Tax-Efficient Retirement Planning in Westlake: A Guide for Pre-Retirees

Tom and Susan Miller had done everything right. The Westlake couple diligently saved in their 401(k)s throughout their careers - Tom as an engineer at a local manufacturing firm, Susan as a teacher in the Rocky River school district. They celebrated their retirement with a trip to Florida, imagining the comfortable life ahead. Then came their first full year of retirement taxes: a bill that was nearly $15,000 higher than they expected. 

Many pre-retirees in Westlake and throughout Northeast Ohio focus intensely on accumulating retirement savings but overlook a critical factor: tax efficiency. The difference between a thoughtful tax strategy and simply "taking withdrawals as needed" can mean keeping tens of thousands of additional dollars over the course of your retirement. Money that stays in your pocket instead of going to the IRS.

In this guide, we'll explore three key strategies that can help Cleveland-area pre-retirees minimize their retirement tax burden: understanding how different income sources are taxed, implementing strategic withdrawal sequences, and taking advantage of Roth conversion opportunities in those golden years between retirement and required minimum distributions.

Understanding Your Retirement Tax Landscape

Before we can optimize your tax situation, it's essential to understand that not all retirement income is created equal from a tax perspective. The IRS treats different income sources very differently, and understanding these distinctions is the foundation of tax-efficient retirement planning.

Traditional IRA and 401(k) withdrawals represent the most common source of retirement income for Westlake families. These distributions are taxed as ordinary income at your marginal tax rate—the same as your paycheck was during your working years. If you withdraw $50,000 from your traditional 401(k), you'll pay federal income tax on the full amount.

Roth IRA distributions, by contrast, are typically tax-free if you're over 59½ and the account has been open for at least five years. This tax-free status makes Roth accounts incredibly valuable in retirement, especially for managing your taxable income in strategic ways.

Social Security benefits present a more complex picture. Depending on your "combined income" (adjusted gross income plus non-taxable interest plus half of your Social Security benefits), anywhere from 0% to 85% of your benefits may be taxable. Many Cleveland-area retirees are surprised to learn that their Social Security can be taxed at all.

Pension income is generally fully taxable as ordinary income, similar to withdrawals from traditional retirement accounts. Investment income from taxable brokerage accounts includes a mix: qualified dividends and long-term capital gains receive preferential tax rates (0%, 15%, or 20% federally, depending on income), while interest and short-term gains are taxed as ordinary income.

Ohio offers a silver lining for retirees: the state doesn't tax Social Security benefits and generally treats retirement income favorably. However, pension income and retirement account distributions are still subject to Ohio's graduated income tax rates.

Understanding how tax brackets work in retirement is crucial. Let's consider a Cleveland couple, both 66, with $300,000 in retirement savings split between traditional IRAs. If they withdraw $70,000 annually, they might assume they're in the 12% federal tax bracket. However, those withdrawals could also trigger taxation on their Social Security benefits, effectively pushing their marginal rate much higher on the last dollars withdrawn. This "tax torpedo" catches many retirees off guard.

Tax-Efficient Withdrawal Strategies

The concept of "tax diversification" is relatively simple but compelling: having retirement savings in different tax treatments (taxable, tax-deferred, and tax-free accounts) gives you flexibility to manage your taxable income strategically each year.

Most financial advisors recommend a general withdrawal sequence, though your specific situation may call for adjustments. The conventional wisdom suggests withdrawing from taxable accounts first (brokerage accounts with stocks, bonds, and mutual funds). Why? These accounts often have a lower tax burden since qualified dividends and long-term capital gains receive preferential rates. Additionally, spending down these accounts early can reduce future required minimum distributions (RMDs) from tax-deferred accounts.

Next come tax-deferred accounts (traditional IRAs and 401(k)s). These withdrawals are fully taxable as ordinary income, so you'll want to be strategic about amounts and timing. Finally, tax-free accounts like Roth IRAs should generally be preserved as long as possible, allowing them to grow tax-free and serving as a hedge against future tax increases or high-income years when you want to minimize taxable distributions.

However, there are important exceptions to this sequence. The years between retirement and age 73 (when RMDs begin) present a unique opportunity to strategically "fill up" lower tax brackets. If you retire at 62 and your income drops significantly, you might intentionally take larger distributions from traditional accounts while you're in the 12% or 22% federal bracket, rather than waiting until RMDs force you into higher brackets later.

Consider a physician who retired from her Westlake practice at age 64. Her income dropped from $280,000 annually to just $45,000 from part-time consulting and investment income. Rather than living solely on her taxable account, her financial advisor recommended taking $50,000 annually from her traditional IRA, keeping her total taxable income around $95,000. This strategy "fills up" the 12% and 22% brackets while she's in her 60s, reducing the amount subject to higher rates once RMDs begin at 73.

Another critical consideration is Medicare IRMAA (Income-Related Monthly Adjustment Amount) thresholds. If your modified adjusted gross income exceeds certain levels ($106,000 for individuals, $212,000 for couples in 2024), you'll pay substantially higher Medicare Part B and Part D premiums. Strategic withdrawal planning can help you avoid inadvertently crossing these thresholds.

Don't forget about the standard deduction, which for 2024 is $27,700 for married couples filing jointly ($14,600 for singles), with an additional $1,500 per spouse over 65. Many Bay Village and Avon Lake retirees who previously itemized during their working years find that the standard deduction now exceeds their itemized deductions, particularly after paying off their mortgages. This shift can influence decisions about charitable giving, state tax prepayments, and the timing of major expenses.

Roth Conversion Opportunities

For many Westlake pre-retirees, Roth conversions are among the most powerful, yet underutilized, tax-planning strategies available. A Roth conversion involves moving money from a traditional IRA or 401(k) into a Roth IRA, paying income taxes on the converted amount in the year of the conversion. While paying taxes voluntarily might seem counterintuitive, the long-term benefits can be substantial.

The magic years for Roth conversions are typically between retirement and age 73 when RMDs begin. During this window, many retirees experience their lowest-income years, creating an opportunity to convert traditional retirement funds at lower tax rates than they might face later. Once RMDs begin, you lose control over the amount you must withdraw each year, potentially pushing you into higher brackets whether you need the money or not.

When evaluating conversion amounts, several factors come into play. You'll want to consider your current tax bracket, projected future brackets, the time horizon until you'll need the funds, and your state tax situation. A general principle is to convert enough to "fill up" your current tax bracket without pushing yourself into the next one, though circumstances vary.

One critical best practice: pay the conversion taxes from a taxable account, not from the IRA itself. If you convert $75,000 and pay $16,500 in taxes from the IRA, you've only moved $58,500 to the Roth. Paying taxes from outside savings means the full $75,000 begins growing tax-free.

Multi-year conversion strategies often work best. Rather than converting a significant amount in a single year and potentially jumping into a higher bracket, spreading conversions over several years can keep you in lower brackets throughout. Michael Chen, a healthcare executive from Rocky River, worked with his advisor to convert $60,000 annually for five years after retiring at 63. By age 68, he had moved $300,000 to Roth accounts, all while staying in the 22% federal bracket. When his RMDs begin at 73, they'll be significantly smaller, and he'll have substantial tax-free reserves to draw from.

It's worth noting that Roth conversions are particularly valuable if you anticipate your heirs will inherit your retirement accounts. While beneficiaries of traditional IRAs must typically withdraw (and pay taxes on) the entire balance within 10 years, inherited Roth IRAs remain tax-free to your beneficiaries. A powerful legacy planning tool for Bay Village and Westlake families who want to maximize what they leave behind.

Tax-Loss Harvesting and Asset Location

Beyond withdrawal strategies and Roth conversions, tax-efficient investing involves two additional concepts that Northeast Ohio pre-retirees should understand: tax-loss harvesting and asset location.

Tax-loss harvesting is the practice of selling investments that have declined in value to realize capital losses, which can offset capital gains and up to $3,000 of ordinary income annually. Unused losses carry forward to future years. For example, if your stock portfolio includes a technology fund that's down $8,000 and a healthcare fund that's up $8,000, you might sell both, realizing the loss to offset the gain, then reinvest in similar (but not substantially identical) funds to maintain your asset allocation. This strategy is particularly valuable in taxable accounts and during volatile market periods.

Asset location strategy asks a deceptively simple question: which investments should you hold in which types of accounts? The goal is to place tax-inefficient investments in tax-advantaged accounts (like IRAs) and tax-efficient investments in taxable accounts.

Tax-inefficient investments include actively managed funds with high turnover, real estate investment trusts (REITs), taxable bonds, and funds that generate substantial short-term capital gains. These investments produce income taxed at ordinary rates, so sheltering them in traditional IRAs or 401(k)s makes sense. Tax-efficient investments include index funds, low-turnover ETFs, individual stocks you plan to hold long-term, and municipal bonds. These generate primarily qualified dividends and long-term capital gains, which receive favorable tax treatment even in taxable accounts.

For Ohio residents, municipal bonds deserve special consideration. Interest from Ohio municipal bonds is exempt from both federal and Ohio state income taxes. For Westlake investors in higher tax brackets, this can make Ohio munis attractive, particularly in taxable accounts. However, it's essential to coordinate this decision with your overall portfolio strategy, as munis typically offer lower yields than taxable bonds and may not be appropriate for everyone.

Working with a Fiduciary Advisor

Tax-efficient retirement planning isn't a "set it and forget it" endeavor. Tax laws change, your income varies, family circumstances evolve, and investment returns fluctuate. What made sense three years ago might not be optimal today, which is why ongoing attention from a qualified professional is so valuable.

A fee-only fiduciary advisor brings several advantages to tax planning. First, there's coordination with your CPA. While your accountant prepares your tax return based on last year's activity, a financial advisor thinks proactively about next year's tax situation, modeling different scenarios and helping you make strategic decisions throughout the year. Many Cleveland-area retirees find that their advisor and CPA working together creates a powerful team.

Second, personalized tax modeling is essential. Generic advice like "fill up the 22% bracket" means different things for different families. A Westlake couple with pension income will have different opportunities than an Avon Lake couple relying solely on retirement accounts. An advisor can build a multi-year tax projection specific to your situation, showing how different strategies play out over time.

When looking for a financial advisor in Westlake, prioritize the fiduciary standard. An advisor who is legally obligated to put your interests first. Fee-only compensation (rather than commissions) eliminates conflicts of interest. Experience with tax-efficient strategies, familiarity with Northeast Ohio considerations, and a collaborative approach with other professionals round out the key qualities to seek.

Building Your Tax-Efficient Retirement

Tax efficiency in retirement isn't about dodging your obligations, it's about being smart with the timing and sourcing of your income to minimize what you owe legally. For many Westlake families, implementing even a few of these strategies can preserve tens of thousands of dollars over a 20- or 30-year retirement.

The key takeaway is that every situation is unique. The optimal strategy for a 64-year-old Bay Village physician with substantial traditional IRA balances differs dramatically from that of a 58-year-old Rocky River business owner with significant taxable investments and a smaller 401(k). Your health, family situation, legacy goals, and risk tolerance all play roles in determining your ideal path.

If there's one piece of advice that applies universally, it's this: start planning at least five years before your target retirement date. The strategies that offer the most value require time to implement effectively. Roth conversion opportunities, such as strategic withdrawal sequencing and tax-loss harvesting, work best when you have years, not months, to execute them thoughtfully.

How do these strategies work for your situation? Schedule a complimentary consultation with our Westlake team to review your retirement tax strategy. We'll analyze your specific circumstances and show you the potential impact of tax-efficient planning on your retirement income.