Don’t Defer Income in your Retirement Gap Years

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Don’t Defer Income in your Retirement Gap YearsJust because you have stopped working and dropped a few tax brackets doesn’t mean that you still cannot be making important tax planning decisions. You should be asking yourself the following key questions:

  • Is the majority of my income from taxable wages or other ordinary income that will cease to exist in retirement?
  • Do I have a significant amount of assets in pre-tax retirement accounts?
  • Is a large portion of my investment income tax-exempt?
  • Are there any large charitable gifts that I have been considering over the next several years?
  • Is my mortgage close to being paid off?

Your “Retirement Gap” years, the period between your actual retirement and the mandatory distribution age of 70 ½ years old can be a prime planning opportunity.

For many people, the transition from a top earning bracket to one of the bottom brackets with minimal taxes is a welcome change. This is what we have seen too many times – We find many people inadvertently defer income because they feel like they don’t need it yet. Unfortunately, what they end up doing is saving a little tax now to pay a lot of tax later once they reach their required minimum distribution (RMD) age of 70 ½. Here are seven strategies that you may be able to take advantage of to maximize the retirement “gap”:

  1. Consider a Roth IRA conversion to accelerate taxable income into the gap years. When done right you may be able to accomplish this in a tax-free or very low tax manner. Future distributions from a Roth IRA are tax-free for both principal and earnings, and the Roth IRA is not subject to the RMD rules that require distributions after age 70 ½. In addition this draws down the balance in your traditional IRA, which helps decrease the base on which RMDs are calculated once you do turn 70 ½.
  2. Take advantage of the 0% tax rate on long-term capital gains in the bottom tax bracket. That stock you have been holding for 30 years that you have been too afraid to sell because of the substantial unrealized gain? This may be the time to sell it worry free.
  3. In the year of retirement, consider factors such as accrued vacation due, unexercised stock options, final bonuses, You may be able to plan your retirement in a way to have these payments hit your account in January of the following tax year and reduce your tax burden overall. For stock options, you typically have 90 days from the date you leave to exercise, so if you time your retirement right in the last 90 days of the year, you have a choice on staggering exercise of the options if you choose.
  4. Shift your investment mix – The strategy that applied when you made your initial investments may have changed. All too often we find clients that have significant amounts invested in tax-exempt securities even though they are now in a low bracket. The tax savings advantage of these investments is now diminished and you may be able to increase your after-tax return by shifting to taxable investments.
  5. Payoff your mortgage. Without a large state income tax deduction from withholding on your wages many people are closer to the standard deduction in lieu of itemized deductions. Items like mortgage interest may now not be worth the same to you that they once were.
  6. “Frontload” charitable contributions in your final working year. You may still be in a high tax bracket in your retirement year. Consider accelerating charitable deductions into this tax year, or using a vehicle like a donor advised fund (DAF) in order to accelerate these deductions without giving all the money away at once.
  7. Start paying investment fees on your retirement accounts with funds from taxable accounts. In high earnings years you may have been subject to alternative minimum tax (AMT) which negates the tax benefits of deductions such as investment management fees. Now that your situation has changed, you may now be able to take advantage of this deduction. Paying fees from outside the account has the added advantage of keeping more money in the tax-deferred account allowing it to continue to grow in a tax-deferred manner.

A low tax bracket in retirement does not mean that tax planning is not necessary or possible. In fact, we find it means the opposite, it is a “golden opportunity”. Above we have outlined seven simple strategies you can consider to solve the question of how to be tax-efficient in retirement. By taking action during these retirement gap years, you can significantly decrease your overall income tax liability in retirement. If you recently retired or are approaching retirement, and you will have a few years before you reach the mandatory distribution age of 70 ½, then contact us at once to review these strategies.