If you're planning on making tax-deferred retirement accounts the last pot of money you tap after retirement, you've got a lot of company. And why not? The idea that your 401(k) or traditional IRA can keep growing and churning out more tax-deferred money seems like a sound strategy.
But you may want to rethink this conventional wisdom. Instead of focusing on deferring taxes, Morningstar's Mark Miller suggests looking at how to minimize your overall total taxes during retirement – which can mean tapping tax-deferred accounts first.
A financial advisor can help you decide on an order in which to tap your retirement accounts.
"The idea is to use dollars in 401(k) or IRA accounts to meet living expenses - or convert a portion of these assets to Roth IRA accounts - before claiming Social Security in years when your marginal tax rate is lower than it will be after you start to receive benefit," Miller writes.
Tax Considerations in Retirement
One consideration Miller highlights is the fact that collecting Social Security benefits while making withdrawals from tax-deferred retirement accounts will very likely mean you'll pay taxes on your Social Security benefits.
Single tax filers who bring in between $25,000 and $34,000 in what the IRS calls "combined income" can be taxed on 50% of their Social Security benefits. Meanwhile, those who earn over $34,000 in combined income will pay taxes on up to 85% of their benefits. The limits for joint tax filers are $32,000 and $44,000. (Combined income is your adjusted gross income, plus nontaxable interest income from bonds and half of your Social Security benefits.)
As Miller notes, when Social Security benefits first became taxable in 1984 and then extended in 1994, the legislation didn't include adjustments to the income levels that trigger what some advisers call the "tax torpedo." This refers to the combined effect that earned income and Social Security have on a retiree's tax liability.
"The original idea was to tax only relatively high-income beneficiaries, and that remains the case. But the number of people affected is rising. That's because Social Security benefits are indexed to wage growth and adjusted for inflation, while the income threshold levels used to determine the taxable amount of Social Security benefits are fixed by law and not indexed for wage growth or inflation.
What You Can Do
Aside from drawing down tax-deferred accounts before claiming Social Security, one way to sidestep this "tax torpedo" is by having Roth assets.
Remember, for someone in the 22% tax bracket, each $1 of compounded earnings in a taxable 401(k) or traditional IRA yields just 78 cents – plus the potential tax triggered on Social Security benefits. But every $1 of compounded earnings in a tax-free Roth IRA equates to $1 of retirement income. And because it's non-taxable, it doesn't count toward your combined income.
One of the many considerations for retirees is figuring out how to complete Roth conversions in the most tax-efficient manner possible. Doing so will mean you'll have more tax-free money to draw upon without adding to your combined income. But you'll want to keep the amount of money you convert low enough so you're only subject to the lowest income tax brackets.
Alternatively, you could rely strictly on cash from taxable accounts to meet living expenses early in retirement, allowing yourself to delay Social Security benefits. Remember, Social Security increases by 8% every year between your full retirement age (67 for most people today) and age 70.
Figuring out how to make this work means each individual will need to run their own numbers, a task that's not too difficult for people projecting the impact of withdrawals from an IRA plus collecting Social Security benefits. People with additional concerns or complex situations can consult with a financial advisor or tax planner. They can also turn to a lower-cost service like Income Strategy, which calculates Social Security and drawdown sequencing, as Miller notes.
Bottom Line
Tapping your tax-deferred assets first can help lower your total tax burden in retirement, Morningstar's Mark Miller writes. This flies in the face of conventional wisdom, which dictates you withdraw tax-deferred assets last, allowing them to continue to grow. But this alternative strategy allows you to defer Social Security and maximize your future benefit. Roth conversions are another way you can generate tax-free income in retirement that won't add to your combined income.
Tax Planning Tips
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A financial advisor can help you plan for retirement taxes and offer advice on how to draw down your assets in a tax-efficient manner. Finding a financial advisor doesn't have to be hard. SmartAsset's free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now.
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If you're focused on limiting your tax liability in retirement, you may be thinking about moving to a more tax-friendly state. SmartAsset has a retirement tax-friendliness tool designed to help you identify the states that are most and least tax-friendly for retirees.
Photo credit: ©iStock.com/jacoblund, ©iStock.com/adamkaz, ©iStock.com/Luke Chan
The post Want to Minimize Retirement Taxes? Don't Follow This Popular Strategy appeared first on SmartAsset Blog.
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