Tax Strategies for Retiring with a Large Nest Egg
As retirement approaches, managing taxes on a sizable nest egg becomes one of the trickier challenges for many retirees. While the idea of finally enjoying life after years of hard work, saving, and sacrifice is an exciting prospect, having a strategy to minimize taxes is essential to ensure that the government takes only what it’s legally entitled to, and no more.
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Planning ahead to handle taxes in retirement can offer significant benefits, from improving long-term financial health to safeguarding future healthcare costs. A recent Reddit post highlighted a real-life example of a couple grappling with the question of how to manage their substantial nest egg and avoid overpaying taxes.
The 62-year-old husband earns a $180,000 annual salary, with his employer contributing $22,000 per year to his 401(k). In addition, he contributes $30,000 annually to his personal Roth 401(k). His wife, 58, retired in 2021 with a $70,000-per-year pension and her own 401(k). Together, they also own two rental properties, generating $2,000 per month in passive income.
While the husband plans to retire at 63 and join his wife, they are concerned about the tax implications of their assets. Their financial planner does not provide tax advice. Their assets include a $4.3 million 401(k), a $400,000 Roth 401(k), and a $2.2 million 401(k) for the wife, along with $2.5 million in liquid investments. Together with their earnings and passive income, the couple’s wealth outpaces their expenses, allowing for luxury purchases and travel. However, they’re still worried about taxes and how to plan for the future.
Potential Tax Strategies for Retirees
For this couple, several strategies could help reduce their tax burden while still enjoying life in retirement:
- Relocation: Many retirees choose to move to states that don’t have state income taxes, such as Florida, Texas, or Nevada. This strategy can help reduce the overall tax load, especially for those living in states like California or New York, where state and local taxes can take a significant portion of income. For some, relocating to another country with a lower cost of living—like Portugal or Thailand—could also be an option, though it would involve additional logistics and planning.
- Reallocate Contributions: The couple doesn’t currently contribute to a Health Savings Account (HSA), which can be a valuable tax-deferred savings vehicle. The husband could stop contributing to his Roth 401(k) and instead redirect those funds to an HSA, allowing him to make pre-tax contributions and reduce taxable income.
- Turn a Hobby Into a Business: If the couple has any hobbies they’re passionate about, turning them into a business could offer numerous tax benefits. Business expenses like transportation, materials, and promotion are deductible, which could lower their overall taxable income. Additionally, establishing a business before retirement can help justify a lower tax bracket once they leave the workforce. The IRS allows businesses to claim losses for up to three years, offering flexibility in deciding whether to continue or close the business.
Portfolio Considerations
With a combination of post-tax and tax-deferred investments, it’s crucial for the couple to manage their portfolio in a way that minimizes tax liability during retirement. Here are a few strategies:
- Invest in Municipal Bonds: While the husband is still employed and liquid investments remain untouched, he might consider shifting a portion of their portfolio into tax-free municipal bond funds. These bonds offer tax-free coupon payments, and if they live in a state with its own income tax, a state-specific municipal bond fund could offer even more tax advantages.
- Prioritize Roth IRA Withdrawals: After retirement, if they need to withdraw from their retirement funds, it’s best to tap into their post-tax Roth IRA first. This will reduce the overall taxable amount and help limit capital gains taxes. Liquid investments can also be withdrawn before dipping into tax-deferred accounts.
- Let Tax-Deferred Accounts Grow: The couple should allow their tax-deferred accounts, like their 401(k) plans, to grow as long as possible. The funds in these accounts won’t be taxed until they are withdrawn, and required minimum distributions (RMDs) won’t start until age 72, providing further flexibility in how and when to access those funds.
Final Thoughts
Managing taxes in retirement is essential for preserving wealth and ensuring that retirees don’t give away more than necessary. While strategies like relocating, rebalancing contributions, and optimizing investment portfolios can help, it’s important for retirees to seek professional guidance to make informed decisions based on their unique financial situation.
As always, this article is meant for informational purposes only. For personalized retirement and tax advice, it’s best to consult with a financial planner or tax professional.