How to Minimize Tax Risk in Retirement

When it comes to retirement investing, diversification is essential. By spreading investments across many different asset classes — such as bonds, stocks and mutual funds — temporary losses in one type of investment can be offset by gains in another one.

The same concept holds true when you start to turn those savings into income in retirement. Tax diversity may be a lesser-known concept — but when it comes to helping ensure a healthy retirement, tax diversity can be just as important as having a diversified portfolio. After all, the more you minimize the taxes you pay on withdrawals from those retirement accounts, the more money you get to keep.

As you approach retirement, it’s important to have this discussion with your financial or tax advisor, but here are some basics to get you started.

The biggest consideration is your tax-deferred retirement accounts, such as traditional Individual Retirement Accounts and traditional 401(k) and similar workplace plans. Those accounts give you lots of tax benefits up front: You can take tax deductions for your contributions, and your investments grow tax-deferred. But once you start taking withdrawals, you’ll be responsible for paying taxes on the money you take out.

Traditional Individual Retirement Accounts: Cash distributions from your IRA are taxed as regular earned income. But once you hit age 72, the IRS throws in another wrinkle: the required minimum distribution (RMD). This requires you to take money out so the IRS gets its tax payment. And the IRS is serious: If you don’t take your required distribution by the required date, you’ll face a tax penalty equal to 50 percent of what you should have withdrawn.

Figuring your minimum withdrawal isn’t rocket science, but it isn’t straightforward, either. The IRS publishes a table listing a “distribution factor” by your age. Take the total of all your traditional IRAs’ account balances as of December 31, and divide it by the appropriate distribution factor.

Be careful about when you take your first required withdrawal. You’re allowed to postpone the initial distribution in the year you turn 72 to the following April 1, but your second withdrawal must happen before Dec. 31 of that same year. If you take that option, check whether taking two withdrawals in the same tax year will push your income into a higher tax bracket.

When it comes to taking withdrawals from your IRA before age 72, there are two main schools of thought: One is that you should access tax-deferred accounts first, like traditional IRAs, 401(k)s and similar employer-sponsored plans; the other is that you should access tax-free accounts, like Roth IRAs, first.

In his book The Power of Zero, David McKnight recommends putting as much of your retirement savings as possible into tax-advantaged accounts, such as a Roth IRA. As McKnight explains in the book, he foresees massive tax increases coming, which could reduce the value of savings that are in tax-deferred accounts such as 401(k)s and taxable CDs.

Roth IRAs: Investors face no required minimum distributions when they take distributions out of a Roth account. You paid taxes on your original contributions, which allows you to withdraw both the contributions and your earnings completely tax-free (this only applies to qualified withdrawals, which typically means the account has been open and funded at least five years and you are at least 59.5 years old).

One tax strategy is to convert traditional IRAs or 401(k) accounts to Roth IRAs or Roth 401(k)s. You’ll pay taxes at the time of the conversion, but you won’t face taxes on any future earnings when they’re withdrawn. If you’ve already turned 72, you’ll need to take that year’s minimum distribution before you convert the account. Typically, this move makes the most sense the longer you have until you retire or need the money.

Traditional 401(k)s: The same required minimum distribution applies with your 401(k), but there is a way to defer it. If you’re working when you turn 72 and are not a 5-percent owner of the business sponsoring the plan, many plans allow you to delay the first withdrawal until you retire. This applies only to your current workplace account, however.

Roth 401(k): Even though qualified withdrawals aren’t taxable from these accounts, minimum distributions are required at 72, except in a plan if you’re still working. You can avoid the withdrawals by rolling a Roth 401(k) into a Roth IRA. Another advantage is that Roth IRAs may offer a wider variety and lower fees.

State and local taxes: Many retirees stretch their nest eggs by moving to lower-tax states such as Florida, Texas, Nevada, Alaska, New Hampshire, South Dakota, Tennessee, Washington and Wyoming. In addition, 13 states also have their own estate taxes, often with lower exemption amounts than the federal estate tax.

Establishing a new tax domicile is relatively easy for those who move, but can be complicated for people who maintain more than one household.

If you have questions about financial strategies for retirement, connect here with a Mutual of Omaha financial representative.

Registered Representatives offer securities through Mutual of Omaha Investor Services, Inc., Member FINRA/SIPC. Investment Advisor Representatives offer advisory services through Mutual of Omaha Investor Services, Inc.

Mutual of Omaha and its representatives do not provide tax and/or legal advice, and the information provided herein is general in nature and should not be considered tax and/or legal advice.

Information in this article is current as of February 2020.