If you want to cut your taxes now, there are multiple ways to do it.
You can contribute to a traditional retirement account or put money into a health savings account. You might be eligible to take advantage of education-related credits. Or, if you have a side gig–or a self-employed spouse–you may have the option of claiming certain business deductions or writing off home office expenses.
But what–if anything–can you do with your retirement accounts to minimize your tax burden in retirement?
Having the right mix
Most federal employees have considerable retirement savings in a tax-deferred traditional TSP (i.e., a Thrift Savings Plan). However, few of the federal employees we work with have much money in a tax-free Roth TSP.
In this post (and companion video), I want to show you how having the right mix of money in traditional and Roth retirement accounts can save you on taxes, depending on your situation.
If your income stays the same in retirement…
Consider an example. Let’s say you’re in the 22% tax bracket right now. You’ve run the numbers, and you figure you’ll be in the same 22% bracket after you retire.
This is often the case for federal retirees. When they add their pension to their Social Security benefits–and factor in withdrawals from their TSP–their income ends up being comparable to what it was when they were working full-time. (Because of these assorted “income streams,” very few drop to a lower tax bracket in retirement.)
If your income increases in retirement…
Here’s another possible scenario. Let’s say you are currently in the 22% bracket, but when you retire, you anticipate your income and tax rate will be even higher. This is possible especially when you factor in RMDs (Required Minimum Distributions). These distributions (from your traditional TSP or any traditional IRAs you own) are taxable, and even if you don’t need that money for living expenses, the government requires you to withdraw these taxable funds within a certain time frame.
RMDs are a reason many retirees find themselves, at age 73 or 75, suddenly pushed into a higher tax bracket.
If the tax code changes in retirement…
Another reason your tax rates could be higher in retirement is tied to the “Tax Cuts and Jobs Act” passed by Congress in 2017. Often referred to as the “Trump tax cuts,” this legislation will expire or “sunset” in 2026–unless Congress renews it.
If Congress fails to act, tax brackets are set to revert to their former rates/amounts. Instead of brackets of 10%, 12%, 22%, 24%, 32%, 35%, and 37%, the revised brackets will be 10%, 15%, 25%, 28%, 33%, %35, and 39.6%.
Since it’s impossible to predict what our political leaders might do, we have to conclude there is at least a chance tax rates could rise.
Lowering your tax bill in retirement…
If, for any of these reasons, you suspect your tax rates could be higher in the future, it might make sense to do some Roth conversions now. A Roth conversion is where you take money from your traditional TSP, pay taxes on it now, then put the remainder in a Roth account where it can grow tax-free.
If you’d rather pay taxes now at a lower rate than taxes later at a potentially higher rate, the right mix for you is to have more money in a Roth account and less money in your traditional TSP.
Does this mean you should have 100% of your money in Roth and none in traditional? Probably not, but systematically shifting money in that direction could save you on taxes if tax rates do, indeed, rise.
If your income drops in retirement…
Let’s flip the scenario. Suppose you’re a double-income family in the 32% tax bracket. After crunching the numbers, you realize that when you stop working, your income may dip enough to drop you into the 22% bracket.
In that case, it would make sense to delay paying taxes on your retirement funds. Even if the Trump tax cuts are not extended and the 22% bracket goes back to its previous 25% rate, that’s still less than the 32% tax rate you’re paying now.
If that scenario were to happen, you’d probably want to put money in your traditional TSP (and avoid paying taxes at a 32% rate). After you retire, you can withdraw that money and pay the taxes you owe…at a lower rate.
The name of the game is paying taxes at a lesser rate. If you believe your income or tax bracket in retirement will be lower than it is now, it makes sense for you to have more money in a traditional account.
If you think your future income and/or tax rate are likely to be higher, then you’ll want to accumulate more money in a Roth account–and less in a traditional TSP or IRA.
Are there exact percentages (i.e., X amount of traditional vs. X amount of Roth) that you should shoot for? No. The goal here is to be strategic, leveraging the tax brackets to your advantage, and moving money accordingly.
Some of our clients decide they want to do Roth conversions, so we help them shift money in that direction–from taxable, traditional accounts to tax-free Roth accounts.
It’s critical to remember that when you’re doing this kind of tax bracket planning, you can’t convert an entire $500,000 traditional IRA into a Roth IRA all at once. Actually, you could–but that would bump you up two or three tax brackets!
You want to be systematic and precise, converting the right amount of money each year, for a certain number of years, to end up with a smart mix of accounts that best suits your retirement needs.
To recap:
Having the right mix of money in your retirement accounts could save you thousands of dollars in taxes.
Paying taxes at a 22% rate now as opposed to paying 25% or 28% later is smart.
Likewise, if you’re in one of the higher tax brackets now, it makes sense to keep your funds in a tax-deferred traditional account until you retire and drop into a lower tax bracket.
For many, all this “tax talk” leaves them confused about which mix is best. If that’s you, please reach out. In the top right corner of our website’s home page, christycapital.com, you’ll see a green TALK WITH AN ADVISOR button. Click it, and leave us a short message. We’ll be in touch right away.
At Christy Capital Management, we help folks take the mystery out of retirement (and out of taxes in retirement). We’d love to help you too.
