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6 Ways to Curb Taxes in Retirement

Jason Stipp
Christine Benz

Jason Stipp: I'm Jason Stipp for Morningstar.

It's Tax Relief Week on, and today we're talking about taxes in retirement. Joining us with a few tips is Morningstar's Christine Benz, our Director of Personal Finance.

Christine, thanks for being here.

Christine Benz: Jason, great to be here.

Stipp: Taxes, and a lot of other things actually, can change in retirement. You brought six tips to help reduce tax bills in retirement. The first one has to do with something you should start before retirement that can be a big help in retirement, and that's build tax diversification. What does that mean?

Benz: That simply means that you want to hold assets in different types of accounts that will receive different tax treatment upon withdrawal. Many people come into retirement with a lot of their nest eggs in traditional IRAs & 401(k)s. Unfortunately when it comes time to take that money out, all of that money is taxed at your ordinary income tax rate. What felt good going in, may not feel so good coming out.

I think for a lot of people it makes sense to have all three types of accounts represented in your portfolio when you come into retirement. That means Roth accounts, which will be tax-free up on withdrawal; the tax-deferred accounts (traditional IRAs and 401(k)s), which are pretty inevitable for most of us who are saving for retirement; and finally, some taxable accounts, where if you buy and hold securities you will be able to get ordinary capital gains treatment on those withdrawals.

Stipp: And how might an advisor help you figure out and when might you use these different accounts? What kind of situations are they valuable for you?

Benz: I've learned a lot about this from our users, who spend a lot of time strategizing about where they go for income on a year-to-year basis. And what they say is, really they can manage their tax brackets by pulling just enough from this account and that account to keep themselves in the lowest possible tax bracket.

I know that some of the tax-prep software will help you with this, but you can also use a tax advisor to give you some guidance if you are not familiar with this area on where to pull money for living expenses in order to manage your tax bracket.

Stipp: The key is of course, having those different pools available when you do reach retirement, so it is important to plan for that.

The second tip also involves the Roth account. Some folks in retirement might think, it's too late, I'm too old, and I shouldn't have a Roth account, but that's not necessarily true.

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Benz: It's not necessarily true, and the key profile for whom a conversion might make sense even after retirement is that person who really is not going to need at least part of his or her traditional IRA during retirement. For that person, where your main goal is to pass that money to your heirs, you might want to consider converting it.

The key benefit is to your heirs--when they do inherit that money, it will be free of income tax. They may owe estate tax on your whole estate, but that money that they receive from you through a Roth will not be taxable.

Stipp: The third tip, Christine, involves required minimum distributions, known as RMDs. These are required from certain types of accounts in retirement--401(k)s and traditional IRAs. Of course, you need to take them, but you say as a tip, be savvy about it.

Benz: That's right. There are a couple of points I would make here. First of all, check with your investment provider to see if they will let you automate your RMDs, so that in case you forget, you won't be liable for that big penalty that you'll have to pay if you do forget to take an RMD.

Another key point I would make is, don't let your RMDs take you off your planned distribution rate. I often talk to people who say, but my RMD is going to take me way over that 4% or 5% that I was targeting [for withdrawal]. There is nothing saying you have to spend that RMD. You can actually reinvest it in a taxable account or if your spouse has some earned income, you can think about reinvesting it in a Roth account.

And finally you can think about being strategic about your RMDs, and think about pulling your money from those accounts that you would want to rebalance anyway. That can be a great way to knit in RMD season with any rebalancing that you might do to get your portfolio's allocations back into whack.

Stipp: Tip number four is don't forget about state taxes, where you live. These can vary, of course, but can also add up to quite a bit.

Benz: They can. So, for people who are in the higher income tax brackets, they might want to think about state-specific municipal bond funds, where you can earn that double tax benefit. Sometimes you can also earn a local tax benefit.

Another thing to keep in mind is that property taxes can be a big percentage of many retirees' household expenses. You may be able to take advantage of freezes or perhaps longtime property owners' exemptions. Check with your municipality to see what sort of programs they have set up to help seniors stay in their homes.

And finally it's important for people who are engaged in estate planning to not forget about the role of state taxes. Right now at the federal level, we have very generous exclusion amounts of about $5 million per individual, $10 million for married couples. But in many states, those exclusion amounts are much, much lower. So you can die with a much smaller estate and still have it be subject to state estate taxes.

Some of those mechanisms that might not seem necessary when you look at where federal estate taxes are, might in fact be quite beneficial at the state tax level. These would be things such as trusts.

Stipp: Tip number five is something especially for folks who have paid off their mortgage, but maybe any retiree would want to consider, and that's when they take their deductions.

Benz: That's right. For a lot of retirees, if they don't have that mortgage deduction, it might not make sense to itemize their deductions every year. There might be years in which they take the standard deduction. But another thing I've learned from our users, it can make sense to kind of bunch those deductions together, so in years when they do itemize they can take the itemized deductions, but use the standard deduction in other years.

So, if you have, for example, medical or dental procedures that are voluntary, you can defer them and group them into a single year. That way, you can deduct them on your tax return.

Stipp: Tip number six, Christine, involves something that's known as the "tax torpedo." When should that be on retirees' radars and what can they do about it?

Benz: This is the taxation of Social Security once your income from a few different sources exceeds certain thresholds. To calculate what's called provisional income, you look at half of your Social Security benefit, as well as tax-free income, and portfolio income. That amount together counts as what's called provisional income. And if you are over certain thresholds, a portion of your Social Security benefits will be taxable.

For people who have provisional income way over, say, $50,000, they really don't need to worry about this, because 85% of their Social Security benefit will be taxable. But for people who are below that level, they may be able to manage their income, particularly from their portfolio, to ensure that they don't hit the thresholds.

One reason it's called a torpedo is that you see a big jump up in the amount of Social Security income that is taxable once you hit a certain threshold. It jumps from 50% of your benefit up to 85%. So, you really need to manage your bands, if you are in that neighborhood of provisional income.

Stipp: Christine, six great tips for retirees to manage their taxes. Thanks for joining me today.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.