How to Beat the Retirement Tax Ambush

The days of tax advantages for retirees are long gone. In the old days, most people could count on being in a lower tax bracket in retirement than during their working years. Now, many people stay in the same tax bracket. For other retirees the marginal tax rate (the rate on the last dollar of income) actually will rise, and they will face some of the highest marginal tax rates imposed.

Several factors conspire against retirees at tax time. Social Security benefits are taxed above certain income levels, and those levels are not indexed for inflation. Because of that more people pay taxes on Social Security benefits each year.

Retirees also disproportionately pay the alternative minimum tax. Often a retiree has less income than during the working years but the same amount of itemized expenses (unless the mortgage is paid off). The combination makes a retiree more susceptible to the AMT.

IRAs and capital gains also can cause retiree tax problems. Required minimum distributions from IRAs can increase each year, generating more taxable income than the retiree needs. Capital gains can be sporadic. A large amount of capital gains one year can trigger the AMT and the phaseout or elimination of various tax benefits.

Tax planning is an important part of a retirement plan. Only after-tax wealth can be spent, so whatever can be done to reduce income taxes in retirement will increase the standard of living. We present key strategies for retirement tax planning in our monthly visits. In this visit, let’s review some of the big picture tax-saving areas for retirees.

IRAs are key. For most people, their most valuable asset is either their homes or their IRAs. Many IRAs are large these days because they contain rolled over 401(k) plan accounts. Maximizing the after-tax value of an IRA takes long-term planning.

Without long-term planning, the IRA can trigger higher taxes than necessary. There are tricky rules involving roll overs, required minimum distributions, and other IRA operations. Break a rule and higher taxes are triggered. Required minimum distributions can increase taxes even when the rules are followed.

IRA owners should plan well ahead of time the actions they are likely to take with their accounts and clearly understand the rules. Otherwise they are likely to miss deadlines or key steps, generating extra taxes or penalties.

IRA owners also should consider major steps such as emptying their IRAs early or converting traditional IRAs to Roth IRAs. We discuss the conversion strategy in this month’s visit and have discussed emptying IRAs early in past visits. Those articles are available in the archive on the web site.

Invest with tax efficiency. Tax efficient investing is fairly easy during the accumulation years. Invest primarily for long-term capital gains in taxable accounts and stuff as much money as possible in tax-advantaged accounts.

During the distribution years, tax-efficient investing is more complicated.

Most of us have several accounts with different tax consequences, such as taxable accounts, IRAs, 401(k)s, annuities, and others. The tax consequences vary not only on the investments but also on withdrawals and distributions.

During either the accumulation or distribution years the first step is to determine the desired asset allocation of the total portfolio. Then, the preferred account for holding each type of asset should be determined. We have discussed this in past visits, and those discussions are in the Archive on the web site. Briefly, assets that generate a lot of ordinary income or short-term capital gains are best held in tax-advantaged accounts. Taxable accounts are best for assets that generate little income and those that generate mostly long-term capital gains. The desired asset allocation is the primary goal, even if it means holding the “wrong” asset in the “wrong” account. But when possible the assets should be held in the account that is best for them.

Determine which accounts to spend first. During the distribution phase of our investment lives the order in which we spend down the different types of accounts affects how long the total portfolio lasts.

The general rule is to spend taxable accounts first. Take advantage of the benefits of tax-deferred and tax-free accounts for as long as possible by letting income and gains compound in them. Another reason to spend taxable accounts first is that we do not know how long the 15% rate on long-term capital gains and dividends will last. Use it while it is here.

After spending taxable accounts, spend tax-deferred accounts next. Leave tax-free accounts such as Roth IRAs for last.

There are exceptions to these spending guidelines.

As mentioned above, sometimes it is a good idea to empty an IRA early. On the other hand, if you plan to leave something to charity, it makes a lot of sense to leave it from the IRA instead of other assets. The charity will not owe income taxes on the distributions, and your heirs can inherit tax-advantaged assets.

It is unlikely that anyone can follow the perfect tax efficient investing and distribution strategy. To the extent you can follow these rules, however, your wealth will last longer for both you and your heirs.