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Securing Lower Taxes

John Yeigh

THE TWO SECURE ACTS2019’s and 2022’s—may inadvertently increase the federal and state tax rates on tax-deferred retirement accounts, such as 401(k)s, 403(b)s and IRAs. While well-intentioned, the laws result in required withdrawals being bunched into fewer years—which could push people into higher tax brackets. But there are ways this tax toll might be lightened or avoided, as you’ll see.

With tax-deferred accounts, the normal advice is to delay taxable distributions for as long as possible to give more time for investment growth. That rule might need to be ditched. Why? For starters, the two SECURE Acts have raised the age when required minimum distributions (RMDs) must begin—from age 70½ in 2020 to age 72 in 2022, 73 in 2023 and 75 in 2033.

Now, consider that the average lifespan of Americans fell during COVID-19. In practice, then, there might be just a decade or so of required withdrawal years before the balance goes to beneficiaries. And that could be quite a taxing event.

Widows and widowers, for example, can owe higher taxes than married couples with equivalent incomes. Widows with taxable incomes between roughly $45,000 and $90,000 would pay a 22% top marginal tax rate, versus 12% for a married couple filing a joint return showing similar income. This is the so-called “widow’s tax,” which has been well-documented on HumbleDollar and elsewhere.

Similarly, children or grandchildren who inherit might be hitting their peak earning years—and paying taxes at their highest marginal rate. Compounding the problem, 2019’s SECURE Act shortened the distribution period for inherited IRAs to 10 years for most beneficiaries. Previously, distributions could be taken over a beneficiary’s remaining actuarial lifespan—the so-called stretch IRA.

If we assume that these heirs take equal annual distributions, they’d need to withdraw roughly 10% a year, instead of the 3% to 5% per year typical under the old stretch IRA. These larger distributions could push some heirs into higher tax brackets for a decade. Admittedly, this is a nice problem to have.

Still, if you want to mitigate taxing situations like these, here are eight ideas, some of which overlap:

  1. Fund Roth accounts, while also converting traditional IRAs to Roths. Because Roth money isn’t taxed again, you’d avoid higher income tax rates in later years. The benefits of Roth conversions have been broadly covered here and here.
  2. Take earlier and more frequent distributions from your traditional retirement accounts. Earlier distributions could be beneficial under three circumstances—if future marginal tax rates would be higher once RMDs kick in, if federal income tax rates rise as scheduled in 2026, and if beneficiaries would be taxed at a higher rate than the current account owner, perhaps because of their fortunate inheritance.
  3. Take earlier IRA distributions and invest that money in a taxable account. Subsequent gains would be taxed at lower capital gains tax rates. If held until death, the investments could receive a step-up in basis and pass income-tax-free to heirs.
  4. Take earlier distributions and give the proceeds to family members or other potential heirs. Yes, you’d owe income tax on the withdrawals. But if the gifts are kept at $17,000 or less per person in 2023, there would be no gift-tax consequences.
  5. Name more beneficiaries for your traditional retirement accounts, so the resulting extra taxable income would be spread among more folks.
  6. Slow or stop contributions to retirement accounts if adding more money is going to result in highly taxed RMDs.
  7. Use qualified charitable distributions to reduce the balance in a tax-deferred IRA. Those who have passed age 70½ can give away up to $100,000 a year from an IRA directly to charities without incurring taxes. But be careful: Money given to a donor-advised fund or private foundation doesn’t qualify for this tax exemption.
  8. Bequeath your traditional retirement accounts to charity, while saving Roth and taxable account money for your heirs.

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1silverloon
1silverloon
1 month ago

Thank you, John, for the most excellent article.

tiflmike
tiflmike
2 months ago

Nice article. However I’ve always been of the opinion that a 401k should be treated like an annuity. After retirement start withdrawals immediately at the minimum rate. Why scrimp and save all your working life and then don’t reap the benefits? This is the simplest approach. Do what you will with the proceeds depending on your personal circumstances.

Martin McCue
Martin McCue
2 months ago

Good article. Thanks. Some useful insights. For example, this tells me that I still should take the IRA distribution in 2023 I would have had to at age 72, even if it only spreads my withdrawals by one. But I am still conflicted about whether there is any value for a 72-year-old to flip any SEP money to a Roth – my accounts are rather large and I think I’d need a big economic downturn to make even a partial conversion useful at my age. Otherwise, I doubt I’d earn enough in today’s market to catch and pass the tax hit.

Last edited 2 months ago by Martin McCue
louis H
louis H
2 months ago

John, it’s too bad there’s not a universal “future retirement financial planning course” that pre-retirement folks can take that touch on these topics. My self education has come through reading articles and comments from folks like you that contribute such learnings. A couple of other topical areas for consideration to add to the list that I have traversed over the 13yrs in retirement:

  • Higher Medicare IRMAA premium avoidance in income planning
  • Health insurance pre 65(Obamacare) and Income planning to assist with Healthcare subsidies and CSR(cost sharing reduction)
  • Widow(er) tax planning topic. What happens to RMDs when spouse dies. This plays to the Roth conversions before 73. I am watching this firsthand by handling my mom’s finances and doing her taxes. Since my father died and it forced the move from the married to single RMD table, it certainly has had a dramatic impact on emptying out the IRA that she inherited. Couple that with the fact that she is also in a higher tax bracket since being forced out of the “married tax bracket” that exposes more of her income to higher taxes.
  • Social security claiming strategy. In many states, Soc Sec income is not taxed. Thus, by delaying your claiming you actually get a “two-fer” benefit. Higher monthly benefit and after tax income.
Jonathan Clements
Admin
Jonathan Clements
2 months ago
Reply to  louis H

Taxes in retirement is a very complicated topic. I’ve got a piece in the works that tackles the subject, but it’s hard to address all the various issues and all the tradeoffs in a single article.

rayanmiller6303
rayanmiller6303
2 months ago

I have an ok funded retirement and hope to retire before 63 but can see almost no scenario where I don’t start spending down the 401k before 70 (SS) or RMD’s

Olin
Olin
2 months ago

You point out many tax planning issues everyone should know before retiring, and probably more importantly once reaching age 59 1/2. Wish I could go back in time and apply what I know now, but then I was cash poor and couldn’t pay the tax for the conversions to a Roth.

My situation is better today, but now it’s too late for Roth conversions to make sense. If one doesn’t know what they need to know years before they retire, then Uncle Sam becomes a bigger black sheep in your financial future.

Why is it that so many of us never receive retirement planning guidance during our working years? All I knew was to have a 401K and if I saved x amount every year I should have x amount when I retire. Most, assume we’ll be in lower tax brackets at retirement, but not so when you kick in: SS, pension and RMDs. And double that if you’re married. All of a sudden you’re making more than you were when working full time.

Going forward, wish I could seek out a reasonable fee only financial planner. Have tried the CPA route in hopes of some tax strategies, but that hasn’t worked out.

Didn’t mean to vent, but this excellent article was very informative and everyone of us is in a different financial basket. Thank you John!

macropundit
macropundit
2 months ago
Reply to  Olin

I understand fully the frustration. There either are very few actual tax planners, or they are extremely hard to find. Financial folks that say they can do tax planning really just want to manage your money. And a tax preparer, even CPAs, often are little help I know from firsthand experience. Roth conversions? Of course it’s a judgement call, but they’ll utter “You know you’re going to lose money!” (otherwise known as paying taxes) and that’s their view of that.

But in my no doubt jaded view, I think it’s analogous to the situation with financial advisors are kinda nonsense, and I’ve never used one and am the better for it. Most of them are full of crap salesmen. But then I watched Rukeyser’s Wall Street Week with my dad and financial magazines and then blogs for many years, and don’t get scared when they bring up the Modern Portfolio Theory I’m supposed to be impressed by.

I think people have to break down and learn the tax issue for themselves. I finally got a handle on what I wanted to do in terms of taxes recently. Some aspects are very arcane, but it’s discoverable if you read or hear enough and keep at it. There are some wonderful resources on YouTube, and you can engage comments and actually learn from people who’ve been down the same road.

My accounts are large too, and I’m still working, but I finally decided to do small Roth conversions yearly anyway. For me it is simple opportunity cost calculations. I can’t see the future, but I know how much I’m willing to pay (give up in taxes) to get stuff I’d like to have. I’m the only one that can make that call. Roth conversions aren’t for everyone, and it doesn’t always make sense. But oftentimes the negative judgments are based on pie in the sky ideal tax rates that you might never get anyway. And if you die you just end up kicking the can down the road and hand your spouse/family the same hard decisions you couldn’t make. No doubt this year and future years my tax guy will note I ignored his advice, but I’ve no reason to care. I can’t see he has any sort of sophisticated view on taxes though he’s a tax professional. The experts can’t help with very much in the end.

Roboticus Aquarius
Roboticus Aquarius
2 months ago

Man plans, God laughs. I know, for many people tax planning is a valuable exercise. For us, it seems like a game of pinball. This is not a complaint; we are very lucky to be in this position, but it does make me laugh.

We put a fair amount into Roth 401(k)s this year, thinking to balance our tax risk. Then our business income unexpectedly more than tripled in 2022, pushing us into higher income tax brackets. Now we’re going back to traditional 401(k) contributions, as it would take enormous income before we pay the same marginal rates in retirement as we will this year.

OldITGuy
OldITGuy
2 months ago

Unfortunately the tax code is so complex that it’s left up to the tax payor to find legal ways to navigate it so as to avoid incurring taxes simply due to ignorance. Your article contains a couple of good ideas I hadn’t considered, so thanks for the help.

Edmund Marsh
Edmund Marsh
2 months ago

Good article, John. As I approach retirement, I’ve learned that the truly complicated part of retirement planning is deferred until the later stages.

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