Use Tax Mapping to Trim Taxes in Retirement

Investing, Investment Taxes, Retirement Income, Roth IRA, Taxes
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Use Tax-Mapping to Trim Taxes in Retirement

By Kathleen Nemetz, MBA, CFP

Learn more about Kathleen on NerdWallet’s Ask an Advisor

Preparing for retirement isn’t just about accumulating enough savings. It’s critical to consider your overall tax picture as well. You can’t always assume that you’ll have a lower tax rate in retirement — especially if most of your funds come from a 401(k), traditional IRA or other taxable income sources.

To help you keep more of your income in retirement, I’m proposing a strategy called “tax mapping.” This can involve shifting some beaten-down assets from tax-deferred status to tax-exempt status or, more generally, redirecting investments into tax-favored categories before retirement.

Shift to a Roth IRA

One easy way to tax map is to convert holdings from a traditional IRA or a 401(k) into a Roth IRA. This involves being taxed on the early withdrawal of your IRA or 401(k) funds, but it means you won’t pay taxes when receiving your Roth IRA distributions in retirement — provided you hold the account for the minimum five years and comply with other IRS requirements.

The advantage of making this shift now, when the market is down, is that you’ll be taxed on the reduced value of your IRA or 401(k) assets. The funds will then grow tax-free, and you won’t have to pay taxes in retirement on the presumably higher value of your Roth IRA.

» MORE: How to Open a Roth IRA

This type of tax mapping requires you to predict what will happen to the value of your assets, and whether the gains and tax-free income are likely to outweigh the price you pay to shift the assets.

Because of that, the best asset for this remap might be a growth stock, such as Amazon, that could be valued at less than what you paid. This means that you’ll pay less tax to shift it now than you would have when the stock traded at a higher valuation — but the price might be expected to reinflate later.

You can shift a stock or asset using a conversion form available from your brokerage company. If you’re concerned about how the temporary increase in income could affect your taxes in the short term, consider making higher pre-tax contributions to your retirement plans or prepaying state and local property taxes due in the following year.

Explore other types of assets

Roth IRAs aren’t the only way to reduce the amount of tax you’ll pay in retirement.

It may make sense to shift some capital from a taxable account, which holds stocks or a mutual fund, to a tax-favored account, such as an annuity. You might also trade highly taxed corporate bonds for tax-free municipal bonds or dividend-paying stocks, since the dividend rate of tax is lower than the income tax rate.

Tradeoffs may arise if you have to sell assets and pay capital gains taxes today to free up the cash to move into another type of investment. But keep in mind that having a Roth IRA or municipal bonds can affect whether your Social Security distributions — likely an important part of your retirement income — are taxed. If your taxable, non-Social Security income exceeds certain thresholds, up to 85% of your Social Security benefit may be subject to income tax.

Next steps

The current market volatility is an opportunity to reboot your retirement accumulation strategies. Use these tax-mapping moves as part of a long-range plan to reduce taxes in retirement by holding assets in the most tax-efficient ways possible. And always consult with a tax expert before making major changes. Otherwise, you may run into some unexpected “gotchas” from the IRS.

Kathleen Nemetz is a certified financial planner in San Rafael, California.


Image via iStock.