How to Build a Tax-Smart Retirement Income Plan in 5 Steps

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While heading into your retirement years can be an exciting milestone to tackle, you might be feeling some uncertainty about your financial situation. The good news is that with some smart, strategic planning and insight, you can maximize your income in retirement for greater peace of mind.

“Taxes will most likely be your single greatest expense in retirement. For any retirement plan to have a chance at success, forward-looking tax planning is an absolute must,” says James Comblo of FSC Wealth Advisors.

For this reason, it’s important to understand the tax implications of your distributions and create a tax strategy. This can reduce your tax liability while maintaining your quality of life during retirement. You can even get started before you retire. Here’s what to consider:

Step 1: Assess Your Income Needs and Sources

Understanding your expenses and the income that will fund them is the first step to creating a tax-smart retirement income plan. Start by listing all your monthly costs and categorizing them as either necessary or optional. Next, identify your income sources, including Social Security benefits, pensions, rental income and withdrawals from your investment account.

Once you know your total income, compare it to your expenses to see if there’s enough to cover everything or if there’s a deficit. If your income falls short, you may need to adjust your budget, delay retirement, or explore strategies to increase income, such as part-time work or modifying your investment withdrawals.

Step 2: Understand Your Account Types and Tax Treatment

Understanding how your retirement accounts are taxed can help you make smarter choices when withdrawing money. There are three main types of accounts to think about:

1. Taxable Accounts – These are accounts like regular investment accounts where you pay taxes on any earnings, such as dividends, interest, or capital gains. For example, if your investments pay you dividends or grow in value and you sell them, you’ll owe taxes on the money you earn. These accounts don’t have special tax benefits, so many retirees use them early in retirement to keep taxes lower on other kinds of accounts.
2. Tax-Deferred Accounts – These include traditional IRAs and 401(k)s. With these accounts, you don’t pay taxes on the money when you put it in, but you do have to pay income taxes when you take money out in retirement. Also, once you hit a certain age (currently 73 for most), the government requires you to withdraw a minimum amount each year, called a Required Minimum Distribution (RMD). Planning the timing of your withdrawals is important to avoid paying more income taxes than needed.
3. Tax-Free Accounts – Roth IRAs are the most common tax-free accounts. The money you put into a Roth IRA is taxed upfront, but after that, it grows tax-free, and withdrawals in retirement are not taxed. This makes Roth IRAs a great option for reducing your tax bill later in life. There are no RMDs for Roth IRAs, which gives you more flexibility in retirement planning.

From here, you want to create a withdrawal plan to minimize your tax burden.

Step 3: Create a Tax-Efficient Withdrawal Strategy

Perhaps one of the most important aspects of retirement income planning is determining the order in which you withdraw funds from your various accounts. Generally, people start by withdrawing funds from taxable accounts first, followed by tax-deferred accounts, and then tax-free accounts like Roth IRAs. This strategy allows for continued tax-free growth in your Roth IRA while taking advantage of lower capital gains tax rates in the short term.

However, there are exceptions to this general rule. For instance, if you’re in a low tax bracket early in retirement, you might consider withdrawing funds from your tax-deferred accounts (traditional IRAs and 401(k)s) or even converting some of your traditional IRA to a Roth IRA. This could help you take advantage of lower tax rates while reducing your required minimum distributions (RMDs) and overall tax liability later in retirement.

Step 4: Optimize Tax Efficient Investments

Asset location can play an important role in minimizing taxes, too. Different types of investments are more suited to specific types of accounts.

For example, tax-inefficient assets like bonds, REITs and high-dividend stocks are better held in tax-advantaged accounts, such as traditional IRAs or 401(k)s. These accounts allow the earnings to grow tax-deferred or, in the case of Roth accounts, tax-free.

On the other hand, tax-efficient investments like index funds or growth stocks may be better positioned in taxable accounts. This is because they typically generate lower levels of taxable income, such as capital gains, which are often taxed at a reduced rate.

Another important consideration for retirees is selecting tax-efficient funds and ETFs. Funds with low turnover, such as broad-market index funds or ETFs, can help limit taxable capital gains distributions. Tax-managed funds are also specifically designed to minimize tax implications by employing strategies like loss harvesting within the fund.

Step 5: Plan for Required Minimum Distributions (RMDs)

Starting at age 73 (based on current U.S. tax regulations), you must take minimum distributions from your tax-deferred accounts, such as traditional IRAs and 401(k)s. These RMDs are taxable and can significantly increase your taxable income, potentially bumping you into a higher tax bracket.

To reduce the tax liability associated with RMDs, you might want to consider strategies like Roth IRA conversions during your lower-income years before the RMD age or drawing down your tax-deferred accounts earlier than required.

“Typically, when an individual retires, if they are not collecting social security yet and are not having to take required minimum distributions from their IRA, they see a decrease in their taxable income for a few years,” says Jennifer Kohlbacher, CPA andDirector, Wealth Strategy at Mariner Wealth Advisors. She explains, “We refer to this time period between retirement and required minimum distribution age as the ‘tax desert’. During the tax desert, an individual typically may be in a lower tax bracket for a few years which allows for some planning. It may make sense during this time to convert some funds in a traditional IRA to a Roth IRA. “

If you like giving, you can also donate RMDs directly to a qualified charity, satisfying the RMD requirement without increasing taxable income. Kohlbacher says for those “over the age of 70 1/2, he or she can have up to $105,000 of their IRA funds sent directly to charity. This strategy is called a qualified charitable distribution. If the funds are sent directly to charity from the IRA, it is tax-free.”

Final Thoughts

By creating a tax-smart retirement income plan, you can better manage your tax burden to ensure you have enough income to enjoy your golden years. From understanding account types and their tax treatments to implementing efficient withdrawal strategies and leveraging tax benefits, planning and strategizing are key to maximizing your retirement income.

Also, it’s important to revisit this strategy annually and adjust based on changes in tax laws, market conditions and your financial situation. Working with a financial advisor or tax professional can ensure that your withdrawal approach aligns with your financial goals.

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