Broker Check

High Impact Planning Prior to Retirement

January 17, 2024

The definition of retirement continues to evolve.   No longer is the image of retirement a couple in rocking chairs on their porch.  Today, retirement is about a “second act” instead of rest.   The more modern view of retirement is using your financial resources to live in to your purpose, take adventurous trips, and deepen relationships with friends and families.   Because we are living longer more active lives  it is essential to plan well in advance in order to increase the longevity of our money.

Over a few decades providing advice we have continued to evolve our process and client experience elements to match the needs, wants and wishes for each client.  When our process identifies that a client is nearing retirement, we begin to adjust our planning and focus in on a few key tax planning items.   The purpose of this article is to define a few of the items and provide some of our thinking on why they are critical elements.

Measuring in Roth Conversions

If a retiree was able to wave their magic wand, they would prefer all retirement assets be in Roth IRA registrations.  The primary reason for this preference is the tax treatment of distributions.   If the distribution qualifies, it is free of federal income tax as opposed to distributions from qualified plans or traditional IRAs that add the distributed amount to ordinary earnings.  The reality is that most clients we work with have a mix of different account types as they near retirement.   Because of this, we look for opportunities to convert traditional IRAs to Roth IRAs over time.

First, let’s start with some background on Roth conversions. A Roth conversion is the process of moving assets from a traditional IRA or other pre-tax retirement account to a Roth IRA, which is a tax-free retirement account. When you convert, you’ll have to pay taxes on the amount you’re converting, but once it’s in the Roth IRA, it grows tax-free, and you won’t owe any taxes on withdrawals in retirement.   There are no income limits on converting to a Roth IRA.  The income limits are only for contributions to Roth IRAs, no conversions.

One of the key benefits of using Roth conversions is that they can help you reduce your taxes in retirement as you are making withdrawals to meet your living expenses.  By paying taxes now (on the amount converted) you can avoid paying higher taxes later when you start taking distributions from your retirement accounts. This can help you keep more of your retirement savings in your pocket and reduce your overall tax burden over time.

A lesser-known benefit of measuring in Roth Conversions of time is lowering the required amount of your required minimum distribution, which results in more control of your future tax cost in retirement.

Most of us anticipate our peak income years to be during our working careers, but this may not end out being the actuality.  Many investors have diligently saved and invested in company sponsored plans which leads to large accumulated balances.  Those balances, coupled with other IRA accounts (if applicable) are the amount on which the required minimum distribution will be taken.

The required beginning date (RBD) for required minimum distributions (RMDs) is the date by which an individual must begin taking RMDs from their retirement accounts. The RBD is April 1 of the year following the year in which the individual turns 72 (or 70 ½ if they reached age 70 ½ before January 1, 2020).

For example, if an individual turned 72 in 2022, their RBD for taking RMDs from their retirement accounts would be April 1, 2023. This means that they must take their first RMD by April 1, 2023, and subsequent RMDs by December 31st of each year.

The long-term impact of using Roth conversions and other tax location strategies can be significant. By managing your taxes effectively over time, you can help maximize your overall after-tax returns and keep more of your hard-earned money in your pocket. This is especially important when it comes to retirement planning, as taxes can be a significant expense in retirement and can impact the longevity of your savings.

The bottom line is this – the Roth IRA is an excellent tool that is available, but it is important to have a strategy that is a multi-year approach to conversions, which allows the current tax cost of conversions to be measured in over time, versus all at once.

Income Related Monthly Adjustment Amount (IRMAA)

Don’t glaze over – hang with me here, this is an important one!

IRMAA stands for Income-Related Monthly Adjustment Amount. It is a surcharge that high-income Medicare beneficiaries are required to pay in addition to their standard Medicare premiums. 

Imagine for a moment if your Netflix subscription cost more just because your income was higher.   You do not get any more features or access to content but you pay a higher amount.   A little planning, at least two years in advance can reduce or potentially eliminate this surcharge.

Here’s how it works:  IRMAA is based on an individual’s modified adjusted gross income (MAGI) from two years prior. For example, if a client is paying IRMAA in 2023, their MAGI from 2021 would be used to determine their surcharge amount. The IRMAA surcharge is calculated based on a sliding scale that ranges from $0 to $504.90 per month in 2023.   

The purpose of IRMAA is to help fund Medicare Part B and Part D by collecting more premiums from higher-income beneficiaries. IRMAA applies to individuals with an income over $88,000 per year and couples with an income over $176,000 per year.

Attention to this monthly amount when creating a retirement income strategy can save hundreds of dollars per month in healthcare premium expense.   Early planning including the use of Roth Conversions to lower traditional IRA balances on which future required minimum distributions are taken can help reduce the negative impact of IRMAA.  We like to spend some time on this one because it translates to real monthly savings that can be spent on more exciting things, like health clubs, a couple of massages per month, or a nice dinner or two. 

Creating a Tax Asset

The final one we’ll touch on today is tax loss harvesting.   As a financial advisor, I often hear clients express frustration with the amount of taxes they owe on their investment gains. Fortunately, there’s a strategy called tax loss harvesting that can help investors reduce their tax burden and potentially increase their returns over time.

Tax loss harvesting is the practice of selling investments that have experienced a loss in order to offset gains realized elsewhere in an investor’s portfolio. By doing this, the investor can reduce their taxable income for the year and potentially lower their overall tax bill.

For example, let’s say an investor purchased 100 shares of XYZ stock for $10 per share, for a total investment of $1,000. Over time, the stock price fluctuates and eventually drops to $7 per share, meaning the investor’s investment is now worth $700. At this point, the investor could sell the 100 shares of XYZ stock and realize a loss of $300. This loss could then be used to offset gains realized elsewhere in their portfolio, such as from the sale of a different stock that had increased in value.

By reducing their taxable income for the year, the investor may be able to lower their tax bill and keep more of their investment returns. Additionally, by reinvesting the proceeds from the sale of the XYZ stock into a different investment, the investor can potentially benefit from the performance of that new investment going forward.

At this point you may be thinking, and rightly so, that these are not isolated tax planning concepts.  They work best when connected to a goals based plan and investment strategy.   Our process connects these elements and implements our approach over time instead of a “set it and forget it” approach.   

If you take nothing else from this article, remember that it is essential to coordinate tax planning with your retirement date decision.  It is ideal to be at least two years out so you can evaluate the use of Roth Conversions, have a sense of your modified adjusted gross income (MAGI) as it relates to Medicare premium expenses, and finally to evaluate the use of tax loss harvesting in your non qualified accounts.