It is a common misconception among retirees to overlook the impact of taxes on their retirement savings until it is time to withdraw funds from their pretax accounts. According to a study by Northwestern Mutual, only 3 in 10 Americans have a concrete plan to reduce taxes on their retirement savings. This can be a costly mistake that can significantly reduce the overall value of your retirement nest egg.
Certified financial planner Sean Lovison suggests using the “bucket strategy” to minimize the tax burden on your retirement savings. By strategically planning to receive more income in lower-earning years, you can fill your “buckets” or federal tax brackets in a way that reduces your lifetime tax burden. For instance, converting pretax individual retirement account (IRA) funds to a Roth IRA while in a lower tax bracket can save you money on future taxes on withdrawals.
Roth conversions involve transferring pretax or nondeductible IRA funds to a Roth IRA, which can help you avoid taxes on future withdrawals. While there are upfront taxes on the converted balance, strategically converting enough to stay within lower tax brackets such as 22% or 24% can be beneficial in the long run. This is especially important as tax brackets can increase to 32%, 35%, or 37% once you start receiving Social Security and required minimum distributions (RMDs).
With the Secure 2.0 legislation pushing the beginning date for RMDs to age 73 by 2023 and age 75 by 2033, it is crucial to consider the implications of growing pretax 401(k) and IRA balances. Many retirees fail to realize the impact of taxes until they start making withdrawals from their pretax retirement accounts, which can lead to a significant reduction in their actual fund value.
CFP Judy Brown emphasizes the importance of tax planning during the “accumulation phase” of growing your retirement nest egg. By diversifying your accounts with pretax, Roth, and brokerage options, you create a tax-efficient strategy that allows you to manage your adjusted gross income more effectively in retirement. This approach provides you with a range of levers to pull and optimize your tax situation as you transition into retirement.
Maximizing your retirement savings through strategic tax planning is essential for preserving the value of your nest egg and minimizing tax liabilities in the long run. By implementing the bucket strategy, considering Roth conversions, and planning for changes in tax brackets and RMD ages, you can proactively manage your tax situation and make the most of your retirement savings. Remember, tax planning is not just important during retirement but throughout the accumulation phase as well to ensure a financially secure future.