The Retirement Tax Bill You Don't See Coming

QUICK SUMMARY

Many people enter retirement focused on how much they have saved. Fewer focus on how much of those savings they will actually get to spend after taxes.

Traditional IRAs, 401(k)s, Social Security, investment gains, required distributions and Medicare premiums can interact in ways that create surprisingly large tax consequences later in retirement.

Good retirement planning therefore asks a different question than simply, "How much money do I have?"

It asks,  "Where is the money located, and what happens when I begin taking it out?"

NOT ALL $1 MILLION PORTFOLIOS ARE THE SAME

Imagine three retirees.

Each has $1 million.

The first has most of it in a taxable brokerage account.

The second has most of it in a traditional IRA.

The third has money spread across taxable, traditional retirement and Roth accounts.

On paper, they each have $1 million.

From a tax-planning standpoint, however, those portfolios can behave very differently.

A traditional IRA contains a future tax obligation.

A Roth IRA can potentially provide tax-free qualified distributions.

A taxable account may create capital gains, qualified dividends, interest income or opportunities for tax-loss harvesting.

The headline account balance therefore tells only part of the story.

Asset location matters.

And in retirement, it can matter a great deal.

RETIREMENT CAN CREATE A TAX-PLANNING WINDOW

One of the most interesting periods in retirement can occur between the end of employment and the beginning of larger mandatory retirement-account distributions.

Income may temporarily decline.

A salary has stopped.

Perhaps Social Security has not yet begun.

Required distributions may still be years away.

That can create an opportunity.

For some retirees, deliberately recognizing income during these lower-income years — including through Roth conversions — may make sense.

The goal is not simply to minimize this year's tax bill.

It is to evaluate taxes across the retiree's lifetime.

Sometimes paying a manageable tax today can reduce a much larger tax problem tomorrow.

Sometimes it cannot.

The important part is making the decision intentionally.

THE PROBLEM WITH AUTOMATICALLY DEFERRING TAXES

Tax deferral is valuable.

But "defer taxes for as long as possible" is not always the same thing as "pay the least tax over your lifetime."

A retiree with a large traditional IRA may eventually face significant required distributions.

Those distributions can increase taxable income whether the retiree needs the money or not.

Higher income can also affect other parts of the retirement picture.

For example, it may influence the taxation of Social Security benefits or Medicare-related costs.

That is why a good retirement tax strategy should look years ahead.

The decision you make at 63 may affect your tax situation at 73, 83 or beyond.

WITHDRAWAL ORDER IS NOT AS SIMPLE AS IT SOUNDS

A common rule of thumb says:

Spend taxable accounts first.

Then tax-deferred accounts.

Then Roth accounts.

There is logic behind that approach.

But retirement planning rarely fits perfectly into a rule of thumb.

A better strategy might deliberately withdraw some money from a traditional IRA during a relatively low-tax year.

Another retiree might benefit from realizing capital gains.

Another might complete a partial Roth conversion.

Someone else may want to preserve Roth assets for later years or for heirs.

The right approach depends on the entire plan.

That means examining:

Current income.

Expected future income.

Tax brackets.

Portfolio composition.

Social Security.

Required distributions.

Charitable giving.

Estate goals.

Potential future tax-law changes.

The best withdrawal strategy is often a multi-year strategy rather than a one-year calculation.

ROTH CONVERSIONS ARE A PLANNING TOOL — NOT A GOAL

Roth conversions receive a great deal of attention.

And for good reason.

Moving assets from a traditional IRA into a Roth IRA can potentially reduce future taxable distributions and create a pool of tax-free retirement assets.

But a Roth conversion generates taxable income today.

That means the question should never simply be:

Should I do a Roth conversion?

The better questions are:

How much?

In which years?

At what tax rate?

Paid from which assets?

What does the conversion do to the rest of the financial plan?

And what problem are we actually trying to solve?

A conversion is a tool.

It should serve the plan, not become the plan.

TAX DIVERSIFICATION CAN CREATE FLEXIBILITY

Investors often talk about diversification across stocks, bonds, industries and countries.

Retirees should also think about  tax diversification.

Having money available across taxable, tax-deferred and tax-free accounts can create options.

In one year, a retiree may want additional taxable income.

In another, they may want to avoid it.

Flexibility matters because retirement rarely unfolds exactly as forecast.

A large purchase may arise.

A home may be sold.

A spouse may die.

Tax laws may change.

Healthcare expenses may increase.

Having multiple sources of capital with different tax characteristics can allow the retirement strategy to adapt.

THE BIGGEST MISTAKE MAY BE WAITING

Tax planning frequently becomes reactive.

A retiree receives a large tax bill and then asks what can be done.

At that point, many of the best planning opportunities may already have passed.

Retirement tax planning works best prospectively.

What should we do this year?

What might we want to do next year?

What changes when Social Security begins?

What changes when required distributions begin?

What happens if one spouse dies and the surviving spouse eventually files as a single taxpayer?

Thinking several years ahead can make an enormous difference.

THE BELLE VIEW APPROACH

At  Belle View Wealth , tax awareness is integrated into the retirement-planning process rather than treated as a separate year-end exercise.

Belle View Wealth does not replace a client's CPA or tax attorney.

Instead, the goal is to help identify planning opportunities and coordinate financial decisions with the professionals already serving the client.

Because investment management, retirement income and taxes are deeply connected.

A portfolio decision can create a tax consequence.

A tax decision can affect Medicare costs.

A Roth conversion can change future distributions.

A charitable gift can affect both taxes and legacy planning.

The value is in seeing those connections before decisions are made.

If you're approaching retirement with significant assets in traditional IRAs or 401(k)s, this may be one of the most important planning questions to ask:

Do I have a tax strategy for retirement — or simply a collection of tax-deferred accounts?

FREQUENTLY ASKED QUESTIONS

Are withdrawals from traditional IRAs taxable?

Generally, distributions from pre-tax traditional IRA assets are taxed as ordinary income. Individual circumstances can vary.

Are Roth conversions always a good idea?

No. Roth conversions can be valuable in the right circumstances, but the current tax cost must be weighed against the potential future benefit.

Should retirees always spend taxable assets before IRAs?

Not necessarily. Coordinated withdrawals from multiple account types may produce a better long-term result than following a rigid withdrawal order.

Why should tax planning begin before required distributions?

Earlier retirement years may provide opportunities to intentionally recognize income at attractive tax rates before other income sources increase later.

If you'd like a second look at how your retirement accounts, withdrawals and future tax obligations fit together, learn more about  Belle View Wealth's retirement planning services  or  schedule a consultation .

Our firm is not licensed to offer tax preparation. We offer tax strategies related to investing and retirement income. Consult your tax advisor regarding your situation. All information contained herein is derived from sources deemed to be reliable but cannot be guaranteed. All views/opinions expressed in this article are solely those of the author and do not reflect the views/opinions held by Advisory Services Network, LLC.