You Did Everything Right. So Why Could Your IRA Become a Tax Problem?

For decades, Americans have been given some pretty straightforward retirement advice:

Work hard. Save consistently. Put money into your 401(k) or IRA. Take the tax deduction. Let it grow.

For millions of people, that strategy worked.

They reached retirement with $500,000, $1 million or even several million dollars accumulated inside tax-deferred retirement accounts.

There’s just one problem.

Eventually, the IRS wants its share.

And for some retirees, one of their greatest financial accomplishments — building a substantial retirement account — can create one of their biggest tax-planning challenges.

Your IRA Isn’t All Yours

This is something many people don’t think about while they’re accumulating money.

If you have $1 million in a traditional IRA, you don’t necessarily have $1 million available to spend.

You have $1 million that generally hasn’t been taxed yet.

When money comes out, those distributions are generally taxed as ordinary income.

For years, that may not seem like a major concern because you’re deciding how much to withdraw.

But eventually, that changes.

At Some Point, the Government Starts Making the Decision

Required minimum distributions, commonly called RMDs, eventually require most owners of traditional retirement accounts to begin taking money out.

And here’s where successful savers can encounter an interesting problem.

Imagine reaching retirement with a sizable IRA and not needing much of it because you’re living comfortably on Social Security, a pension or other income.

Your IRA continues growing.

That sounds wonderful.

And from an investment perspective, it may be.

But you’re also potentially growing a future tax liability.

When RMDs begin, those required withdrawals can increase taxable income — potentially affecting your tax bracket and other income-related costs in retirement.

Suddenly, the question isn’t simply:

“How much money did I save?”

It’s:

“How much of this money will I actually get to keep?”

Then One Spouse Dies

This is one of the retirement tax issues married couples frequently overlook.

While both spouses are alive, they may enjoy the more favorable tax brackets available to married couples filing jointly.

Eventually, one spouse passes away.

The surviving spouse may still have many of the same expenses.

The mortgage or property taxes don’t necessarily get cut in half.

The electric bill doesn’t get cut in half.

The cost of maintaining the house doesn’t get cut in half.

And the surviving spouse may now own most or all of the couple’s remaining retirement assets.

But after the applicable transition period, that surviving spouse generally files taxes as a single taxpayer.

That can mean reaching higher tax brackets at lower levels of taxable income.

This is sometimes referred to as the widow’s penalty.

And it’s one reason tax planning shouldn’t begin after the first spouse dies.

And Your Children May Have Their Own Tax Problem

For many families, the plan is simple:

“Whatever we don’t spend will go to the kids.”

But inherited retirement accounts don’t necessarily work the way people expect.

Under current federal rules, many non-spouse beneficiaries who inherit a traditional IRA are generally required to empty the inherited account by the end of the tenth year following the original owner’s death.

Think about when your children may inherit that money.

They could be in their 40s or 50s.

They may be in their highest earning years.

Now add distributions from Mom or Dad’s inherited IRA on top of their salaries and other taxable income.

You spent decades deferring taxes.

Your children could inherit both your money and the tax bill attached to it.

This Is Why Retirement Tax Planning Is Different From Tax Preparation

Tax preparation asks:

What do I owe this year?

Tax planning asks:

What decisions can I make today that may affect what I owe over the next 10, 20 or 30 years?

Those are very different questions.

For some retirees, it could make sense to intentionally recognize some taxable income earlier in retirement.

That might involve strategic withdrawals.

For others, Roth conversions may be worth exploring.

Some people may benefit from coordinating charitable giving with retirement distributions.

And sometimes the best strategy is simply understanding which accounts should be spent first rather than automatically withdrawing money wherever it’s most convenient.

There isn’t one answer that works for everyone.

That’s precisely the point.

Don’t Automatically Assume Paying Zero Tax Today Is the Goal

Nobody enjoys paying taxes.

So naturally, most of us try to minimize them.

But there’s an important distinction between minimizing this year’s taxes and minimizing taxes over your lifetime.

Suppose you have an opportunity to withdraw or convert retirement money while you’re in a relatively favorable tax situation.

Avoiding that tax today may feel like the obvious choice.

But what happens if that same money continues growing tax-deferred and is eventually withdrawn at a higher effective tax rate?

What happens if your surviving spouse inherits the account?

What happens if your children inherit it during their peak earning years?

Sometimes voluntarily paying some tax today may potentially help reduce a larger tax obligation later.

That’s why these decisions need to be evaluated as part of a larger retirement strategy.

The Years Between Retirement and RMDs Can Be Extremely Important

There’s a period that doesn’t get nearly enough attention in retirement planning.

It’s the time after you stop working but before required distributions become a significant part of your tax picture.

Your salary may have disappeared.

Your taxable income may temporarily be lower.

And depending on your circumstances, those years can potentially create planning opportunities that won’t exist forever.

Instead of simply allowing every tax-deferred dollar to continue accumulating, this may be an opportunity to ask:

• Should we intentionally recognize some income now?
• Would partial Roth conversions make sense?
• Which accounts should fund our lifestyle first?
• How will today’s decisions affect the surviving spouse?
• What kind of tax liability are we ultimately leaving our children?

Those are retirement planning questions — not just investment questions.

Retirement Isn’t Just About How Much You Accumulate

We spend most of our working lives trying to make the number on our retirement statement bigger.

But once retirement approaches, another number becomes increasingly important:

How much of that money will actually be available for you and your family to use?

A $1 million IRA is impressive.

But the account balance alone doesn’t tell you what your retirement will look like.

You have to consider income.

Taxes.

Required distributions.

Your spouse.

Your beneficiaries.

And how all of those pieces interact over several decades.

The goal shouldn’t necessarily be to pay the least amount of tax possible this year.

The goal should be to make informed decisions that help you keep more of what you’ve accumulated throughout retirement — and ultimately transfer your wealth as efficiently as possible to the people you care about.

What’s Your Retirement Tax Strategy?

At Reservepoint Financial, we believe retirement planning shouldn’t stop at building an investment account.

It should include a strategy for turning those assets into income, managing taxes throughout retirement, protecting a surviving spouse and considering what ultimately happens to the money you leave behind.

If most of your retirement savings are sitting in traditional IRAs or 401(k)s, now may be a good time to ask a different question:

Not just “How much have I saved?”

But “How much of it will my family actually get to keep?”

This material is provided for educational and informational purposes only and is not intended as individualized tax, legal or investment advice. Tax laws and individual circumstances vary. Consult appropriate qualified tax and legal professionals regarding your individual situation.