(Bloomberg) — Millions of Americans spend decades saving for retirement only to trip over tax bills at the finish line.
The shift from earning a paycheck to living off savings creates a new problem: figuring out how to turn assets into income without handing more than necessary to the IRS. A March survey by the Allianz Center for the Future of Retirement found 70% of respondents worried about taxes on retirement income, up from 66% in the previous quarter, with Gen X particularly concerned about future tax increases on withdrawals from 401(k)s and IRAs. The oldest members of that generation are quickly approaching the age when they can start receiving Social Security benefits.
At its core, retirement tax planning is not only about minimizing your tax bill but also exerting control over when and how those taxes are paid. Done well, that control can help keep income within a lower marginal bracket over time, rather than triggering spikes driven by required minimum distributions, Social Security benefits or needing to sell assets to cover large unanticipated expenses.
“Good tax planning is really about creating flexibility,” said AK Moody, senior wealth strategist for global tax advisory at BNY Wealth. “The earlier you plan, the more options you have to manage income and taxes over time, which can materially improve retirement outcomes.”
Financial planners and tax experts point to a handful of common missteps that can turn into costly surprises later in life, and the strategies to avoid them.
1. Assuming Social Security Benefits Aren’t Taxed
Many retirees are caught off guard by the tax treatment of Social Security. A 2024 Nationwide Financial survey found that half of respondents believed benefits would be tax-free. In reality, up to 85% may be taxed at ordinary income tax rates.
The thresholds are lower than many expect. For single filers with income above $34,000, or married couples filing jointly above $44,000, up to 85% of benefits are taxable. The IRS calculates this using “combined income,” which includes adjusted gross income, tax-exempt interest and half of Social Security benefits. There’s a lower tier where 50% of benefits are taxed, while income below $25,000 escapes taxation.
For a simplified example of how that could work, consider a high-earning retired couple collecting $80,000 annually in Social Security and another $200,000 from investments. Because they exceed the threshold, 85% of their benefits — $68,000 — are taxable. At a 24% marginal rate, that translates to about $16,000 in taxes on benefits alone.
Dealing with tax surprises in retirement will be easier with an assortment of account types. Retirees drawing primarily from tax-deferred accounts such as traditional 401(k)s and IRAs may be surprised by the size and growth of required minimum distributions (RMDs), which begin at age 73 (rising to 75 in 2033). Having a mix offers more control. Roth withdrawals, for instance, are tax-free if the account has been held at least five years, and aren’t subject to RMDs. Having that flexibility can help prevent bracket creep in high-income years.
Having a taxable brokerage account to pull money from can also help lower tax bills in retirement. Long-term capital gains are taxed at 0%, 15% or 20%, with most investors paying the 15% rate. Strategic tax-loss harvesting can further reduce the burden by offsetting gains.
Individuals can choose from a widening array of products designed to minimize the tax bite from investing. There is more than $1 trillion invested across a multitude of tax-aware strategies that vary in complexity and risk, using everything from hedge funds and exchange-traded funds to individual accounts.
For those light on Roth assets, conversions from traditional IRAs can help, though bear in mind that they come with an upfront tax bill. The payoff is smaller RMDs later. Consider someone with $1.5 million in their 401(k). If they were to split those funds evenly between a traditional account and a Roth, the first RMD would drop from about $56,600 to roughly $28,300.
The ideal mix of account types depends on individual circumstances. “Rather than targeting a rule of thumb like ‘one-third in each bucket,’ I’d look at the tax rate today versus the estimated tax in retirement,” said financial planner Dana Anspach, founder of Sensible Money, a financial advisory firm. For higher earners, the upfront deduction of pre-tax contributions can be compelling, particularly if income — and therefore marginal rates — are expected to decline over time. Conversely, for those in relatively lower brackets, or with reason to anticipate higher future rates, Roth contributions can serve as a form of tax-rate arbitrage: paying taxes at today’s known rates in exchange for tax-free growth and withdrawals later.
3. Ignoring Tax-Loss Harvesting
As the saying goes: It’s not what you make, it’s what you keep. To keep more of the gains on appreciated securities you sell, be strategic about taking losses on other securities to offset those gains when it makes sense, through tax-loss harvesting (TLH). Losses can offset gains, and up to $3,000 of excess losses can be applied against ordinary income each year, with the remainder carried forward.
Robo-advisers such as Betterment and Wealthfront have popularized automated versions of the strategy. Their systems monitor client portfolios for opportunities to harvest losses without meaningfully altering the investor’s market exposure. At Betterment, for example, TLH can be toggled on for standard portfolios composed of exchange-traded funds. When markets dip, the software can sell an ETF at a loss and replace it with a similar — but not “substantially identical” — fund, sidestepping the IRS wash-sale rule that would otherwise disallow the loss. Each trade is evaluated to ensure the expected tax benefit outweighs transaction costs.
Remember, however, that these taxes aren’t necessarily eliminated, but are often just pushed out into the future. Replacement investments reset the cost basis lower, potentially increasing future gains. And the strategy doesn’t make sense for everyone. It may be less useful for investors expecting higher tax rates later or those already able to realize gains at a 0% rate.
4. Delaying Roth Conversions
Timing matters with Roth conversions, especially later in life since large conversions after age 63 can ripple into Medicare costs. Premiums for Medicare Parts B (outpatient hospital care, doctor visits and medical services) and D (prescription drugs) are based on income from two years prior. A large conversion could trigger an IRMAA (income-related monthly adjustment amount) surcharge on those premiums. Premiums are reset annually, so while you’re not stuck with higher premiums forever, they can be a costly surprise.
For retirees in low-income years — before claiming Social Security, for instance — larger conversions may make sense despite the tax hit. More commonly, doing a regular series of smaller conversions over time may be a better way to go. Planners suggest waiting until fairly late in the year when you have a strong sense of what your taxable income will be, and seeing how much of a gap you might have before you’re pushed into a higher tax bracket. If there’s room, savers can pick an amount to convert that leaves them a comfortable margin between brackets in case last-minute additions to taxable income show up at year’s end.
Don’t let the prospect of IRMAA stop you from making important portfolio moves, said Tim Steffen, director of advanced planning for Baird Private Wealth Management: “The long-term benefit of that conversion may outweigh the short-term pain of Medicare premiums, which are a one-year thing.”
5. Leaving Tax Headaches for Heirs
For those potentially handing down retirement funds to children, you can help them avoid a tax trap. Under current rules, most non-spouse heirs must empty inherited IRAs within 10 years, which can boost tax bills if withdrawals coincide with peak earning years and push income into a higher bracket. For example, take a single heir with taxable income of $190,000, so in the 24% bracket, who inherits a $700,000 IRA. If they make annual withdrawals of $70,000 that would lift taxable income to $260,000 — barring other tax planning to lower income — and push most of that gain into the 32% bracket and a bit into the 35% bracket.
Roth accounts offer a cleaner alternative. Heirs still must withdraw the funds within 10 years, but distributions will be tax-free. Converting those assets requires paying taxes upfront during the original owner’s lifetime, but your heirs will appreciate your foresight when you pass the baton.
To contact the author of this story: Suzanne Woolley in New York at [email protected]
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