Are You Looking Forward to Retirement?

I suspect most of us will answer that question with a resounding YES! But planning a tax-efficient strategy to generate needed cash flow in retirement requires foresight and a long runway.  It’s one thing to have saved, but another to plan long-term for optimal tax outcomes in retirement. Let’s examine the available options.

Social Security (SS)

When should you start claiming benefits? You are eligible to collect Social Security at age 62, but subject to severe earnings limitations until you reach full retirement age (FRA). If you continue to work and you earn more than $17,640 (for 2019) you essentially will receive just two-thirds of your age 62 monthly benefit until you attain FRA. Waiting until full retirement age eliminates the earnings restriction and results in benefits that are roughly 70% of what you’ll receive at age 70, when the benefits stop growing except for cost of living increases.

There are a variety of scenarios addressing the timing of each spouse’s enrollment in Social Security. It may make sense for a non-working spouse to start collecting at age 62 while the working spouse holds off until FRA, or age 70. Depending upon your total income as much as 85% of your SS benefits are subject to federal income tax; typically they are exempt from state income taxation.

Retirement Plans

Pre-tax retirement plan withdrawals – from a 401(k), cash balance plan or rollover IRA – are taxable as ordinary income when received. Currently so-called required minimum distributions (RMDs) are mandatory at age 70-1/2 (the SECURE Act currently under consideration by the U.S. Senate would raise that to age 72). The exact requirement is that RMDs must commence no later than April 1st of the year following the year in which you turn 70-1/2. If you wait until that date you will have to take two distributions in one year, which may bump up your incremental tax rate, so some tax planning is required here.

Roth IRAs have no RMDs during your lifetime and can produce tax-free cash flow, an important advantage when trying to maximize tax savings in retirement. Everyone should have a Roth component within their retirement plan assets. But here is the long runway: every year a traditional IRA can be converted to a Roth without respect to your income (unlike outright Roth contributions, which are income-limited). Those conversions generate taxable income, although the amounts can be timed to keep you in a desired tax bracket in the year(s) of conversion. But depending on the amount converted each year it takes quite a number of years to accumulate significant Roth assets.

Non-retirement investment accounts offer the opportunity to take dividends and interest in cash or reinvest them within the account. Positions can be liquidated at preferential capital gain tax rates. Conventional wisdom has advocated draining these accounts first before tapping retirement accounts, but that is just one of several available options for cash flow in retirement.

Tax-Deferred Annuities

Tax-deferred annuities are another potential source of retirement cash flow. Typically distributions are discretionary and include a return-of-principal component and a taxable income component. The issuer of the annuity contract tracks and reports those amounts.

Some retirees have traditional pension benefits, fixed for life, from long-ago employers or not-for-profit organizations who sponsor 403(b) and 457 plans. Those include teachers and public service employees among others. Like Social Security these are what they are, and tax planning has to be worked around them by supplementing with other available cash flow options.

Life Insurance

Life insurance cash surrender value (CSV) loans are potentially another source of tax-free cash flow, but the runway to accumulate those cash values is also quite long. Whole life insurance isn’t for everyone, but the ability to create a tax-deferred asset is appealing.

Beyond income tax considerations, Medicare premiums are indexed to income and can have a substantial impact on Social Security benefits. Ideally you want to manage taxable income to stay within desired boundaries.

A Final Word

So ultimately the goal in retirement is to have sufficient cash flow to sustain your desired standard of living while minimizing income taxes and Medicare premium surcharges.

These are areas where your CPA or financial planner should be able to assist using tax projection and other relevant software tools. I recommend that you initiate that process sooner rather than later.

~ Kathy Lyle, CPA

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