How to minimize taxes in retirement

How to minimize taxes in retirement

Update:  Before jumping into today’s article I wanted to give you an update on the learning post from last week.  It must have struck a chord with the IR community (who, like those from Lake Wobegon are good looking and above average), because it was the most read and forwarded article on the site to date.  If you enjoy learning new things, follow along with the challenges as we go and you’ll have plenty of things to talk about at the next cocktail party.

With the current challenge I’ve memorized the Americas, Europe and Africa.  A good start, but there are a lot of countries in Asia and Oceania that will be challenging.  With that update, let’s move on to today’s post, which is an article that I wrote for the Financial Planning Association.  With tax time upon us, I thought many of you would find it helpful.


As April 17 (you have two extra days this year) rapidly approaches, people all across the fruited plain are sharpening their pencils, firing up their calculators, and figuring out what, if anything, they owe Uncle Sam.  For all the ink spilled lamenting the complexity of the tax code, doing your taxes during your working years is a pretty straightforward task for most people.  Just add up what you made, subtract any allowable credits or deductions, and then grab your checkbook.

The process is similar during retirement, with the exception that you have greater control over your income, which means greater control over your tax bill.  That control means you can stretch your nest egg further by making good distribution decisions.  With that in mind, here are five ways to minimize your tax bite during retirement.

Know which accounts to access first

The money you’ve saved for retirement is likely held in different types of accounts that are taxed differently.  Some accounts are fully taxable, while others, like traditional IRAs, defer taxes until you withdraw the money.  Still other accounts, like Roth IRAs, may be free from federal taxes altogether.

Which accounts should you tap first?  A good rule of thumb is to take money from your taxable accounts first.  This will allow the money in your tax deferred accounts to continue compounding.  Access tax-free accounts last.

One exception to the rule of thumb might be if you are in a lower tax bracket now and anticipate that you will be in a much higher tax bracket in the future.  In that case, you may want to begin taking distributions from your tax-deferred accounts earlier.  In any event, work closely with your tax and financial advisers each year to make distributions decisions that make the most sense for your specific situation.

Minimize taxes on Social Security

If Social Security is your only source of income, chances are that you will not need to pay taxes on those benefits.  If you have other income sources, however, you may need to pay taxes on a portion of your benefits if your modified adjusted gross income (MAGI) plus one-half of your Social Security benefits exceeds what the IRS calls the base amount for your filing status.

For example, if your MAGI plus one half of your Social Security benefits is between $32,000 and $44,000 (for those married filing jointly) in 2012, you may need to pay taxes on 50 percent of your Social Security benefits.  If your income exceeds $44,000, you will likely need to pay taxes on 85 percent of your Social Security benefits.  Armed with this knowledge, it’s easy to see how a poorly timed IRA distribution or acceptance of some part-time work during retirement can impact your tax bill in a given year.

Relocate to a tax-friendly state

Different states tax things differently.  Consequently, where you decide to live during retirement is no small decision when you think about the various types of taxes that you pay (e.g. income taxes, Social Security and Medicare taxes, capital gains taxes, dividend taxes, property taxes, sales taxes, estate taxes and inheritance taxes).  If a particular state is willing to cut you a break in one or more of these areas, it is worth factoring that into your decision making.

For example, do you plan on working at least part time during retirement?  There are seven states that do not impose personal income taxes.  Will most of your income be from Social Security?  Thirty-six states don’t tax Social Security benefits.  Do you anticipate a free-spending retirement?  There are five states with no sales taxes.  Do you have a pension?  Ten states don’t tax federal, state and local pension income.  Before deciding where to live, inventory your income streams and decide which state will allow you to keep more of what you make.

Consider tax-free bonds

Municipal bonds are issued by states or municipalities and are usually exempt from federal taxes.  They may also be exempt from state and local taxes if you live in the state that is issuing the bond.  This preferred tax treatment along with their historically low default rate make municipal bonds a staple in many peoples’ retirement accounts.

Take advantage of Net Unrealized Appreciation (NUA)

If you own highly appreciated company stock in your 401(k) or other employer sponsored plan, you should review your options carefully before rolling that money into an IRA when you retire.  That’s because tax law permits you to distribute those shares from your 401(k) and pay income tax on the basis (your original purchase price) of the shares while continuing to defer the taxes on the unrealized gains.  Once the stock is eventually sold, you will only pay capital gains taxes on the difference between your basis and the sale price.  If, however, you roll all of those shares into your IRA at retirement, you will pay ordinary income taxes on the entire amount when you eventually distribute it from your IRA.

This strategy might be particularly appealing to someone in a high marginal tax bracket who currently pays income taxes at a much higher rate (35 percent) than capital gains taxes (15 percent).

Unfortunately, your tax bill doesn’t retire when you do, but there are actions you can take to minimize what you owe.  By working closely with your advisers, you can maximize your income and increase retirement security.

One small change that will produce huge results

One small change that will produce huge results

The question I’m asked most frequently by clients about their retirement is this:

“Will I have enough?” 

If baby boomers are losing sleep over an issue, that’s it.  And I don’t blame them.  There’s a lot hanging on the answer to that question.  Having enough means freedom, opportunity, peace of mind, and independence.

So how can you improve your chances of success?  A few years back the mutual fund company Putnam and the data firm Lipper did a study on that very topic.  They measured the impact of changes in several key variables like asset allocation, fund performance, and contribution rates.

Rather than bore you with the details, I’ll just share one conclusion.  The variable that had the greatest impact by far was how much a person saved.  In fact, increasing savings rates from 2 percent to 4 percent had 90 times (90 TIMES!) the impact of being able to perfectly pick the best performing mutual funds.

So if you want to make a small change today that will have a huge impact on your retirement security, get online or call your HR department and increase the percentage that you’re contributing to your 401(k) each month.  The change will take five minutes, but will have more impact than anything this side of winning the lottery.

Thanks for reading.  Have a great weekend!



Monthly rewind: January edition

Monthly rewind: January edition

There have been quite a few new readers at Intentional Retirement lately and I’m glad to have you all here.  Each month, I post a quick summary of the new articles at the site for anyone who may have missed something.  January’s articles are below.

We’re one month into the New Year.  How are you doing with your plans and goals?  No worries if things aren’t perfect, but stick with it.  Just like compound interest can produce amazing results with your investments, compound effort can produce amazing results with your life.  Don’t hesitate to touch base with me (or the rest of the IR community through the comments section after each post) if I can ever help.


How to help your kids and grandkids

How to help your kids and grandkids

We’ve all heard the expression “Give a man a fish and feed him for a day.  Teach a man to fish and feed him for life.”  When it comes to our kids and their finances, it’s sometimes tempting to give rather than teach, because we want to help them out and we want them to be happy.  We could do them a great service, though, if we took a little time to pass on the lessons we’ve learned (sometimes painfully) about how to save and handle money.

In that spirit, I’ve included an article in today’s post that is focused on helping people in their 20s and early 30s plan for retirement.  It is the first installment in a three part series that I am doing for the Omaha World Herald on retirement planning for different life stages.

As you’ll see below, starting early makes a HUGE difference.  If you know someone who could benefit from that advice, I’d really appreciate it if you forwarded them the article.  You can also share it to twitter or facebook using the buttons below.

Thanks in advance!  I’ve heard from several of you this week who needed help with one issue or another.  Don’t ever hesitate to touch base if I can lend a hand.


Note: If any of the charts or other information don’t display correctly in the email version of this post, just click the post title to view it on the web.

Want a nest egg in 40 years or so?  Start early.  In fact, start now.

Steven Covey once said “Begin with the end in mind.”  For people in their 20s, that is about the best retirement advice you will ever get.  Why?  Imagine your life 40 years from now.  If the past is any guide, you will just be getting ready to transition out of work and into retirement.

Assuming all goes well, Future You will have a nice comfortable nest egg set aside and will be on the cusp of an exciting new phase in life.  There’s just one thing.  In order for Future You to have a shot at that comfortable retirement, Current You has some work to do.  Thankfully, you have a lot going for you.  What are the key ingredients to getting a healthy start?

Start early

Early in life, your biggest asset is time.  Those extra years can make a huge difference when it comes to your investments.  The chart below shows a hypothetical example of the benefits of starting early.  It compares five people saving for their eventual retirement at age 65.  They save identical amounts each month ($500) and earn identical rates of return (8 percent per year, compounded monthly) on their investments.  The only difference is when they start.  Molly starts at 20.  It’s a stretch, but she makes it work.  Kelly, on the other hand, spends his extra income on a steady diet of video games and Mojitos and doesn’t get around to saving until he hits 30.

How much of a difference do those 10 years make?  About $1.5 million.  Said another way, Molly saved $60,000 more than Kelly ($6,000 per year for 10 years), on the front end, but that extra money resulted in an extra $1.5 million on the back end.  The crazy thing?  She could have stopped saving at 30 and never added another dime to her account and she still would have ended up with more than Kelly.  Behold, the power of compound interest.

The longer you wait, the more drastic the difference and the more you need to save to catch up.  The second part of the chart below shows how much our fictional characters would need to save each month in order to end up with the same amount as Molly.  Waiting until 50 to start means that Pat would need to save more than $7,500 each month to catch up.  Niel would need to put away the equivalent of a new car each month.  As you can see, starting early allows time and compound interest to do most of the heavy lifting.

Make it automatic

Saving for retirement takes discipline.  That is especially true if you are in your 20s and won’t see the payoff for decades to come.  It’s like making a car payment each month for a car that you won’t be able to drive until 2057.

Rather than relying on willpower, make your saving automatic.  Have your employer take money from your paycheck each month to add to your 401(k).  Set up a Roth IRA that systematically pulls money from your checking account.  You can start with as little as $25 per month.  After awhile you will get used to living without the money and you won’t even think about it.  I believe it was Newton’s Third Law that said “For every dollar earned, there is an equal and opposite way to spend it.” Or something like that.  Make it easy on yourself.  Make your saving automatic.

Save enough

One of the most common questions that people have when it comes to setting aside money for retirement is “How much should I be saving?”  The answer, of course, depends on your specific situation.  Recently, a professor by the name of Wade Pfau has done some interesting research on this topic.  He calls it the “safe savings rate.”

At the risk of drastically simplifying his research, this is the question he was trying to answer: How much does a person need to save in order to safely fund retirement even after the ups and downs of the market are taken into account?

His conclusion for someone in their 20s (a.k.a. someone who can save for 40 years)?  Using historical market data and assuming an allocation of 60 percent stocks and 40 percent bonds, he found that someone saving for 40 years and then living for 30 years in retirement had a 100 percent chance of replacing half of their pre-retirement income if they saved 8.77 percent per year.  Increasing the savings rate to 12.27 percent, resulted in a 70 percent replacement rate.

Of course past performance is no guarantee of the future, but his research is helpful in that it gives you a specific number to shoot for.  Saving 10-15 percent of your income might seem like a stretch, but you don’t need to get there overnight.  Start with something small, like 1 percent per year, with the goal of increasing it each time you get a raise.  Combine that with the employer match on your plan (most employers will match a certain percentage of what you put in) and you’ll be at 10% before you know it.

Allocate Properly

Asset allocation (the breakdown between stocks, bonds and other asset classes) is a critical element to investment success.  In fact, research shows that it is responsible for as much as 90 percent of return.  The remaining 10 percent is determined by the specific investments you buy and when you buy them.

Work with a trusted adviser or the representative assigned to your plan at work to make sure your allocation is appropriate for your situation.  Then review that allocation regularly and make changes as necessary.

Don’t raid the piggy bank

The average person changes jobs 5-10 times over a lifetime.  Each time you change, it’s tempting to take the money from your 401(k) rather than rolling it over to an IRA or to your new employer’s plan.  This is especially true if you have things like moving expenses or if you lost your job involuntarily and need some resources to make ends meet.  Do everything you can to avoid taking these premature distributions.  Not only will you pay taxes and a penalty (assuming you’re younger than 59 ½), but it also means that the advantages you gained from starting early go out the window.

The secret

The biggest objection to starting early is that it’s not easy to save at the front-end of your career when your income is limited and you have so many expenses like a new work wardrobe or furnishing your house or apartment.  I’ll let you in on a little secret.  It doesn’t get any easier.  There will always be wants and needs competing for your limited resources.  The key is deciding to start, no matter the amount, and then making saving a lifelong habit.

2012 IRA and 401(k) contribution limits

2012 IRA and 401(k) contribution limits

Just a quick post to let you know about some changes to contribution limits for the New Year.  The amount you can contribute to your 401(k) is increasing by $500 in 2012.  The new maximum is $17,000.  Those over 50 can make an additional “catch up” contribution of of $5,500 for a total of $22,500.

IRA limits are staying the same: $5,000 plus an additional $1,000 for those over 50.  Income limits on both Traditional and Roth IRAs are being increased, however, so more people will be able to take a tax deduction for Traditional IRA contributions or be eligible to make Roth contributions.  Touch base with me if you have questions about your specific situation.

Enjoy the day!  It’s going to be 60 degrees in Omaha today.  Not bad for January.


10 resolutions that will keep you on track for a secure retirement

10 resolutions that will keep you on track for a secure retirement

Most New Year’s resolutions relate to either fitness or finances.  I’m not a real authority on fitness, but I do have a few thoughts on finances.  Below are 10 ideas to make sure your retirement planning is on track for the New Year.

1.  Automate your saving—Make sure you stick to your savings goals by having money deducted each month from your paycheck or checking account.

2.  Increase your contributions—Getting a raise in 2012?  Rather than spending it, commit to setting it aside for retirement.  Those over 50 can contribute $22,500 to a 401(k) and $6,000 to an IRA in 2012.

3.  Create a debt payoff plan—Set a goal to enter retirement debt free.  Read this article for help in putting together a plan.

4.  Schedule an annual review with your financial adviser—Review how your investments performed and whether or not any changes or rebalancing are in order.

5.  Talk with your spouse about retirement—Make sure you’re on the same page with your spouse about retirement.  Here are 10 questions to get the conversation started.

6.  Test drive your retirement budget—Want to know if your retirement budget is realistic?  Try living on it for six months and then use what you learn to refine and improve your plan.

7.  Take a mini-retirement—A mini-retirement is longer than a vacation, but shorter than, well, retirement.  It’s a great way to learn more about a place or an activity that you are considering for retirement.

8.  If close to retirement, set aside one year of retirement expenses in cash—A major risk in the early years of retirement is that you will begin withdrawing money at a time when your investments are performing poorly.  Avoid this sequence risk by having a year of withdrawals set aside in cash.

9.  Check your insurance coverage—As you age and the kids move out, your insurance needs change.  You may want to consider adding a long-term care policy or making changes to your other insurance coverage.

10.  Update your estate plan—Everyone needs an estate plan that is current and clearly spells out their wishes.  Meet with a trusted adviser to get your affairs in order.

Hopefully a few of those ideas struck a chord with you.  If you’d like more information on planning for the New Year, be sure to read this.

Thanks for reading.  Touch base if I can ever help.