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To have the ability to create tax efficient income in retirement, you should begin by setting the table correctly in your accumulation years. Most people understand the concept of diversification: “Don’t put all of your eggs in one basket”. We diversify our investment choices to lower our portfolio’s risk. It is also important to diversify how you save for retirement, moving away from saving all your retirement “eggs” in pre-tax accounts and utilizing post tax and tax advantaged accounts as well.
Not all money is taxed the same. Let’s say you need to withdraw $100 from your savings. Depending on which account you withdraw it from will determine the amount of money you receive once taxes are accounted for. If you withdraw it from a Traditional IRA, you may receive $90, $88, $78, etc., depending on your current income tax bracket. If you take it from a post-tax account such as an Individual, or Joint account, you may get $100 or you may need to pay capital gains tax, leaving you with $85, or $80 or even $76.20. If you were to withdraw from a tax-advantaged account, such as Roth accounts, you will most likely receive $100. When you have account type tax diversification, you will have control and flexibility around how you “source” your retirement income. (Here is a link to a previous article we wrote on Blending Income Streams) This control and flexibility allow you to both blend income streams to pay the least amount of tax possible in the short term and allows you to best plan for how to pay less tax in the long term, say for a retirement that may last for 30 years. Account type diversification can also provide protection against future legislative policy changes, whether it is rising tax rates, a change of how capital gains are treated, or estate taxes, etc.
To illustrate why this is important, we’ll walk you through a real client case study: meet our clients, Doreen and Dave. They are both 65 years of age and both retired in 2022. They have approximately $2 Million dollars combined in IRAs, $650,000 in a joint account and $235,000 in Roth IRAs. As we have worked with them for several years leading up to their retirement, they were advised and were successful at creating account tax diversification. Now that their paychecks have stopped, they will need $150K coming into their checking account annually and they will need the ability to grow that amount through the years to account for inflation.
As retirement income specialists, building out their long-term plan is our first step. We use software and technology to determine what their overall situation will look like given certain parameters, and what tax bracket(s) they are projected to spend most of their retirement years in. We factor in the expiration of 2017’s Tax Cut & Jobs Act (TCJA) and if the client holds similar beliefs to us, that tax rates will not only return to those higher rates prior to TCJA, but will actually need to go significantly higher, we will run a scenario with higher taxes as well. We also project, if no tax planning and income planning is in place, what tier of Medicare Surcharges they will hit, how much their required minimum distributions (RMDs) are projected to be if they defer until age 73, and we’ll get a handle on what Social Security claiming strategy will work best for their situation. Now, armed with a good picture of what their future financial world may look like, we create strategies to optimize it. For Doreen and Dave, who were good savers and had the bulk of their wealth in pre-tax IRAs, we saw where the opportunity was to do Partial Roth conversions prior to the end of 2025 (TCJA’s expires on 12/31/2025). By doing these Roth conversions, we will accomplish getting money out of the IRA while paying tax at these historically low rates, increase their tax advantaged “bucket” and control the impact of RMDs in the future. (There are no RMDs for Roth IRAs to the original account owners.) We then looked at Social Security and how best to claim it from these three vantage points: investment planning, income planning and tax planning. We decided in their case to keep social Security offline as long as it makes sense to leave more room for partial Roth conversions. For them, it made sense to over-withdraw from their investment accounts temporarily to maximize this guaranteed, inflation adjusted benefit. We also looked at claiming the smaller benefit earlier than age 70 (in this case at age 68) to help meet this client’s income goals.
Next, we take a look at where to source the income from (which type of account) and when. How can we source their $150k income annually to minimize tax and avoid those annoying and detrimental retirement tax traps (IRMAA surcharges is the top pain point with clients). We know that if we can plan, pay attention and utilize their various tax silos to source their income strategically, we can minimize the tax due and therefore, make their wealth last longer. What worked best for Doreen and Dave was to utilize their low tax years prior to TCJA expiring to fill up to the top of the 24% bracket by utilizing partial Roth Conversions, then after year 2026, we would target keeping them out of Medicare premium surcharges by blending distributions from the IRA and their Joint account (the standard premiums for Part B and Part D are increased by surcharges imposed on those with Modified Adjusted Gross Income (MAGI) exceeding $97,000 on an individual return or $194,000 on a joint return). Their plan called for allowing the Roth IRA to grow and compound until it made sense to tap it downline to manage their tax bracket. We knew from our discussions with them that if money were to be left over at the end of their plan, they preferred to leave their children Roth money rather than Traditional IRA money because of the SECURE Act’s new distribution rules for non-spouse beneficiaries. Being thoughtful with their decumulation strategy meant that this client had more wealth at the end of life and paid significantly less in tax over their combined retirement years. It meant that whoever the surviving spouse was, they were better positioned to manage the “Widow’s Penalty” of becoming a single tax filer and it meant that their beneficiaries would be better situated in the future. The point to note here is that the strategy that works best is different for everyone and having good communication between your tax professionals and your Financial Advisors as well as both a long-term plan and a shorter/annual plan is key.
Ideally, tax planning begins with analyzing how best to save in your accumulation years to create tax diversification. This should begin early, decades before we begin thinking about creating retirement income! Here, it’s important to understand your company’s retirement plan beyond its investment options—you need to understand the plan’s saving options as well. However, if you are already retired, or on the doorstep to retirement, partial Roth Conversions can be a vehicle you can use, where and when it makes sense, to create some tax diversification in your later years. To understand how to think through the partial Roth Conversion process, download our whitepaper, The Consumer’s Guide to Partial Roth Conversions.
When your table is set correctly, you have flexibility over which account types to withdraw your money from and when. In retirement, this gives you the ability to have some control over the amount of your taxable income, which allows you to manage for Social Security and Medicare income thresholds, avoid the tax traps like net investment income tax and the AMT. All of these are foundational tenets of creating tax efficient income and increasing the longevity of your wealth. Then, tax planning continues up to and through retirement, by assessing a client’s goals, estate plans and income needs. Having a comprehensive Income, Investment and Tax plan can provide you with valuable insight into strategies you can do today to help prepare you for a successful tax-efficient retirement.