Proper retirement tax planning is essential for clients to understand as they prepare to retire. Living on a fixed income can be difficult for many retirees, and avoiding unnecessary taxes can help stretch out their retirement income strategies.

Retirees face significant tax obligations. They’re required to pay income tax on any pensions and withdrawals from all tax-deferred investments made during the same year. Tax-deferred investments include traditional IRAs, 401(k)s, and similar accounts, as well as tax-deferred annuities when withdrawals are made. These taxes can significantly impact a retiree’s nest egg, giving them less money to live on.

Luckily, there are many strategies to help lower taxes paid on retirement income.


Roth Conversions


A Roth conversion involves converting funds from a traditional IRA account into a Roth IRA account. Roth conversions can reduce the total amount of taxes paid during retirement, but the trade-off is that taxes on converted amounts are due in the year of the conversion. Understanding when and how much money to convert can be complex and time-consuming for financial advisors. Software like Tax Clarity® and Income InSight® can help advisors assist clients interested in Roth conversions, improving their overall retirement tax planning strategy.

With Roth conversions, the following is true:

  • Taxes are charged on the total amount converted.

  • Part of the conversion is tax-free if you’ve already made nondeductible IRA contributions.

  • You can make tax-free withdrawals from a Roth account, although you may have to pay taxes on earnings made within five years of the conversion.

Harvesting Capital Gains and Losses


Harvesting capital gains occurs when an asset sells for more than its original price. Investments held for more than a year before selling are considered long-term gains and are taxed at lower rates. High capital gains taxes can be reduced by making long-term investments, offsetting gains with losses, and using retirement plans that offer tax advantages. Short-term capital gains are taxed at significantly higher rates than long-term capital gains.

In some years, when clients have low overall income, it may be possible to harvest some capital gains at a 0% rate, effectively realizing a free “step up in basis”.

Harvesting capital losses involves selling securities at a loss to offset capital gains taxes, limiting short-term capital gain recognition. With tax-loss harvesting, an investment that has an unrealized loss is sold, allowing a credit against any realized gains that occur in the portfolio. The asset sold is then replaced with a similar asset to maintain the portfolio's asset allocation and expected risk and return levels.


Social Security Taxes


According to the IRS, up to 85% of Social Security payments may be taxable. Determining what portion is actually taxable is a much more complicated exercise, as only 50% of each Social Security dollar is counted in the calculation, which is then subject to thresholds that vary based on marital status, ultimately resulting in a taxable benefit amount. An important strategy for managing taxes on Social Security benefits is blending other income sources, such as withdrawals from IRA accounts and taxable accounts.


Retirement Tax Planning and the Tax Torpedo


When clients are required to pay a marginal tax rate on their income that exceeds their statutory tax rate, it’s known as a tax torpedo. This can negatively impact an individual’s overall net worth over time, due to the higher tax rate they're forced to put toward disbursements.

To avoid the tax torpedo, consider these options:

  • Make more contributions to Roth IRA accounts regularly, and max out annual contributions.
  • Pull from pre-tax funds earlier in retirement to help lower required minimum distributions (RMDs).
  • Delay collecting Social Security benefit payments.
  • Consider Roth conversions.

Retirement Tax Planning and Your Practice


Effective retirement tax planning is equal parts strategy, preparation, and planning. Covisum’s software suite can help financial advisors assist clients with smarter decision-making and long-term tax planning. Learn which software best fits the needs of your practice with our Product Matchmaker tool.

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