Optimize income subject to tax
The U.S. tax system is a progressive one, with federal income tax rates ranging from 0% to 39.6%. While retirees, especially those with paid-off mortgages, may not need large amounts of income to sustain their lifestyles, they can protect their savings by minimizing income tax liabilities.
"Retirees should not leave room in the lowest tax brackets," says Waldean Wall, vice president of advanced markets for Allianz Life.
Trigger taxable income
To take advantage of the opportunity to "top off your bracket," retirees should trigger taxable income equal to the amount of room left in their tax bracket. For example, a couple filing jointly with $40,000 of combined income falls in the 15% bracket, which tops out at $75,300. They can earn another $35,300 before the next bracket applies, not counting the standard deduction or personal exemptions, which would add room for another $20,700.
One strategy involves "anticipating required minimum distributions from retirement plans that could push them into a higher tax bracket in future years," says Wall. By taking distributions before age 70 1/2, more income can be legally shielded from potentially higher taxes when it's time to take RMDs. Plus the income could sustain the couple's lifestyle, enabling them to delay drawing Social Security until a later age, when benefits are larger.
However, McKelvey warns, such strategies should be done in concert with comprehensive investment planning.
Apply long-term capital gains strategies
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Retirees should take advantage of preferential tax treatment given to long-term capital gains and qualified dividends. Long-term capital gains (i.e., the gains recognized when securities held for longer than one year are sold) are taxed at lower rates than ordinary income. Taxpayers in the 10% and 15% tax brackets are not subject to long-term capital gains tax at all -- their rate is 0%. Taxpayers in the middle tax brackets are subject to this tax at 15%, and those at the highest tax bracket of 39.6% will see long-term capital gains taxed at 20% -- roughly half of the ordinary income tax rate.
But it's possible to dodge even the lower capital gains rate. Retirees who plan to sell stock to fund their living expenses should determine whether a more favorable tax strategy could be employed. Instead of selling stock with significant untaxed appreciation that could trigger long-term capital gains tax, retirees could consider tapping funds that generate no taxes, such as a Roth IRA.
Use net unrealized appreciation strategy
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Retirees should pay particular attention to employer-granted stock held in their retirement plans, especially if the stock has risen in value. "Gain on employer stock is not included in taxable income when it is distributed in kind from a qualified plan as part of a lump-sum distribution that is not rolled over to an IRA," says Wall.
"Net unrealized appreciation"
That means that after you separate from service, you can roll over the company stock into a brokerage account and the balance of pre-tax investments into an IRA -- all within the same year. This strategy is called "net unrealized appreciation." If you do this, you will have to pay tax on the stock's basis amount -- the value of the stock when you first acquired the stock from your employer. For example, if the collective basis is $20,000, you must pay tax on the $20,000 for the tax year you transfer the shares to a brokerage account. When you sell the stock, whether the next day or in 10 years, you pay long-term capital gains on the appreciation.
As long as the stock is not rolled over to an IRA, the taxpayer can take advantage of lower capital gain rates. However, Wall says retirees cannot realize an unlimited amount of tax-free dividends or long-term capital gains, so they should consult a tax specialist before selling the stock.
Don't let the Medicare surtax surprise you
A 3.8% surtax for Medicare applies to net investment income of taxpayers with modified adjusted gross income, or MAGI, in excess of certain thresholds -- $200,000 for single taxpayers and $250,000 for married taxpayers filing jointly. These threshold amounts are not indexed for inflation.
Distributions from retirement plans, Roth IRAs, municipal bonds, grantor trusts and qualified annuities are not subject to the net investment income tax.
What net investment includes
Net investment income does include interest, dividends, passive activity income, capital gains, rents, royalties and income from nonqualified annuities. "The surtax may apply to undistributed net investment income for certain trusts, as well," says Wall. For 2016, tax at the highest marginal rate applies to trust income exceeding $12,400.
Retirees should determine whether distributions during the year could raise a surtax problem. If so, the income needed to cover living expenses should be generated from assets that will not trigger the surtax.
Take advantage of Roth IRA conversions
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A Roth IRA conversion occurs when a taxpayer converts assets from a traditional IRA, which holds tax-deferred assets, to a Roth IRA, which holds assets that have already been subject to income tax. At the time of the conversion, income tax will be due on the assets converted. Because the assets held in a Roth IRA have already been taxed, qualifying assets can be withdrawn tax free in later years. Qualifying assets include those that have been in the Roth IRA for at least 5 years.
Retirees can take advantage of this tax timing difference in various ways, Wall says. For example, if there is room in a lower or middle tax bracket, a taxpayer can convert pre-tax IRA assets equal to the amount of room remaining in those lower tax brackets.
Alternatives to liquidation
Also, retirees can withdraw qualifying Roth IRA assets, instead of liquidating assets that trigger income subject to tax, to limit the amount of Social Security benefits subject to income tax.
"Conversions can be helpful with managing net investment income subject to the Medicare surtax, and the various tax bracket thresholds for future years," adds McKelvey.
Roth conversions are subject to special tax rules, so any retiree wanting to take advantage of this strategy should consult with their tax adviser.
Convert to a Roth to reduce estate tax
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Retirees who have accumulated serious wealth can use Roth conversions to reduce their exposure to estate tax. While 99.8% of estates won't have to worry about this tax, the top tax rate is 40% -- a substantial hit to heirs of the super-rich.
Currently, the estate tax exemption amount is $5.45 million. Traditional IRAs can be converted to Roth IRAs regardless of a person's income level, and the converted assets are not subject to estate tax.
"Because the money used to pay the income tax due on conversion is paid to the U.S. Treasury, that amount is no longer in the IRA holder's estate upon which estate tax could be due," says Wall.