Retirement costs money — an enormous, mind-boggling amount of money. Here’s a thought exercise for some context.
Imagine you are one of the lucky few college graduates that rolls out of the diploma mill and into a well-paying job, and at age 24 you’re earning a handsome $50,000 per year. Being financially savvy, you save 10 percent of your income each year. For the next 43 years, you remain consistently employed, you receive regular raises, your investments achieve satisfactory returns, and there are no financial catastrophes. This is about as good as it gets, and by age 67 you’re sitting on a nest egg worth nearly $1.4 million (keep in mind that this is a fantasy scenario for most Americans, who are woefully underprepared for retirement).
This, combined with Social Security (assuming it’s still around in 43 years), is the money that will be available to you through a retirement fund that is expected to last about 20 years. And to be clear, this is probably enough — well within the “comfortable” zone that is targeted by many financial planners, who advise people to replace at least 70 percent of their pre-retirement income in retirement. Those who are bullish tend to shoot higher, targeting closer to 100 percent of pre-retirement income or more, depending on how well investments are performing.
In this scenario, between the the two income sources, you’re still earning a six-figure income throughout retirement. And with the notable exception of Roth-style savings vehicles, most income sources in retirement are taxed. This includes withdrawals from a traditional tax-deferred 401(k) or IRA as well as Social Security receipts and most pension payments.
As at any interface with the Internal Revenue Service, savvy financial planners have developed strategies to reduce this tax friction. Just as ”most investors are familiar with the idea of maximizing their assets by minimizing taxes during their earning and wealth-building years,” says Ken Hevert, vice president of retirement products at Fidelity, “limiting taxes on those savings in retirement is equally important.” Here are some strategies outlined by Fidelity to do just that.
1. Get the withdrawal formula right
In general, according to Fidelity, you want to keep things as simple as possible — and sometimes, the simplest withdrawal strategy can be the most effective. Fidelity recommends that retirees make withdrawals from their accounts in the following order:
- Minimum required distributions (MRDs)
- From taxable accounts
- From tax-deferred accounts
- From tax-free accounts
Satisfying minimum required distributions is fairly straightforward. In exchange for all those tax incentives that your IRA and 401(k) receive, the IRS wants you to actually, you know, use the money you so prudently saved. When you reach the age of 70.5, you’re required to withdraw a certain amount of money from your retirement accounts each year, or face financial penalties. MRDs do count as taxable income, unless they are made from things like Roth accounts.
From here, you want to try to ensure that any assets you have in tax-free accounts remains there as long as possible. The last thing you want late in retirement is to be wrestling with Uncle Sam over your tax liability, especially if you face increasingly large medical costs that require increasingly large withdrawals.
2. Be aware of the Social Security tax formula
Up to 85 percent of your Social Security benefits are subject to taxation, depending on how much money you make. Here’s the tricky thing, though: When you start claiming Social Security benefits, half of those receipts count toward your “combined income,” which is what the IRS will use to determine how much of your Social Security it wants to take back. The combined income equation is your adjusted gross income, plus nontaxable interest, plus that half of Social Security receipts.
For a single filer, if this comes out to more than $25,000 per year, you will owe some taxes on up to 50 percent of your entire Social Security income — if it comes out to more than $34,000, you will owe taxes on up to 85 percent of your benefits.
3. Tax brackets matter, especially in the long run
It can be hard, but ideally you would like to have a very good idea of your expenses in retirement (as you would at any other point in life). While most working people don’t have throttle-like control over how much income they receive in any given year, retirees with well-funded nest eggs can, if they choose, make enormous withdrawals. Larger withdrawals, of course, can bump you into a higher tax bracket, which is contrary to the idea of reducing tax friction as much as possible.
One way some people choose to manage their retirement income is by targeting a marginal tax rate. This generally means never withdrawing more than a certain amount of money from taxable accounts in any given year.
4. Keep an eye out for selling opportunities
There’s one nice thing about the capital gains tax: If you’re in a low enough income tax bracket, it doesn’t exist. At least, it doesn’t exist as far as you’re concerned. The laws dealing with capital gains are constantly changing, but in 2014, those in the 10 percent and 15 percent income brackets could realize long-term capital gains, such as from the sale of stock, without being taxed.
If you have some assets you want to get rid of, doing so instead of making large withdrawals could actually be a good way to limit your overall tax liability.