Retirement presents a welcome reprieve to most, but also a vast change in financial responsibilities. For most retirees, sources of cash flow transition from earned income, salary, and wages to Social Security benefits and distributions from IRA’s, retirement plan accounts, pensions, annuities, and investment accounts. Accessing cash from each source may result in a different tax consequence. A financial advisor can help minimize the tax consequences both pre-retirement and post-retirement through a blend of tax-deferred, tax-free, and taxable retirement accounts. This leads to the first tax consideration for a retirement portfolio.
1. Tax on Distributions from Retirement Accounts
Tax-Deferred
After age 59 ½, distributions can be made from retirement accounts without paying early withdrawal penalties. However, distributions from traditional IRA’s, 401(k)/403(b)/457(b) accounts, and pensions are subject to taxation as ordinary income. Traditionally, income levels should be lower in retirement; therefore, marginal tax rates should be lower than in peak pre-retirement earning years. Nonetheless, tax will be paid on withdrawals from these retirement accounts. Tax has been deferred but not avoided.
A portion of distributions from traditional IRA’s may be nontaxable if nondeductible contributions have been made in prior years. Some taxpayers have to treat their contributions to traditional IRA’s as nondeductible due to taxable income limitations. The total amount of nondeductible contributions should be tracked on Form 8606 of the tax return. The ratio of nondeductible contributions to total account value will be applied to the distribution amount to determine the nontaxable portion.
Tax-Free
Distributions from Roth IRA’s and Roth 401(k)’s are tax-free due to being funded with after-tax dollars.
Taxable
Distributions from taxable brokerage accounts are not a taxable event, but the activity occurring within the account is taxable. Dividends and interest received can be used for retirement funding rather than reinvesting, but if more funds are needed, capital gains or losses will be recognized on the sale of securities.
2. Required Minimum Distributions
Minimum distributions (RMD’s) are required annually from retirement accounts beginning at age 70 ½. The first RMD is due April 1 of the year following 70 ½, and subsequent RMD’s are due December 31. The amount of distribution is determined by the total value of the account at year end divided by a distribution period from the IRS’s Uniform Lifetime Table. Failure to take a RMD results in a tax equal to 50% of the undistributed amount. RMD’s are not required from Roth IRA’s, but are required from Roth 401(k)’s.
3. Roth Conversions
There are opportunities for income tax planning post-retirement, and one of those opportunities is converting a traditional IRA to a Roth IRA. The negative aspect of the conversion is that tax must be paid on the conversion amount in the year of conversion. Distributions from IRA’s are ordinary income, so a large conversion could result in a step up in tax bracket. Naturally, it is beneficial to convert in a year when other sources of income are down to avoid the highest marginal tax rates. When a substantial amount of tax is paid up front, the breakeven point of tax savings is pushed further back. It is also advisable to use other sources of cash to pay the tax, so the entire conversion amount has the ability to grow tax-free rather than an after-tax amount. After the conversion, the account has the ability to grow tax-free without minimum distribution requirements (see consideration 2). The savings become significant if the account owner lives past life expectancy.
4. Net Investment Income Tax
Enacted by the Affordable Care Act and first effective in 2013, the net investment income tax (NIIT) is a 3.8% tax on the lesser of net investment income or adjusted gross income in excess of $200,000 for single filers and $250,000 for joint filers. The tax has an impact on higher net worth retirees and others who have accumulated significant portfolios producing investment income. Although distributions from retirement accounts are not classified as investment income, the distributions increase adjusted gross income which may subject investment income to the tax when the applicable threshold is crossed. The $200,000/$250,000 thresholds are fixed amounts not indexed for inflation; therefore, as wealth and investment income grow, the potential for NIIT or the actual NIIT liability grow.
5. Charitable Gifting of Appreciated Securities
Charitable gifting of appreciated securities is one of the most efficient ways to give to charities while also enjoying the full benefit of the charitable tax deduction. This technique is advantageous in that a charitable deduction can be taken for the fair market value of the security (limited to 30% of adjusted gross income) without realizing capital gains on the security. It is most beneficial to give securities that have significant appreciation and are no longer wanted in the retirement portfolio. Charities will need a brokerage account to accept the securities, so contact should be made with the charity beforehand to ensure that they accept gifts of securities.