Mid wealth retirees typically rely on Social Security, savings, and sometimes pensions to fund retirements. By timing receipt and expenditures of these different kinds of funds, retirees often can generate significant tax savings.
Savings can be either tax free, tax deferred, or taxable. Typical tax free savings are the kinds of municipal bonds that generate tax exempt income. The most common tax deferred savings are IRAs and qualified retirement plans like 401(k) plans, pensions, and profit sharing plans. Qualified retirement plans and some IRAs are particularly advantageous because their initial funding is with pre-tax dollars.
Because tax deferred accounts generate taxable income when withdrawn, it usually makes sense first to spend taxable amounts and defer withdrawing from tax accounts. Therefore, one retirement strategy calls for funding living expenses with Social Security and taxable investments in order to retain tax deferred accounts intact for as long as possible. While that can be sensible for some people, other folks may be able to save substantial tax by deferring Social Security and funding early retirement year expenses entirely from taxable accounts.
Instead of taking Social Security early or at normal retirement, it can pay to wait. Deferring the start of Social Security can increase wealth in two ways. The later you start Social Security up to age 70, the higher your annual benefit. At the same time, starting Social Security later keeps Social Security out of your income longer, which may reduce your income tax rate in early retirement years.
If you don’t take Social Security when you first retire and you keep retirement funds like 401(k) and pension accounts tax deferred by leaving them in the retirement plan or rolling them over to an IRA, your income probably won’t be large if it consists of income and dividends on modest taxable investments, possibly supplemented by tax free bond income. In that case, deferring Social Security will keep your taxable income and tax bracket down.
In addition, as you spend your taxable savings for normal living expenses, your taxable income will drop even further. Depending on your taxable income and tax rate, you may be able to realize substantial reductions in potential tax on your tax deferred accounts by converting some of them to Roth IRAs each year before you start to take Social Security. Roth IRAs are includible in taxable income upon conversion but earnings on the Roth IRA after conversion aren’t taxed at all.
Depending on your other income, you may be able to convert as much as $50,000 from tax deferred regular IRA to Roth IRA without increasing your federal income tax bracket. For instance, if you are married filing jointly with taxable income of $19,000, you would be in the 15% federal income tax bracket in 2011. If you convert $50,000 of your regular IRA or 401(k) account to a Roth IRA, you would stay in the 15% bracket and pay only $7,500 federal income tax on the conversion, which you probably can make up simply through by avoiding tax on post conversion income on the Roth IRA as well as savings by paying tax at a 15% rate rather than the 25% or higher federal income tax rate that would apply to withdrawals from tax deferred accounts and Roth conversions when you are at a higher income tax rate.
By timing spending of pre-tax and post-tax accounts and the start of Social Security, middle wealth retirees can realize significant reductions in potential income tax and increase overall wealth accordingly. However, it is crucial to analyze your particular spending habits, savings, income, and obligations before embarking on any financial plan. While the financial strategies discussed below may save tax and increase wealth for many people, they also can backfire and generate higher tax, lower return on investment, or other negative consequences for people in certain situations.
