Tax Planning

Why tax planning is so necessary in retirement

If you want to keep more of what you make, tax planning for your retirement savings is essential. Not only does it help you keep more of what you earn as you grow, but it is never more important than in retirement when you live on a steady income.

Well, failure to ruin the tax plan is not going to ruin a retirement plan. In other words, nothing needs to be done to have a successful retirement; However, if you are interested in getting the most of your money and ultimately getting more of what you have saved and invested, this is a must do.

Retirement is different

What makes tax planning different in retirement is the fact that you have more control over your income. While in employment, your salary is basically your income. There are a few small things you can do, such as: B. Contributing to TSP or HSA to lower your income, but your flexibility is limited.

Like most retirees, you will likely start collecting your FERS annuity right away, but this can be the only constant for several years. The rest of your federal retirement income comes from social security and the savings plan or capital income. The last two are flexible.

Each source of income is taxed differently

It is important to understand how any source of income is taxed.

FERS annuity = taxable income except for a small part. Approximately 95% of your FERS annuity will be taxed.

social insurance = The amount of your social security that is taxed depends on your provisional income. The provisional income includes your adjusted gross income from other sources, tax-free interest, and 50% of your social security covering it.

TSP or IRA distributions = 100% taxable income.

capital gain = long-term capital gains are taxed at a different tax rate, which is 0%, 15% or 20%.

Roth IRAs or Roth TSP = Distributions are 100% income tax-free as long as your account has been open for at least five years.

The easiest way to understand the possibilities is if we look at an example.

Retirees Joe and Jan, both 62 years old, have the following:

  • FERS annuity = $ 40,000
  • Full Retirement Age Social Security (FRA) = $ 30,000
  • TSP Balance = $ 1,000,000
  • Roth IRA = $ 200,000
  • Taxable account = $ 220,000 (base $ 90,000) held for 10 years
  • Savings accounts totaling $ 150,000
  • They take the standard $ 25,100 deduction when filing their taxes

The only income they have to claim until they are 70 is their FERS annuity, or $ 40,000. Social Security (SS) can commence at any time up to age 70 and IRA distributions are not enforced until RMDs commence at age 72. The special pension is another possible income if you retire before the age of 62.

Like Joe and Jan, you need to know how each of your sources of income is taxed in order to make tactical decisions to keep taxes lower over the course of your life! When you know the above, you can decide how to “fill in” your tax bracket. “Topping up your tax bracket” is simply the process of using the lowest marginal tax bracket you can each year.

Joe and Jane’s taxable income while on their FERS annuity only is $ 40,000 less the standard deduction of $ 25,100, which is $ 14,900. This puts them in the 10% tax bracket, but the 12% tax bracket goes all the way up to $ 81,050 for joint marriage filing. To top up their 12% tax bracket, they could either sell capital gains on a taxable account or make a Roth conversion up to the top of the 12% tax bracket.

The Rother Konversionsweg

Populating their 12% tax bracket with a Roth conversion would mean they would take $ 66,150 off their TSP and convert it to their Roth IRA. You would pay 12% income tax on the conversion for a total of $ 7,938. There are many benefits to moving assets to your Roth that you could potentially benefit from in the future. Remember that the tax bill must be paid when converting and it would be ideal if it were paid from a different account. Paying the tax bill from a separate account would enable them to get most of the money into the income tax-free Rother shelter.

Converting to a Roth has the following advantages:

  • No future RMDs
  • Tax protection from future higher taxes
  • Pass on assets to heirs free of income tax
  • Heirs can receive income tax-free growth for up to 10 years after inheritance
  • Income tax flexibility in the future

The capital gains route

Or that couple could choose to sell stocks and pay capital gains taxes. If they choose this path of capital gains they could sell up to $ 65,900 while staying in the 12% tax bracket.

The long-term capital gains rate for income up to $ 80,800 is 0%. This means that they could implement this strategy two years in a row and eliminate most (if not all) of the taxes they would pay on their taxable account ($ 220,000 balance on a $ 90,000 basis).

At the normal capital gains rate of 15%, they would have paid $ 19,500 in taxes. They could either reinvest the proceeds from the sale and create a new base, or they could use the funds for income purposes.

The combo route

This would simply mean doing a combination of the two. The retirees could sell positions in their joint account to meet taxes on the Roth conversion, or use any combination of the two.

Future income flexibility

Having more money in Roth IRAs gives retirees more income flexibility in the future. If they start collecting SS at the age of 67, their income will increase significantly.

At that point, retirees could be at the top of the 12% tax bracket or the 22% tax bracket.

Let’s say your taxable income is $ 70,000 and you want to stay in the 12% tax bracket. They could choose to take $ 11,000 from TSP and get the rest of their income from the Roth IRAs. The income from Roth IRAs is completely income tax exempt, meaning it does not affect your taxable income.

This strategy could help keep your social security taxes as well as your overall tax burden lower.

Effects on IRMAA

Some federal employees choose Medicare Part B when they turn 65. Part B premiums may be increased based on your Modified Adjusted Gross Income (MAGI). The Income-Based Monthly Adjustment Amount (IRMAA) can increase retirees’ healthcare costs.

IRMAA starts at $ 88,000 MAGI for single taxpayers and married couples filing joint taxpayers at $ 176,000 MAGI. Anyone carrying out a Roth conversion should be aware of the IRMAA and know from what income it starts. Access to income tax-free assets in a Roth IRA could help a retiree on the income threshold avoid IRMAA. Again, distributions from Roth IRAs are income tax-free and do not affect MAGI for IRMAA.

Other ways to limit taxes in retirement

In my next article, I’ll cover more ways retirees can lower their lifelong taxes in retirement. But the strategies listed above are the ones that I think will work well for many retirees.

© 2021 Brad Bobb. All rights reserved. This article may not be reproduced in any reproduction without the express written consent of Brad Bobb.

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