Tax-Smart Retirement Strategies
Taxes are complicated and so is retirement. When you combine the two, it can get a bit overwhelming. The silver lining is that people who are retired or are on their way to being retired, have some incredible opportunities to implement tax savings strategies that could benefit them for the rest of their lives. Here are five Tax-Smart Retirement strategies to consider.
Filling Your Tax Brackets
Imagine you pulled up to the gas station and on that particular day, the gas was free. Would you pump one gallon and then leave? Of course not! You’d fill it up to the brim, go home, switch cars, and fill that one up too. Even if it wasn’t free, let’s say it was $1/gallon, you’d still jump at the chance to fill up because that’s relatively inexpensive and you’re not likely to see that price again. This sounds like a no-brainer, but people rarely follow the same logic when it comes to filling up their tax brackets.
People in their 60s, especially affluent retirees and pre-retirees, have a unique window of time where they can control their income sources to create substantial tax savings. Making the right moves, like filling up low tax brackets, can help set you up for tax savings that will last for the rest of your life. To know which brackets to fill and when to stop, it’s helpful to start by projecting your income at age 70 and beyond. At that point, you will have Social Security coming in along with Required Minimum Distributions from your retirement accounts, plus any other income you may have. By determining what your future bracket looks like, you can make an informed decision to fill up any relatively low brackets now. There are a number of advantageous ways to precisely increase your income once you know how much room you have. Roth IRA conversions are one of the most popular strategies, along with Traditional IRA distributions and capital gain harvesting.
Avoiding Phantom Tax Brackets
Let’s say it was getting close to the end of the year and you decided to pull $10,000 out of your retirement account for some gifts and a vacation. How much do you think it would cost you in taxes? If you were in the 22% tax bracket you would think it would be $2,200. However, some retirees who thought they were in a modest tax bracket could pay as much as 55% on that distribution, despite the fact that the top tax bracket is 37%. How could that be possible? Millions of ordinary retirees with six-figure income fall prey to what I call “Phantom Tax Brackets.”
The tax code is wildly complex, and all those rules create results that you wouldn’t otherwise expect. Retirees usually have income like Social Security, capital gains, and qualified dividends that are subject to complex phase-ins and alternate rate structures. At the low end of the income spectrum, these income sources are tax-free. As income increases, more and more become taxable, creating a cascading effect. Retirees often also have deductions like health care expenses that are subject to income-based limitations. On top of that, Medicare premiums increase with your income, acting as another layer of tax. All of those dynamic sliding scales can create effective tax rates that are much higher than the stated rate. Careful planning and design of your income should be conducted to avoid these Phantom Tax brackets whenever possible.
Where You Buy Impacts What You Keep
Let’s pretend you have two buckets: One of the buckets leaks, and the other one you borrowed from your Uncle Sam (he takes a portion of whatever you carry in his bucket). If you had to carry some water, you’d want to avoid the leaky bucket. If you had to carry gold coins, the leak wouldn’t matter and you certainly wouldn’t want to have to give Uncle Sam a bunch of your gold, so go ahead and use the leaky bucket. The same logic holds true when we think about investments, like stocks and bonds, and the buckets that you hold them in, like retirement accounts and taxable accounts. Different assets and different accounts each have their own unique tax considerations. The bucket in which you buy stocks will have a direct result on the after-tax return you receive, and the impacts can be sizable. In the industry, we call this strategy Asset Location.
There are a number of factors that incentivize us to hold stocks in taxable accounts and ordinary-income producing assets, like bonds, in tax-deferred accounts.
Many stocks pay qualified dividends, which are taxed at a lower set of rates (0%,15%, 20%) than ordinary income.
The price appreciation you receive on your stocks is only taxable upon sale and also subject to the same favorable rates as qualified dividends. You control the timing of when this capital gain income is recognized.
If you hold appreciated stocks, there are ways to capitalize on those gains without paying tax. They can be donated to a charity or passed down to your family at death, effectively eliminating the taxable gain. Additionally, taxable gains can be offset by taxable losses via a tax-loss harvesting strategy.
By holding bonds in tax-deferred accounts, like retirement accounts, the ordinary income they produce is shielded from tax.
Bonds have a lower expected return profile, which leads to relatively lower growth in retirement accounts and subsequently lower Required Minimum Distributions in the future.
It Pays to Delay
We all hate waiting. In fact, I bet you’ve probably declined a sizeable travel voucher because you didn’t want to be bumped to another flight just a few hours later – I know I have. But maybe it would sweeten the deal if they also threw in a pass to the first class lounge with the comfortable chairs, buffet, and open bar? I see similarities when I examine the choices people make with Social Security. The majority of benefits are claimed as soon as they become available, while only 4% of people wait all the way until age 70.
By deferring Social Security, benefits will increase by about 8% per year which can provide a big boost to your overall retirement cash flow. What most people don’t realize is that those patient few may also get a pass to the tax-free income buffet while they wait. In that period between retirement and age 70, you may be able to strategically recognize hundreds of thousands of dollars in income with little or no taxes. Some may find that Roth IRA conversions can reduce future taxes via lower RMDs and also provide a powerful mechanism to pass tax-free wealth to the next generation. Others may use the opportunity to sell appreciated assets and fill up the 0% capital gains bracket as they down-risk their portfolio.
The New Rules for Being Charitable
The 2017 changes to the tax code created winners and losers. Unfortunately, many who are charitably inclined got the short end of the stick. With the modifications to itemized deductions, millions of households are no longer getting the benefit of a tax deduction for the generous donations they make. The good news is that those tax benefits are still available to those who carefully create a charitable strategy.
One strategy to potentially consider to increase the tax benefit of your charitable giving is to lump multiple years’ worth of contributions into a single contribution in order to help ensure your itemized deductions exceed your standard deduction. The advantages of this strategy can be further enhanced by donating appreciated assets to a Donor Advised Fund. These accounts function like a simplified private foundation, where contributions can be made with an upfront tax deduction, while you maintain control of the charitable distributions over time. By using appreciated assets to fund the DAF, you also receive the benefit of removing capital gains from your portfolio that would have otherwise been taxed.
Another relatively new and powerful charitable strategy is the Qualified Charitable Distribution. This is only available to those who are 70 ½ or older. Instead of writing a check to a charity, the QCD allows you to distribute cash directly out of your IRA to a charity and have it count against your Required Minimum Distribution. Instead of receiving a deduction, that may not be fully realized if you don’t itemize, you get to exclude the QCD from income. This means that you will receive the full benefit of the contribution, regardless of if you itemize. This will also have an added benefit for some as it reduces your Adjusted Gross Income, which could result in lower Medicare surtax or lower Medicare IRMAA premiums.
Sources: Medicare.gov; IRS: Retirement Topics – Contributions; SSA.gov: Apply for Benefits; IRS: FAQ Distributions(Withdrawals)
This is intended for informational purposes only and should not be construed as personalized investment or tax advice. Please consult your investment and tax professional(s) regarding your unique situation.
Justin D. Smith
Financial Advisor