Tax Diversification for Retirees: Use It to Make Tax Reform Even Better

Tax reform made tax diversification even more valuable and important.

Tax diversification allows you to manage your tax bracket by planning and controlling distributions during retirement. When properly done, under the new tax rate tables, many middle-income retirees will be able to stay in the 0% federal income tax bracket for most of retirement.

To achieve diversification, spread your retirement nest egg among the different types of accounts. There are tax-deferred accounts, which primarily are the traditional IRA and 401(k)s, as well as employer pensions. Annuities also are tax-deferred accounts.

Taxable accounts are the regular investment accounts at brokers and mutual funds. Finally, there are tax-free accounts, which primarily are Roth IRAs and health savings accounts (HSAs). The cash-value accounts of permanent life insurance also can be considered tax-free accounts.

Once you have money in these different accounts, your knowledge of the tax law and especially the tax brackets allows you to determine what your tax rate will be by managing how money is taken from the different accounts. The strategy is even more powerful after tax reform, because tax rates are lowered and the standard deduction that shelters income is doubled. Those benefits are somewhat offset by the loss of personal exemptions and perhaps some itemized expense deductions. But a retiree with tax diversification still is in a powerful position.

Let’s take a look at the hypothetical case of Max and Rosie Profits.

In 2018, Max and Rosie anticipate receiving $60,000 of Social Security benefits. They also estimate taking $45,000 of required minimum distributions (RMDs) from traditional IRAs and realizing $15,000 of long-term capital gains from their taxable accounts.

Offsetting the income is the $24,000 standard deduction for a married couple filing jointly, plus an additional $2,500 deduction for each being age 65 or older ($1,250 per spouse). That gives them a standard deduction of $26,500. Their total tax bill would be $7,461.

Suppose this $120,000 of income doesn’t meet the Profits’ spending needs for the year. They need an additional $5,000 of cash.

If they take that $5,000 from a traditional IRA, you might think that since they are in the 12% tax bracket, they’ll owe $600 of additional taxes. That’s not the case, because of the Stealth Taxes in
the tax code.

Max and Rosie are in the income range where each additional dollar of income increases the amount of Social Security benefits that are taxed. In their case, another $4,250 of Social Security benefits are taxable at 12%. Also, the additional IRA distribution, plus including more Social Security benefits
in gross income, pushes some of their long-term capital gains out of the 0% bracket to the 15% tax bracket. When it’s all added, Max and Rosie owe an additional $2,497.50 of federal taxes because of the $5,000 IRA distribution.

If the Profits have a Roth IRA, it makes a lot more sense for them to take that $5,000 from it tax free. That won’t trigger any additional taxes. Or if the Profits have an HSA and at least $5,000 of qualified medical expenses for the year, they could take the money tax free from the HSA.

Other options Max and Rosie could consider would be to sell some investments from a taxable account
and recognize long-term capital gains instead of the ordinary income they incur from a traditional IRA distribution. Even better, if some of the investments in the taxable account are below their purchase price, they could sell some and deduct the loss against their capital gains.

If the Profits take the $5,000 traditional IRA distribution, they would still owe lower taxes in 2018 than they would have in 2017 under the same scenario. But they can do better. By having tax diversification and managing their sources of retirement spending, the Profits can reduce taxes substantially and make their nest egg last longer.

The lower income tax rates and higher standard deduction are temporary. They’re scheduled to expire after 2025, unless Congress takes action to extend them or make them permanent.

Retirees with lower incomes than the Profits and who have tax diversification find themselves in an enviable position. In many cases, they’ll be able to manage their distributions to stay in the 0% tax bracket or close to it. Even if your taxable income pushes you into the 10% bracket, remember 10% is the
tax rate only on the additional income above the 0% bracket. When you determine the average tax rate on your total income, it will be in the single-digit percentages until you move very high in the 10% bracket.

This strategy requires more planning than other strategies. You need to know the break points for the income tax brackets, capital gains tax rates and taxation of Social Security benefits. You also need to be aware of any other Stealth Taxes you might face.

As you can see from the example, the savings from following the strategy can be dramatic and worth the work.