It's frustrating when you’ve been responsible and saved diligently for your retirement throughout your working career, but the tax bites keep on coming. If you are retired, or near to retirement, you’ll want to use tax-efficient ways to withdraw money from your investment accounts. There was a rule of thumb from the financial investment community that said just leave those tax-deferred accounts alone and use the money from your taxable accounts until you reach age 70½. You can then start taking Required Minimum Distributions, or RMDs.
Here’s the problem: that equation assumes that your income has decreased in retirement and that simply may not be true.
RMDs are taxed as ordinary income at the time of withdrawal, so they could push you into a higher federal tax bracket than you expected. Let’s say a 63-year-old married woman born in 1953 has $1 million in tax deferred accounts. If she had RMDs of nearly $47,000 at the age of 70½, combining it with $47,000 from Social Security and a pension or rental property income, and she would be bumped into a higher rate tax bracket.
Another factor to consider is the reduction of individual income tax rates that went into effect this year, because of the Tax Cuts and Jobs Act, which expires in 2025. Those tax cuts may not be extended or may be changed, so future tax rates might go up again in 2026. When that tax cut expires, you’ll need to review your tax burden again.
So, what can you do?
If you are a retiree between 59½ and 70½, you might want to consider a Roth conversion. Proactively convert a portion of your tax-deferred accounts into a Roth IRA on an annual basis. You’ll have to pay federal income tax on the amount you convert every year. However, you’re taking advantage of lower rates before those provisions mentioned above expire and before the RMDs begin. The goal is to convert just what you need to keep you in your current tax bracket.
Be mindful that you must do this right. Work out the numbers so you don’t trigger a higher Medicare premium or the 3.8% Medicare surtax. There are a lot of moving parts, so make sure you talk to your tax advisor.