Minimizing taxes on retirement income

[mxt0133]

My parents are about to retire in 3-5 years and they are clueless on how their various income streams will be taxed in retirement.  They will have SS, pensions, 403(b), and 401(k) funds as sources of income.

Currently if ordinary income is under $44k for a married couple then SS income is not taxed.  So the plan is to keep their ordinary income, pension, 403(b), 401(k), interest, and any other earned income under $44K.

Are there any other strategies that they could consider to minimize their taxes?

They have a paid off house, but are considering selling it because the do not want to maintain a home anymore.  But if they do sell it then their yearly expenses will go up, due to rent, and might require them to increase their 403 and 401k distribution which could push their income higher and cause their SS income to be taxed.

On the other hand they could use the proceeds from the sale of the house to help lower the distributions from their 403 and 401 accounts.

Any others here have experience in this situation and care to share their strategies?

[MDM]

Only the generic thought that "tax minimization should be a means, not an end."

Too much concern about "not paying taxes" is one thing that got my mother into indexed annuities - at the cost of much more in uncaptured earnings than she deferred from taxes.

If it were my folks (and they were willing to share details), I'd start with current spending and adjust that to provide expected spending in retirement.  Then compare that spending to expected income and go from there (depending on what you find).  The longer they can (comfortably) delay taking SS, the better the likely outcome.

[garrettld]

I need more info to be able to give you real numbers, but I think I can still help. Sorry this post is super long!

Intuit's TaxCaster is a great tool for this.
This calculator might also be useful.

First of all, you're incorrect about how Social Security benefits are taxed. You have to pay taxes on up to 50% of your SS benefit if your combined* income is between $32k and $44k, then taxes on up to 85% of your SS benefits if your combined income is greater than $44k.

If they intended to earn $44k plus their SS benefit, then sorry, they'll be paying taxes on most of it. Granted, they'll be in a low tax bracket.

*Combined income has a very specific meaning with respect to taxation on social security benefits. It's not just your mom's income plus your dad's income. It's their combined AGI plus any non-taxable interest plus half of their total SS benefit.

So let's say your parents' SS benefit is around the average at an easy-to-work-with $30k/year. That's $15k towards their combined income. You can add $17k in non-taxable interest and other income to their SS benefit before they reach the $32k mark. As long as you stay under this level of combined income, they'll pay no taxes on their SS benefit.

So the combined income number is $32k, but they're actually able to take home $30k + $17k = $47k.

Since the standard deduction and personal exemptions are more than $17k, they can actually take home more than $17k and still pay no taxes. If they have the elderly tax credit (65+) then they could take home up to $22600 before paying a dime in taxes. That'd give them $52600 to spend every year.

The best way to visualize this, I think, is to put their SS benefit and desired 401(k)/403(b)/pension income into the "Other Income" section of the TaxCaster calculator. Play with the amounts and watch the numbers on the right.

To minimize their lifetime tax burden (and yours, if you inherit anything from them), they should determine how much they can distribute from retirement accounts and pension without paying any taxes. Whatever the amount is, they should roll this money into a Roth IRA every year even if they don't need that money. The rollover will be a taxable event, but since they're keeping their income low, their tax burden will be zero. They should continue this until (a)their 401(k) and 403(b) accounts are depleted or (b)they die.

This has a number of benefits: it will prevent their 401(k) and 403(b) portfolios from getting massively big and requiring huge RMDs once they reach 70 & 1/2. Huge RMDs are bad because it means they'll pay lots of taxes. It will also mean that they can access that rolled over money at any time in case of an emergency, completely tax-free (after the 5-year wait period). Thirdly, when they die and you inherit their estate, the Roth IRA will start automatically distributing the money to you according to normal RMD rules, but it will still be tax-free, even for you.

If their spending is so high that they need more money, they will just have to pay taxes on it. It still might be a good idea to roll money into a Roth IRA to prevent large RMDs in the future, though. If their 401(k) and 403(b) accounts aren't actually that big, then it might not matter at all. I'd talk to a retirement planning professional about this before making a decision.

[mxt0133]

MDM - I agree. I would not advise annuities just to lower their this tax liability, if they need to pay taxes then I see it as a good problem to have as they would actually have income without having to work.

garrettld - Thank you for the correction and the explanation it was very, very, helpful.  It gives me a better understanding of the matter when talking to a tax/retirement planning professional.

[Exflyboy]

Contribute to a traditional IRA and replace this with after tax savings.

Frank