Retirees: Want to Keep Your Money? Make a Tax Plan

An older man puts cash in his back pocket.

(Image credit: Getty Images)

published 17 July 2024

When you visualize retirement, you may think about traveling to exotic destinations, spending more time with family or taking a favorite hobby to the next level.

Regardless of how you picture it, living in retirement takes a totally different mindset than working toward retirement. Retirees must pivot from a decades-long mindset of building wealth to coordinating their assets into a reliable income stream.

Taxes are an important piece of the retirement planning puzzle. Unlike your working years when your employer withheld and prepaid your taxes, in retirement you must fund your own tax bill. But many people don’t know where to begin. RBC Wealth Management surveyed 2,000 households on the cusp of or recently in retirement and found 7 out of 10 agreed they need advice on income planning and tax strategies in retirement. Only 49% understood the tax implications of withdrawals, and just 44% understood how required minimum distributions (RMDs) work.

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Your retirement strategy needs a solid foundation of tax planning to preserve as much of your “retirement paycheck” as possible. Here are the most common tax rules that I have seen catch retirees off guard:

Social Security. About 56% of people who get benefits pay federal income taxes on them, according to the Social Security Administration. That’s because their income in retirement exceeds limits set by tax rules and regulations. And remember, there are several states that tax Social Security as well.

Ordinary income tax rate. The level of income you have in retirement affects your tax liability. If you meet certain income thresholds or receive capital gains from taxable investments, you may face additional taxes.

Alternative minimum tax (AMT). Individuals who reach certain income levels may be subject to AMT. This tax is calculated by eliminating certain deductions that are typically allowed under standard tax calculations.

Medicare surtax. Married couples filing joint returns with incomes above $250,000 and single filers with incomes of $200,000 or more may be subject to a 3.8% tax on net investment income. The tax can be applied to interest, dividends, capital gains, rental and royalty income and non-qualified annuities that exceed the threshold amounts.

The key is to keep track of taxes and plan ahead to pay them. Consider having taxes withheld from taxable distributions, making quarterly estimated payments or setting aside funds specifically for your tax bill to take the sting out of Tax Day. That said, preparing for the “gotchas” is only part of a good tax strategy. Diversifying your income sources and timing the sequence of withdrawals can help minimize our tax burden.

The right place (and time) for your retirement assets

In real estate, it’s all about location, location, location. In retirement, asset location is important, too.

Our research found that 68% of those approaching retirement don’t have a strategy for drawing on various investments and assets for income in retirement. The first step is to identify all your sources of income and assets that will be used to fund your retirement. A mix of accounts with different tax treatments allows for greater flexibility when managing your taxes in retirement and may even lower your overall tax bill. Your account mix should include:

Taxable accounts. These include brokerage accounts and income on certain types of investments, including dividend interest and distributions from mutual funds, even if the fund is not sold. If you sell your investments like stocks, bonds and mutual funds, you’ll pay taxes on the gains.

Tax-deferred accounts. Think individual retirement accounts (IRAs) or tax-deferred employer-sponsored plans, such as 401(k)s and 403(b)s. They allow you to delay paying taxes on investment gains, and potentially accumulate more over time through tax-deferred compounded growth. Deferred accounts allow you to contribute pretax income, reducing your current tax bill.

Tax-free accounts. You pay taxes when you contribute, but your investment will benefit from years of tax-free compounded growth, and withdrawals in retirement are also tax-free. These accounts include Roth IRAs and Roth 401(k)s, as well as health savings accounts.

Many soon-to-be retirees save for their retirement in tax-deferred accounts such as IRAs, 401(k)s and 403(b)s because they are funded with pretax income and reduce their current tax bill. But distributions from those accounts will be treated — and taxed — as ordinary income. To help minimize the tax burden from these accounts, retirees can plan the right timing for their withdrawals.

In general, it’s wise to withdraw from your taxable accounts first, then tax-deferred, then tax-free. However, earlier in retirement when your income is lower, it might make sense to tap your tax-deferred accounts. A strategy called “tax bracket topping off” can help determine how to access tax-deferred funds and take advantage of the lower tax bracket, especially prior to when required minimum distributions (RMDs) kick in and you may have additional taxable income and less flexibility.

The great tax sunset is coming — are you ready?

Asset location and withdrawal sequencing are complicated enough on their own, but many households have to keep an eye on changing tax laws, too. Both pre-retirees and retirees need to plan for the possibility of being in a higher tax bracket in the near future. That’s because unless Congress acts, many of the benefits from the Tax Cuts and Jobs Act (TCJA) of 2017 are expiring after 2025.

In 2026, tax brackets will revert back to pre-TCJA level. For example, the top individual income tax bracket will go back up to 39.6% from the current rate of 37%.

A Roth conversion or partial conversion can work well early in retirement, when income is lower than it will be when you have to start taking RMDs. Converting assets gradually over a few years can also spread out the taxes you’ll pay.

The TCJA also provided estate tax relief through an elevated exemption that is now $13.61 million per individual. That would be reset to about $7 million in 2026 as adjusted by inflation.

The decedent’s estate will pay a 40% estate tax on any assets above the exemption level. With proper planning, the hypothetical estate tax on a decedent’s $13.61 million estate transferred to their heirs this year would be $0. The estimated tax bill for a similar inheritance in 2026 would be about $2.65 million, and this does not include any potential state estate taxes. An estate planning attorney can help you develop strategies to mitigate any tax burden on your heirs.

The bottom line

Planning for income in retirement is a balancing act. Assessing the need for income against investment risk, taxes and longevity is a dynamic process. But you’re not alone. A financial adviser can help with an annual revisit to your income plan.

RBC Wealth Management does not provide tax or legal advice. All decisions regarding the tax or legal implications of your investments should be made in connection with your independent tax or legal advisor. No information, including but not limited to written materials, provided by RBC WM should be construed as legal, accounting or tax advice.

Investment and insurance products offered through RBC Wealth Management are not insured by the FDIC or any other federal government agency, are not deposits or other obligations of, or guaranteed by, a bank or any bank affiliate, and are subject to investment risks, including possible loss of the principal amount invested.

RBC Wealth Management, a division of RBC Capital Markets, LLC, registered investment adviser and Member NYSE/FINRA/SIPC.

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

Angie O’Leary is head of Wealth Planning at RBC Wealth Management–U.S. Angie and her wealth planning team are focused on helping clients live life with more clarity and confidence through goals-based planning delivered by skilled financial advisers. As a 30-year veteran of the financial services industry, Angie sits on several industry roundtable and advisory boards and is often asked to contribute her expertise. Angie has authored numerous white papers, published articles and is active in the media and press. She has a passion for financial literacy and is an advocate for women and their financial success.