A key part of retirement planning is looking at all the ways you can maximize the value of your money. This can be done through your regular stocks and bonds investments — or even through strategic tax planning!
Unfortunately, a lot of people (even financial advisors!), fail to focus on the latter. They think that retirement planning is all about getting the best returns on your investments in the market. But they can’t control the markets.
Instead, we like to focus on what you can control, like:
When you retire and how much you spend
How/when you take your Social Security & pension
How much you have set aside for short-term vs. long-term
How much risk you take in the market
AND Tax Planning
In this blog, our main focus will be on tax planning and how you can optimize your tax situation during your retirement!
Read on and find out the 5 best ways you can optimize your taxes to achieve your ideal retirement!
Before we begin
To better understand tax planning, let’s first briefly discuss how it’s different from “tax advice.”
Tax advice is about getting your taxes for the current and previous year completed correctly. While it’s a great process and is equally important, it doesn’t help you plan for the long-term.
Tax planning, on the other hand, is about looking towards the future and understanding all the possible ways you can bring down your overall tax rate. Depending on tax rates over the years, you could do this by using strategies like deferring your taxes to later, lower-income years, or by paying your taxes upfront.
This may go against the general tax advice you often see, but believe it or not, it can be more beneficial in the long run.
Now that you understand the goal of tax planning, let’s get started!
Pay Attention to Where You Put Your Money
The different types of accounts that you put your money into can be taxed differently based on the applicable tax laws. That’s why it’s important to identify the right types of accounts to use, and for what.
For instance, if you have stocks growing inside your traditional IRA, you’ll be required to pay income taxes on them when you take that money out.
However, if you have the stocks held outside of your traditional IRA in a regular old taxable account, the growth that they experience over the years (which is called long-term capital gains) is treated differently, tax-wise. Capital gains have a lower tax rate compared to regular income tax rates, which is why you may want to consider holding your stocks outside of your IRA.
When it comes to bonds, the interest earned on them is always income-taxable irrespective of the account they are held in.
You can take advantage of these different tax laws and minimize your taxes by holding your stocks out of your IRA and into a regular account while keeping the bonds inside your IRA.
Consider Which Accounts to Withdraw From
You can change your tax situation drastically by using a withdrawal strategy that meets your retirement needs.
As we mentioned above, money taken out from your traditional IRA is income taxable. But with a Roth IRA, that money is tax-free.
There may be certain rules you need to meet in a Roth IRA, but assuming you have met those, would you rather have your Traditional IRA grow and have more income that’s taxable? Or would you rather have your Roth IRA grow and have more tax-free income?
We think your answer will be the tax-free income!
Now, you may ask, “How can I do that?”
Our answer: Consider your choices! If you need to withdraw money during your retirement, we suggest that you take the Traditional IRA money out earlier, before it grows even larger. This will allow your Roth IRA to keep on growing. It’s also possible to convert your money from the Traditional IRA over to the Roth IRA.
Not many people realize it, but this can be highly impactful over the long-term!
Be Mindful of When You Take Your Money Out
When you hit retirement, the idea of when you pay taxes and when you spend that money can be easily separated out. The easiest way to think about it is by thinking about New Year’s Eve versus New Year’s Day. These two days are one day apart, but have a difference between one tax year and the next!
For example, imagine that you want to buy a car worth $20,000 in January and you are $10,000 away from the top of the 12% bracket. You may buy the car in December, or you may decide to wait until January to make that transaction. Either way, you’ll end up with $10,000 in the 12% bracket and the remaining $10,000 in the 22% bracket.
But what if you do it over two transactions? This way, you’ll have $10,000 at the 12% bracket over two different tax years. If you run the math, that’s a thousand dollars less in taxes!
This is why you should think about how much money you need, when you need it, and where it should come from. You may even consider borrowing that money if the tax savings can outweigh the interest expenses associated with loans!
Boost Your Social Security
Did you know that only 0-85% of your Social Security is taxable? If you think about it the other way, this means that 15-100% of it can be tax-free!
This is why, when you have a choice, you should try to bring down your fully taxable Traditional IRA income and boost your Social Security income.
If you need to take out money after you retire, you can turn to your Traditional IRA first instead of starting your Social Security. This is the opposite of what most retirees do. They take Social Security first, and delay withdrawing from their Traditional IRA until later on ‘when they have to.’
By doing this, you’re not only bringing down your 100% taxable IRA income, but you are also boosting your Social Security 8% each year you wait to claim it, with at least some of that tax-free! That’s a pretty good tax-planning trade-off.
Create a Charitable Giving Plan
A lot of people believe that giving money is an expression of their faith. We love that and we want to encourage your giving in any way we can!
That’s why we believe in putting in some additional thought when planning out your giving. By doing so, you can not only save on taxes, but can also give even more thanks to your tax savings!
You can learn a lot more about this in our guidebook, 6 Retirement Questions You Aren’t Asking (But Should Be!).
One way to save on taxes is to think about the way you gift. If you give $1,000/month to charity that’s $12,000 per year and with current laws a married filing joint couple is unlikely to have that benefit them through itemized deductions. If you gave $1,000/month to charity in one year, and at the end of December gave away $12,000 (basically pre-paying next year’s intended gifts) then you get $24,000 in charitable deductions in that year.
Following this example you don’t get any charitable deductions in the next year, but that’s OK - you’re regular way wasn’t getting you any itemized deductions anyway!
This strategy very likely saves more taxes over that 2 year time frame because you put your deductions into one year, moving you into a situation where you got more deductions than doing it the regular way.
Bunching your charitable deductions into one year can be incredibly helpful.
It’s also important to consider how you gift. There can be a significant difference between writing a check to charity and giving away stocks or mutual funds. When you give away the stocks or mutual funds (that you have held more than 1 year) you get to avoid paying the long-term capital gains. It’s better to gift the stocks direct to charity than to sell the stocks and write the check!
Another great way for giving to charity is through qualified charitable distributions. This is done by transferring your IRA money directly to the charity of your choice. Instead of taking out your Required Minimum Distribution each year, and sending some of that money to charity flip it around: Send the money to charity from your IRA, and then take the remainder amount to you directly. Using this technique has even helped one of our clients save $2,200 per year in taxes!
We encourage you to make use of these 5 steps as a checklist every year to make sure you are making the best use of your money! You might not be able to get all five of these in every single year, but they can definitely serve as a guide for your tax planning throughout your retirement!