I recently sold my business and am moving to the lake for retirement.
What are you most excited about in retirement?
Half of my income isn't going to go to Uncle Sam.
Not so fast...you will still pay taxes in retirement, but we can minimize those taxes. Tax planning for business owners is the foundation for paying less in taxes today and in the future.
In this blog, we are going to teach you how to reduce your taxes in retirement.
Reduce Your Taxes in Retirement
One of the biggest misconceptions is tax planning is over once your income stops.
Taxes will continue and tax planning should continue as well.
Luckily there are ways to reduce those taxes in retirement.
We are going to break this blog into two areas.
Taxable income sources in retirement.
Strategies to reduce taxes in retirement.
In each section, we will look at the income sources you are facing and strategies to consider to reduce your taxes.
Let's Dive in.
Required Minimum Distributions (RMD)
The first income source to be aware of is the most common. These are the RMDs from your retirement accounts.
Let's first look at what an RMD is. Over the course of your life, you have likely contributed to accounts that allow you to defer taxes into the future. These accounts include the following:
Traditional 401(K)
Solo 401(K)
Traditional IRA
When you made a contribution to these accounts the government allowed you to take a tax deduction in that year. This is a common strategy we use for business owners with high incomes. The downside to these accounts is that eventually, the government wants their pound of flesh. The government will force you to take money out of these accounts at age 72.
The amount is determined by two factors.
How much money was in the account at age 72?
What your age is?
You will take the dollar amount in your accounts eligible for RMD and match it with this table.
Let's look at an example of someone who is age 72.
RMD assets on 12/31 of the previous year = $1,000,000
Age 72 Distribution Period = 27.4
RMD = $1,000,000/27.4 = $36,496.35
This will be the amount you are required to take out of your tax-deferred account in the upcoming year. This will be added to your taxable income for that year.
Now before you get upset that you have to pay more taxes let's look at strategies to reduce your RMD.
Qualified Charitable Distributions - Strategy 1
The first strategy to consider is a QCD. A QCD is a strategy that involves gifting your RMD to a charity of your choice. This is an excellent strategy to consider and here is why.
When you gift a QCD directly to charity this will allow the income to never hit your tax return. In the example, we could give the entire $36,496.35 to charity and it would be as if we had no additional income.
Roth Conversions - Strategy 2
The next strategy to consider is a Roth conversion. As a refresher, a Roth IRA and a Rraditional IRA have a couple of key differences.
Roth IRA = Tax-Free Growth
Traditional IRA = Tax-Deferred Growth
Roth IRA = No RMD
Traditional IRA = RMD
Having more money in your Roth IRA is going to reduce your overall RMD tax liability. Many clients approaching retirement want to consider a Roth conversion strategy. This is the process of moving money from your Traditional IRA into your Roth IRA.
When doing this you will pay taxes today on the dollars you move into your Roth, but you will eliminate any future taxes on these dollars.
The earlier you consider this strategy the more impactful it will be.
So the next time you fear your RMD consider these strategies.
Portfolio Income
One of the most common types of income in retirement comes from your portfolio. These are taxes owned on the investments within your accounts.
Before we look at different strategies to consider it is key to understand how taxes work in these accounts.
There are three basic types of accounts you can have in an investment portfolio.
Each of these accounts will affect your taxes in retirement.
Tax Deferred Accounts:
401(K)'s
IRA's
Sep IRA's
Solo 401(K)'s
Taxation:
These are accounts that you will pay ordinary income on all money you take out, but by leaving the funds in these accounts you will defer all taxes.
Tax-Free Accounts:
Roth IRA's
Roth 401(K)'s
Taxation:
These are accounts that grow tax-free and all distributions are tax-free. These are the best accounts to have assets in during retirement.
Taxable Accounts:
Brokerage Accounts
Taxation:
These accounts will be taxed along the way. Every decision you make in these accounts has immediate tax consequences.
Now that we have an understanding of each type of account you could be drawing from let's look at the different strategies to reduce portfolio taxes in retirement.
Asset Location - Strategy 1
The location of your investments is a key strategy for reducing your taxable income. Before we look at the best structure let's look at the taxes owned on investments.
Bonds - These assets are part of your defensive strategy. The main benefit of a bond is that it will pay consistent income to you over time. This income will be taxed as ordinary income.
Stocks - These assets are part of your offensive strategy. The goal of these assets is to appreciate over time. When you own stocks there are two ways to make money. The first is dividends from those stocks which will be taxed immediately. The second is capital appreciation or the position going up in value.
To summarize there are two ways to make money on investments.
Income - The money paid through interest or dividends throughout the year.
Capital Appreciation - The money you make by an investment going up in value.
Typically the most tax-efficient strategy is to place your income-producing assets in your tax-deferred accounts. This will allow that income to be generated on an annual basis to be deferred in the future.
While your income-producing assets will be in your tax-deferred accounts your capital appreciation assets will be allocated towards your taxable brokerage and tax-free accounts. Typically this is best because we can control when we pay taxes on these positions. We would need to sell the position to create additional taxable income.
Asset location is a strategy all individuals in retirement should discuss with their advisory team to ensure they have the right investments in the right accounts.
Tax Efficient Investments - Strategy 2
This strategy will be focused specifically on your taxable brokerage account. After all most business owners in retirement have a significant amount of funds in these types of accounts.
These funds may have come from saving money over the years or the sale of a business.
In these types of accounts, there will be three forms of income.
Interest from Bonds
Dividends from Stocks
Capital Gains from Stocks
In retirement, it is key to have the right investments to minimize taxes.
Interest from bonds can be either tax-free or taxable. Depending on your tax bracket will change what type of bond we should own. Taxable bonds will pay a higher return but that is only best depending on the overall tax bracket you are in.
Dividends from stocks can be paid in two ways. Qualified dividends and ordinary dividends. Qualified dividends will be taxed at a lower rate than ordinary dividends. Most stocks can get qualified dividend treatment with the proper investment strategy. This could be the difference in paying 0% in tax on your dividends up to 37%.
Capital gains from stocks are determined by the difference between your cost basis and your current value. The most important consideration is how long you have held these assets.
Capital gains have two different classes. The sale will be treated as a short-term gain or a long-term gain.
Short-term gain - Held for under 1 year.
Long-term gain - Held for over 1 year.
Now the important part. How are they each taxed?
Short-term capital gains will get taxed as ordinary income with the highest tax bracket being 37%.
Long-term capital gains are a different story. They receive special tax treatment and get preferential rates.
When possible always sell assets at long-term capital gains to significantly reduce your taxes.
Managing an investment portfolio in retirement is key to paying the minimum amount in taxes.
The biggest mistake we see business owners make is ignoring taxes during retirement. There is no perfect strategy to fully reduce taxes, but there are many ways to reduce taxes.
If you are a business owner looking to reduce your taxes in retirement we are here to help.
Tax planning will always favor those business owners who take the time to get educated and they combine that knowledge with the right team. If you are concerned about your tax team or want to get better educated about taxes in retirement reach out to our team below.
If you are a business owner who is looking to find a financial team that specializes in you, schedule a call, and talk with a Moment founder.
Not sure what questions to ask, check out this video on 10 questions you should ask when interviewing a financial advisor.
Get in Touch With An Advisor
Frequently Asked Questions
Here are some answers to questions I received frequently about this topic.
Are you a fiduciary? Moment Private Wealth serves clients as a fiduciary 100% of the time.
How does Moment Private Wealth make money? We are only paid in one transparent way, by our clients. We receive no kickbacks or participate in any profit-sharing arrangements. Our fees are simple, transparent, and clear for our clients.
How are you different than other financial advisors? We are specialists in working with professional athletes and business owners. We limit the number of new clients we take on. This allows us to provide unparalleled value and highly personalized service to professional athletes and business owners. We work as a team to service our clients. We believe in building a team of “A” players. This ensures our clients receive world-class tax, estate, insurance, and investment strategies. We focus on educating first, then executing.
Where do you hold my investments and how can I see them? Moment Private Wealth uses Fidelity Investments as a third-party custodian for our client investment accounts. As a third-party custodian, Fidelity safeguards and provides reporting to you and the IRS each year. Clients can also access all financial information via the Moment Private Wealth Client Portal.
How do you work with other members of my team? We believe in the power of the team. Our client teams consist of Moment Private Wealth, an accountant, an attorney, a banker, and an insurance specialist. We help our clients build out their team of individuals or work with existing partners clients have. Our goal is to ensure every family has a team of experts to protect their interests.
What is the penalty for not taking my required minimum distribution? You will owe a 50% penalty on the amount that was supposed to be distributed from your retirement account.
What is a required minimum distribution (RMD)? Required minimum distributions are the amount the government requires you to take out of your retirement accounts at age 72. When you tax these dollars they will be taxed as ordinary income.
How to pay less in taxes as a business owner? Taxes are going to be your largest lifetime expense. Our goal is to help you pay the least amount possible and never leave the IRS a tip. Our team of specialists understands this and works to reduce your taxes today and in the future.
How do taxes work as a business owner? When you own a business you are going to get taxed in two ways. First, you will be taxed as an employee through the W2 wages you take from the business. Second, you will be taxed on the profits that your business earns.
What are the best tax strategies for business owners? The best tax strategies can save you thousands if not millions in taxes. The best strategies will be specific to your needs and goals. Strategies most business owners consider take into account what they expect to make in income this year as well as in future years.
*Moment Private Wealth offers information on tax and estate planning that is general in nature. Tax and Legal advice are not provided by Moment Private Wealth. Consult an attorney or tax professional regarding your specific legal or tax situation.
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