Reed Family Finance

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by Abby Reed Leave a Comment
In our time together each week, my goal is to help teach you the questions you need to ask to help you make sound financial decisions. Over the years, I have written a lot about the importance of having a tax-advantaged plan within a financial strategy. After all, if you can avoid paying extra money to Uncle Sam—legally, of course—and keep more in your pocket, why wouldn’t you?

Several of our articles have addressed the power of tax-advantaged investment vehicles: things like Roth IRAs, cash value life insurance, et cetera.

What I want to focus on today is what I like to call the "sweet spot" of our tax lives. The "sweet spot" is that short time in our adult lives when many taxpayers fall into a lower tax bracket, after having retired from full-time jobs. Think about it: we stop receiving a salary and, if we have planned well and are able to wait to tap into our tax-deferred accounts, and can also delay collecting Social Security as long as possible, we will potentially find ourselves in a much lower tax bracket for a few years. But for many retirees, this period of low taxable income won't last.

Think about when we need to start taking those Required Minimum Distributions in our 70s, around the same time many of us will start collecting those hard-earned Social Security benefits. We will likely find our income moving right back into a higher bracket.

So when you find yourself in that sweet spot, likely in your 60s, after retirement and before mandatory withdrawals, what moves should you make?

One thing to consider is whether it makes sense to convert some or all of your traditional IRAs or 401(k)s into a Roth IRA. As you know, when you take a distribution from a Roth IRA, there are no federal taxes due on that money. All contributions are made with after-tax money and the earnings are tax-free. On the other hand, when you convert money from a traditional IRA or 401(k) to a Roth IRA, you pay ordinary income taxes on the amount converted. So, if you are temporarily in a lower tax bracket, this may be an ideal time to convert at least some of this money. And remember, you can stretch those conversions over several years, helping to ensure that your taxable income does not get pushed into a higher tax bracket in any one year.

If, however, the bulk of your savings is in tax-deferred accounts, you might have trouble paying the taxes required to make any such conversions. If you don't have the necessary funds outside of your 401(k) or traditional IRA to pay the tax (albeit at a lower rate), a Roth conversion may not make financial sense. As always, seek a qualified retirement specialist if help is needed.

You might be wise to start taking distributions from these tax-deferred accounts before distributions are required. Not only will these distributions potentially be taxed at a lower bracket, but they could lower your future tax liability on your retirement accounts by reducing their overall balance. Also, having the income from any such distributions may allow you to delay Social Security longer than you could otherwise, thereby earning a higher benefit. It is important to note that this plan only works if you are over age 59 1⁄2; otherwise, generally there is a 10 percent penalty for early withdrawal.

The last thing to consider if you have reached your “sweet spot” is whether it makes sense to sell any appreciated assets in a taxable account. If you fall within the 15 percent ordinary income tax bracket, which is common for those in the “sweet spot,” the long-term capital gains tax rate is zero percent, giving you the prime opportunity to sell positions that don’t fit your portfolio strategy, and avoid taxes on any appreciation.

I find that tax planning is one of the trickiest pieces of a solid retirement plan, and one that is often ignored because most investors don't believe they have a choice, or ability to change what they pay. They never find their "sweet spot."
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