Personal Finance

New retirees: Don't overlook this tax-planning sweet spot

Key Points
  • While you're in a lower tax bracket, converting your traditional IRA or 401(k) to a Roth IRA can make sense if you have the cash to pay the taxes due on the conversion.
  • This also can be an ideal time to unload taxable assets with long-term gains.

A special opportunity to do some serious tax-planning awaits many people heading into retirement.

This sweet spot is the stretch of time that starts after you're done with full-time work and before you begin taking required minimum distributions from your 401(k) account or traditional individual retirement account at age 70½. And presumably, you'll find yourself in a lower tax bracket.

"This is a good time to look at whether some strategies can work that help with taxes," said Avani Ramnani, director of financial planning and wealth management at Francis Financial in New York.

Sam Edwards | Getty Images

While there are ways to take advantage of lower tax rates, it's important to make sure any moves you make are in line with your broader retirement objectives.

"Minimizing taxes should not dictate all financial decisions," Ramnani said. "Ultimately, it is about using the best approach to be able to achieve [your] most important life goals."

Here are some ways you might be able to capitalize on your lower tax bracket.

Go Roth

It could make sense to convert a traditional IRA or a 401(k) account — both of which come with taxes on distributions — to a Roth IRA.

While you must pay income taxes on the amount converted, it would be at your temporarily lower tax rate.

In comparison, if you were to leave those assets in a traditional IRA or 401(k) plan until you begin taking required minimum distributions, those withdrawals could push you into a higher tax bracket. As such, a higher tax rate would apply to the assets.

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In contrast, withdrawals from Roth IRAs are generally tax-free.

They also don't have required minimum distributions. In fact, some people simply let the balances accumulate over their lifetime and pass the Roth IRA on to heirs (who also enjoy the tax-free status, although they must meet other rules).

You also can stretch a Roth IRA conversion over several years, which can minimize the tax sting and help ensure the switch doesn't push you into a higher tax bracket in any given year.

However, before you get the wheels rolling, there are some aspects of the conversion to consider.

For starters, you need to make sure you have enough cash available to pay the taxes due. Also, new tax rules that took effect this year eliminate the option to change your mind for conversion done in 2018 or later.

Additionally, the Roth IRA generally must remain untapped for at least five years after the conversion for you to take advantage of completely tax-free withdrawals.

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Sell winning assets

If you own stocks or other assets in a taxable account, it might make sense to sell off appreciated long-term investments while you're in a lower tax bracket.

"It's a great opportunity to cash in on gains that you've been sitting on," Ramnani said.

This is because the tax rate on long-term capital gains — those on assets held more than one year — is based on your adjusted gross income (see below chart). For instance, if a married couple has income under $77,200, they will pay no tax on those gains.

What you pay on long-term capital gains

Tax rate Single taxpayers Married filing jointly Head of household
0%Up to $38,600Up to $77,200Up to $51,700
15%$38,600-$425,800$77,200-$479,000$51,700-$452,400
20%Over $425,800Over $479,000Over $452,400
Extra 3.8%Over $200,000Over $250,000Over $200,000

If you were to wait to sell those appreciated assets at a time when your income is above the threshold for the zero percent rate, you will pay either 15 percent or 20 percent.

Be aware, too, that high earners — i.e., married couples with modified adjusted gross income above $250,000 — are subject to an additional 3.8 percent tax on certain investment income.

Exercise employee stock options

For people who head into their golden years with employee stock options, exercising them at your lower tax bracket might be smart.

"If the value of the stock is high and your exercise price is low, you'll have a lot of built-in gains when you exercise those options," Ramnani said.

Cashing in those options during a lower-tax year will reduce the amount you pay in capital gains taxes.

Unload savings bonds

While U.S. savings bonds have lost popularity as a means of long-term savings due to the low interest rates they're earning, some retirees have been holding on to bonds that were issued when rates were higher.

"For some people, we've seen the interest add up to quite a bit," Ramnani said.

When you unload those bonds, you pay ordinary income tax on the interest you earned. So while you're in a lower tax bracket, cashing them in could be a good idea.