It’s easy to think that you’ll be paying less tax in retirement. After all, you’re not working full time anymore and, odds are, your income is less. But hang on – let’s look at the whole picture:
Your standard deduction is decreasing: The current tax code has lulled us into a sense of complacency – who needs to itemize when the standard deduction is $25,900 for a married couple? But hold on, once this tax code expires at the end of 2025, we’ll be back to the lower 2017 standard deductions of about half of the current levels. And you may be stuck at this lower standard deduction level because typically, once the house is paid off and you don’t have a mortgage interest deduction, you can’t create enough expenses to itemize.
Your tax brackets are increasing: Along with the expiration of our super-sized standard deductions in December 2025, we are also losing our current low tax brackets. As the Tax Cuts and Job Act of 2017 expires, we’ll revert back to our higher 2017 tax brackets. The current 10%, 12%, 22%, 24%, 32%, 35%, and 37% tax brackets will go back to 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%. And they’ll squeeze the brackets too, so you’ll move through the 2017 tax brackets and into the higher tiers faster. Did I mention that this tax cut expiration is already in the codified law? Congress needs to do nothing, and we’ll be back where we were – sort of like Cinderella’s carriage turning back into a pumpkin at midnight.
Your Social Security is taxed in retirement: It’s been around awhile – the Internal Revenue Code has a pesky concept called provisional income where you add up half of your SS benefits, plus all of your other income (including tax-exempt interest). If it is greater than $32,000 for married couples and $25,000 for singles, 50% of your SS will be taxed. Greater than $44,000 for married couples and $34,000 for a single and 85% of your SS will be taxed. This dollar amount is NOT indexed for inflation in the tax code and catches more and more retirees each year.
You might be in a higher tax bracket at age 72: Many retirees have a golden period between retirement and age 72 when they are in a lower tax bracket. But once the Required Minimum Distributions rules kick in for your tax-deferred 401k’s and IRA’s, you can easily get pushed to a higher bracket, where you will stay for your lifetime.
Your non-retirement investment income keeps growing: It’s a good problem to have, but it’s a problem nonetheless. If you have brokerage accounts that report taxable investment income each year, as the account grows so does your taxable income. Assuming a 7% average growth of your portfolio (and using the Rules of 72), a $500,000 portfolio will grow to approximately $4 million in 30 years. If that portfolio creates 5% of taxable investment income, your current $25,000 in taxable investment income will mushroom to $200,000 each year.
Your finances get more complicated: You don’t have an employer to withhold taxes anymore, so now you need to pay quarterly estimates or manage the withholdings of your SS and taxable pensions and investment distributions. Plus, you may have multiple investment accounts that need consolidation to withdraw money tax-efficiently. It’s harder than you think to be retired! But enough of the doom and gloom. What are some commonsense strategies we can employ now to prepare for the future?
Roth Conversions
If you’ve read my writings before, you know I’m going to start with Roth IRA conversions. Roth conversions are where you move money from your pre-tax IRA’s into tax-free Roth IRA’s. You have to pay a one-time tax on the dollar amount you convert, but then the amount converted into the Roth IRA grows forever tax-free and passes to your heirs tax-free. This also reduces or eliminates the need to take taxable Required Minimum Distributions each year, since Roth’s have no such requirement. Short term pain, long term gain.
A Roth IRA conversion strategy works the best if you have money held outside of your IRA to pay the tax on conversion with. It’s not a deal-killer if you don’t, it’s just a better financial answer if you do. If you can swing it, I suggest you convert enough to take you to the top of the 24% bracket each year between now and the end of 2025. You’ll thank me for it later.
Non-Retirement Investments
Keep an eye on tax efficiency as you’re choosing investments within your brokerage accounts. For example, look to tax-free municipal bond funds on the fixed income side of your account and use tax-managed mutual funds on the equity side. Tax-managed mutual funds are designed to minimize the taxable effect to you each year – for example, the fund manager will offset gains with losses, and not trip short term gains, which are ordinary income to you. Additionally, hold investments that provide qualified dividends instead of ordinary dividends. Qualified dividends are taxed at a lower, preferential rate.
You can also look to tax-deferred investments, such as annuities held with an insurance company. Because they are tax-deferred you do not have to report the taxable interest, dividends and capital gains each year on your tax return. One caveat is that withdrawals from these tax-deferred annuities don’t have the same tax preference as withdrawals from a non-annuity investment. But if you’re holding the account for legacy purposes, that may not matter to you.
Bunch Your Itemized Deductions
This an oldie, but a goodie. And this applies both under the current tax code and the 2026 tax code. To the extent you are able, bunch up your itemized deductions into one tax year – elective medical procedures and charitable giving are two easy examples. My favorite idea is to set up a donor advised fund that you control (it’s super easy). Then you make a multi-year contribution to it in one year to get a larger than normal charitable deduction which allows you to itemize. Since you control the donor advised fund, you can then disburse the charitable gifts over a multi-year time frame at a pace you desire. It’s a win-win.
While there is truth to the adage that the only things certain are death and taxes, I do believe that with a little tax planning, we don’t have to pay more than our fair share. Have questions? I have some answers...set up a call and we can talk.