Retirement and Taxes: Part 2 (Planning for Opportunities)

We associate retirement with constraints. However, it can be turned into a beautiful constraint by focusing on unique opportunities at the intersection of retirement and taxes.

In Part 1 of this mini-series, we have explored retirement and Social Security. Part 2 will address other sources of retirement income (namely the 401(k) accounts, IRAs, Social Security, etc.) and talk about the unique opportunities for tax planning that only exist in retirement.


To open the discussion, consider the idea of “a beautiful constraint”. We often think of retirement as a lifestyle of restrictions (for example, having to live on a predetermined income). However, some of those restrictions are benefits in disguise. Not only do they force you to examine what matters most in order to re-align your money with your values, they also present a chance to optimize your taxes, extend the life of your portfolio and create great retirement outcomes.

A few definitions to get us started

Retirement savings articles are filled with acronyms. Roth IRA, 401(k), SEP IRA – how are they different, and why does it matter? Here is a quick guide to help you tell them apart.

401(k) account (or 403(b) plan for non-profits)
A 401(k) account is typically an employer-sponsored retirement savings account. As an employee, you choose your own contribution amount. Your contribution is automatically deducted from your pre-tax earnings, reducing your paycheck and your tax expense. You may or may not get the additional benefit of employer matching your contributions (if you do, that is a fantastic way to grow the balance and boost your returns!)

The IRS establishes a maximum annual contribution to a 401(k) account that puts a ceiling on how much you can add to your account in any given year. The 2017 maximum annual contribution to a 401(k) account is set at $18,000 for those under 50, with an additional $6,000 “catch-up” allowance for those aged 50 and older.

Distributions from a 401(k) in retirement can begin at 59 ½ years of age and are taxed as regular income. Earlier withdrawals are possible, although they result in a 10% penalty. You can borrow against a 401(k) account balance as an alternative to an outright early withdrawal.

Some of the key benefits of a 401(k) account include the possibility of employer match, a reduction in taxable income for contributions made, as well as a relatively high annual contribution limit. Some of the disadvantages include little control over investment options, the fact that distributions are taxed as income, and the required minimum distributions (or RMDs) that start at 70 ½ years of age regardless of whether you need the funds.

Individual Retirement Account or Traditional IRA
An IRA (which stands for Individual Retirement Account) can be used by anyone under 70 ½ years of age. Contributions to an IRA can reduce your taxable income, although specific amounts depend on your income and whether you (and your spouse, if you are married) are covered by an employer-sponsored retirement plan.

You must be at least 59 ½ years old to withdraw IRA funds without incurring a penalty, and traditional IRAs mandate that you begin to take required minimum distributions at age 70 ½ (similar to a 401(k) account). Unlike 401(k) accounts, IRAs do now allow for loans against the balance. Withdrawals in retirement are taxed at regular income rates.

The benefits of IRA accounts include greater degree of control over investment options, and the fact that contributions may be tax-deductible in the year they are made. Some of the cons include a lower deductible limit ($5,500 annually across all IRA accounts, with an additional $1,000 for those aged 50 and over), the fact that distributions are taxed as regular income, and the mandate to begin RMDs at 70 ½.

Simplified Employee Pension Individual Retirement Account (or SEP IRA)
SEP IRAs are a variation of the traditional IRA account created for self-employed individuals. You can contribute up to 25% of your W-2 income or 20% of net self-employment income, up to the maximum contribution limit of $54,000 across all retirement accounts.

Roth IRA
Roth IRAs offer the reverse tax savings compared to traditional IRAs. Specifically, contributions to a Roth IRA do not reduce your taxable income (i.e. you pay tax on that income today), but distributions in retirement are not taxed. In other words, if you expect that your income right now is being taxed at a lower rate than it will be after you retire, you may want to choose a Roth IRA for optimal tax treatment.

Annual contribution limits depend on your income levels and are subject to the overall $5,500 maximum across all IRA accounts if you are under 50 years old, and $6,500 if you are over 50. Roth IRAs allow you to withdraw the money you put into the account at any time without incurring a penalty or paying income tax; however, the earnings in the account must remain untouched for at least 5 years (or they incur both income tax and a 10% penalty).

The magic of retirement savings “buckets”

Why do we care about these differences between retirement savings accounts? The key reason is that you can manage your tax expense by hand-picking the buckets that feed your income in retirement.

For example, you may opt to cover your living expenses from your taxable investment accounts first, then tap your 401(k) account up to the 25% tax bracket, then shift to your Roth IRA that does not increase your taxable income. The idea is to use up the least tax-efficient income streams early on, leaving the tax-deferred streams for later.

The magic of the gap

Most retirees have a gap between the time they begin to receive Social Security payments and the time that they are required to take minimum distributions (RMDs). Social Security payments begin at full retirement age (which varies depending on the year of birth with the current range between 65 and 67 years of age, with a slight increase in payment amount for those who choose to delay the start of benefit payments until they turn 70). Required Minimum Distributions or RMDs on 401(k) and traditional IRAs begin at 70 ½ years of age. As a result, a typical retiree has between 3-5 years to choose a point where his or her income dips low.

That dip is the perfect time to convert the 401(k) account or IRA to a Roth account. That allows you to take advantage of the low tax bracket at the time of the conversion (when the transaction is taxed). And, because Roth accounts do not have RMD mandates, it also means that you don’t have to worry about taxable Required Minimum Distribution payments in the future.

The magic of knowing your options

Keep in mind that Roth conversions do not have to be a binary yes/no decision. Partial conversions can make sense, especially for larger-balance accounts. Since there are no income limits that restrict Roth conversions, you can choose any amount that makes sense for your financial situation – without worrying about minimums or maximums.

The beauty of doing a strategic Roth conversion (or even a well-timed series of such conversions) is that any post-conversion growth in the account is tax-free. The key is to choose the conversion amount that does not push you into a high tax bracket. After all, Roth conversions only make sense financially if the rate that they are taxed at today is lower than the projected tax rate in the future.

Planning for tax opportunities in retirement

Retirement offers unique opportunities for optimizing taxes and extending the life of your portfolio. However, those benefits do not happen by chance. If you are hoping to maximize the tax benefits from strategically timing distributions and conversations of retirement savings accounts, you must consider a variety of rules. It is also critical to be mindful of your shifting tax brackets, lest your decision to minimize tax liability effectively de-value the growth in your accounts.

As with any other decision that has irreversible consequences, I recommend that you work with a financial planning specialist in your area to get this right.