Most people spend their working years trying to reduce their tax bill. Max out the 401(k), take the deductions available to you, defer income when possible, and avoid realizing unnecessary capital gains.
Then retirement arrives and the strategy can change.
For many people, the first several years of retirement create a major tax-planning opportunity that may NEVER come around again. Income from work disappears, but Social Security may not have started yet. Required minimum distributions from IRAs (RMDs) may still be years away. Someone who spent much of their career in a relatively high tax bracket can suddenly find themselves reporting much less taxable income.
In that situation, keeping the tax bill as low as possible every year may actually be a mistake.
The Tax Window Around Retirement
Consider someone who retires at 62 with $1 million in a Traditional IRA that was rolled over, and another $500,000 in a brokerage account.
For decades, they have been contributing to a 401(k), receiving the tax deduction, and allowing the money to grow tax-deferred. Now they retire and no longer have a paycheck.
They could simply live from cash and their brokerage account, leave the Traditional IRA untouched, and report very little taxable income for the next several years.
On the surface, that looks great.
But the Traditional IRA is still growing.
Eventually Social Security will begin. Later, required minimum distributions can force taxed dollars out of Traditional IRAs whether the retiree needs the distribution or not. Under current rules, RMDs generally begin at age 73 for IRA owners reaching that age today.
Instead of leaving the Traditional IRA completely untouched during those lower-income years, it may make sense to convert a portion of it to a Roth IRA.
A Roth conversion means voluntarily paying tax on part of your Traditional IRA today. In exchange, that money moves into a Roth IRA, where future qualified withdrawals can be tax-free and the owner doesn’t have to take RMDs.
That can be especially valuable during the lower-income years after retirement. Instead of allowing the entire Traditional IRA to keep growing until RMDs begin, you can gradually move portions of it into Roth while you still have room in lower tax brackets.
The tradeoff is that you are accelerating taxes. Money that could have remained tax-deferred for years becomes taxable income today.
So the real question is: Would you rather pay tax on some of this money at today’s rate, or leave it in the Traditional IRA and potentially pay tax on a larger balance at a higher rate later?
For someone with a large IRA, a series of smaller conversions during lower-income years can reduce the amount left in the Traditional IRA, lower future RMDs, and build a larger pool of tax-free money for later in retirement.
Your Brokerage Account Creates Opportunities Too
Traditional IRAs are only one part of the discussion.
Someone approaching retirement with $250,000 or more invested outside of retirement accounts may also have significant unrealized capital gains.
Imagine you bought an investment for $100,000 that is now worth $250,000. Selling creates a $150,000 gain, so it can be tempting to avoid touching it simply because you do not want the tax bill.
But retirement may give you an opportunity to recognize some of those gains at a favorable rate.
Long-term capital gains are taxed under a different rate structure than ordinary income, and depending on taxable income, some gains may fall within the 0% or 15% federal long-term capital-gains rates.
That can create an opportunity to sell appreciated investments or diversify a large position during a year when your taxable income is lower.
Again, the goal is not to create taxes for the sake of creating taxes.
The important question is whether you have a tax rate available today that you may wish you had taken advantage of later.
Why Those Low-Income Years Can Disappear
This is where retirement tax planning gets more complicated than simply looking at your current tax bracket.
A 63-year-old retiree may have a very different tax return at 75.
Social Security could be coming in every month. A pension may have started. The IRA may have continued growing, and RMDs are now being distributed each year. The brokerage account could be generating dividends, interest, and capital gains.
None of those things are necessarily bad. They just reduce how much control you have over your taxable income.
That is why the years around retirement deserve so much attention.
Someone may spend 40 years building wealth and have only a relatively short period where they can deliberately move money from one tax bucket to another at attractive rates.
Once that window closes, it may be difficult to recreate.
It Is Not as Simple as “Do a Roth Conversion”
There is a reason we run projections before making these decisions.
Increasing taxable income can have consequences elsewhere in the plan. A Roth conversion can affect how much of your Social Security is taxable. Higher income can affect Medicare premiums. Realizing capital gains can change the rate applied to other gains and investment income.
For a household with substantial assets, several of these items can interact in the same year.
This is also why I am hesitant when someone gives a blanket recommendation like, “You should always convert up to the top of the 22% bracket.”
Maybe.
But first I want to know what the next 10 or 20 years are expected to look like.
How large could the IRA become?
When are you planning to claim Social Security?
Do you have a pension?
How much money is in your brokerage account?
What unrealized gains are sitting in that account?
What does income look like after RMDs begin?
Are there large real estate sales, inheritance, gifts, or other income events expected?
Those answers can completely change the recommendation.
Start Looking Before You Retire
You also do not need to wait until retirement to begin this planning.
If you are in your 50s with a large 401(k), IRA, brokerage account, or a combination of the three, you can start projecting what your taxes may look like before making the retirement decision.
Sometimes that analysis shows that the best Roth-conversion opportunity will be the first few years after retirement.
Sometimes capital gains should be recognized gradually.
Sometimes there is no reason to accelerate taxes at all.
The useful part is knowing that before the opportunity passes.
If you have spent decades accumulating $500,000, $1 million, $2 million or more, the account balances themselves only tell part of the story. How those dollars are taxed, and when you choose to recognize that income, can have a significant effect on how much of the portfolio is ultimately available to you.
A low-tax year is an opportunity.
I would rather identify it ahead of time than realize ten years later that we let it go unused.
How We Approach This at Kraft Capital
Tax planning is part of our ongoing financial planning process at Kraft Capital. For clients approaching or already in retirement, we look at projected income over multiple years rather than making decisions based only on this year’s tax return.
That can include Roth-conversion analysis, capital-gains planning, retirement-account withdrawals, Social Security timing, future RMDs, and the interaction between taxable income and Medicare. We are also available to prepare your taxes so that nothing is lost in translation between the tax plan and the tax return.
For someone who has spent decades building a meaningful portfolio, these decisions deserve the same level of attention as the investments themselves.
If you are approaching retirement or already retired and would like a second opinion on your current retirement and tax strategy, you can schedule a complimentary consultation with Kraft Capital below.
– Clint Kraft
Founder and Financial Advisor, Kraft Capital