitable organization you choose to support.
Always seek professional guidance.
As you can see, there are many advanced strategies to reduce your tax bill in retirement.