One way to potentially lower taxes in retirement is to start taking distributions from tax-deferred accounts before it’s required. Again, once you reach age 59½, you can withdraw funds from those accounts without paying the 10% early-withdrawal penalty. The withdrawals are still taxed as ordinary income, but over time they reduce the size of tax-deferred accounts, and thus the size of your RMDs. Another reason to access those funds before 70½ is that it could help you delay taking your Social Security benefit, which increases in size the later you take it, up to age 70.
That said, it’s important to look at your tax situation at age 59½ before taking early withdrawals. For the many Americans who will still be working at that age, withdrawing too much could push them into a higher tax bracket. Taking Social Security benefits could also push you into a higher tax bracket, but keeping RMDs low means less income would be subject to the higher tax rate.
One of the most popular and appealing strategies for reducing the potential tax consequences of RMDs is converting a traditional IRA or 401(k) plan into a Roth IRA before the age of 70½. Roth IRAs are funded with after-tax dollars and thus are exempt from RMDs during the owner’s lifetime — and when the funds are withdrawn, both the principal and earnings are tax-free. It’s worth noting that the act of converting to a Roth IRA is a taxable event and the five-year rule still applies.
A Roth conversion may make sense when you’re certain you’ll be in a higher bracket when you eventually withdraw the money, which is often the case once RMDs and Social Security are factored in. It may also be a good option when you don’t need the money, aren’t concerned about paying income taxes and would like to leave an income-tax-free Roth IRA to your heirs.
Lastly, if you make a full or partial conversion to a Roth IRA, you may be able to reduce the resulting tax burden via charitable giving during the same year as the conversion — though the donation can’t be funded from your retirement accounts.
There’s a lot to consider as you plan for how to manage your tax obligation in retirement. Consulting with a financial professional, and particularly a tax adviser, can help ensure your choices are most advantageous for your situation.
Catherine Golladay is senior vice president for 401(k) participant services and administration with Schwab Retirement Plan Services.
The information contained herein is proprietary to Schwab Retirement Plan Services Inc. (SRPS) and is for informational purposes only. None of the information constitutes a recommendation by SRPS. The information is not intended to provide tax, legal, or investment advice; please consult with your accountant or investment adviser for how this applies to your specific situation. SRPS does not guarantee the suitability or potential value of any particular investment or information source. Certain information provided herein may be subject to change.