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Avoid Being Pushed Into Higher Tax Brackets In Retirement

This article is more than 7 years old.

My new book, The Overtaxed Investor - Slash Your Tax Bill & Be A Tax Alpha Dog, underscores the key tax challenge facing retirees: being helplessly catapulted into rising tax brackets. Our tax code is progressive. It’s not just that we pay more just because we earn more – that would be true even if the tax rate were flat. Instead, the rate at which we are taxed rises steeply as we push over the borderline into the higher bracketeria. Retirees need to avoid these expensive tax bracket creeps.

Retirement might be likened to a game of Chutes and Ladders. Various events conspire to lift you up the income ladders into the higher tax brackets at the top of the game board. You and/or your spouse claim Social Security, take IRA distributions, inherited IRA distributions, realize capital gains, receive deferred compensation, collect dividends,  rents, pensions, annuities, and so on. Suddenly you are being taxed within an inch of your lives. You are staring in the face of the Alternative Minimum Tax, new Medicare taxes, higher Medicare premiums, higher tax rates on your dividends and capital gains, and higher state taxes to boot. This is far from the financial peace of mind you were expecting after all those years of planning and saving.

That is the problem, and it at once telegraphs its own solution: if you are going to climb the ladders to higher tax brackets, then you have to use the chutes to get back down to the lower brackets again. Ah, but what are the chutes? These are techniques that siphon income from your future, high-bracket reality back to your present, low-bracket world – such that the future high-bracket reality disappears. Can this really be done, outside of a Keanu Reeves movie?

You want to ride the tax brackets like a broncing buckaroo, taming them so that they stay smooth and low. Instead of spending half of your retirement in the 15% bracket and then moving into the 25% bracket for the back nine, you are better off realizing more income earlier, right to the top of the 15% bracket every year, so you spend fewer years paying 25% later.  The same principle applies if you are in the 25% bracket today but from the crow’s nest you can see the land of the 33% bracket ahoy. The logic is simple: top off your income in the lower bracket today to avoid paying higher taxes on those same dollars tomorrow. Less money paid to the U.S. Treasury, more money kept in your wallet.

Let’s talk specifics.  The approach that will be more beneficial depends whether taxable accounts or IRAs dominate your retirement landscape.

For Taxable Accounts: Early Capital Gains Recognition

If you have a taxable brokerage account with a lot of embedded capital gains that you will be forced  tap during retirement to pay for your outrageous living expenses, then realize those gains in as low a bracket as possible. If you are married and your adjusted gross income is below $96,000 (after deductions and exemptions), you can realize these gains all day long up to this income threshold and pay no taxes at all. Or, if you are paying 15% on your capital gains now but see that you will be crossing the $250,000 borderline and it feels like you are going to lose your mind when the Obamacare 3.8% surtax starts to bite, then recognize more capital gains today rather than paying 18.3% tomorrow. The worst tax case applies to married couples filing jointly with over $466,950 in income, who will pay 25% on their capital gains (even more if there are state taxes). If that is what you see in the crystal ball, start recognizing these gains sooner, right to the toppermost of any bracket below this.

For Retirement Accounts: Partial Roth Conversions

While contributing to qualified retirement accounts like 401(k)s and IRAs is a stonking great deal during our working years, in retirement these plans get thrown into reverse. IRAs become unstoppable doomsday machines spewing out ever-larger taxable distributions every year, ratcheting up the mandatory payout according to a tune called by the IRS. For example, here is how the required minimum distribution from a $1,000,000 IRA would grow over time if the IRA experienced 5% net returns.

Notice how the payout more than doubles over the course of retirement. If these distributions ladder you into a higher bracket later, your chute is to take bigger IRA distributions earlier -- ones that use all the headroom right to the top of your present bracket. This is the same strategy that we used with the capital gains, above. The suave move is to make a series of partial Roth conversions, which also exempt these payouts from future taxation (except for the estate tax, of course).  People think of Roth conversions as an all-or-nothing affair, but at the cool kids’ table they are making strategic partial Roth conversions every year up to the top of their lower brackets.

That way, the IRS forced withdrawal schedule gets applied against your lower IRA balance, sidestepping or minimizing the distributions subject to higher tax rates later.

Notice that in both these approaches, the headroom left to the top of your current tax bracket becomes an invaluable tax management tool. This is an asset you didn't even know you had. The most advantageous time for retirement tax planning is during that intriguing interval between the date you retire (with no more paycheck to report) and age 70, when the government forces you to claim Social Security and begin your mandatory IRA withdrawals. This stretch in your 60s is when you are likely to achieve Max Headroom. The sooner you figure out whether you have a problem with the bracket creeps, the longer a ramp you have to solve it

What Else?

Retirees have a few other arrows in their quiver when it comes to determining their tax brackets.

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  • They can donate to charity, either directly from their IRAs (up to $100,000 of their required minimum distribution) or by donating appreciated stock (to get rid of the embedded capital gains liability) from their taxable account.
  • They can take out a mortgage and deduct the interest (on up to $1,000,000 debt for a couple).
  • They can go on margin in their taxable account and deduct the margin interest.
  • They can move to a low- or no- income tax state (preferably one without an estate or gift tax.
  • Other things equal, they can leave the money in their tax-qualified accounts to compound as long as possible.
  • Employees of companies can postpone taking the RMDs from their 401(k) plans past age 70 1/2 provided that they continue to work, their 401(k) plan specifically allows for it, and they are not > 5% owners of the company.
  • They can name their kids as secondary beneficiaries on their IRAs. That way, if the Surviving Spouse does not need or want the taxable distributions, it can be offloaded to the children.

Cross-Generational Planning

Imagine you own both an IRA and a taxable account. Strange to say, the best one to spend most heavily depends on your kids.

If your heirs are in a lower tax bracket than you are, then lean on your taxable account, take only the required minimum distributions from your IRA, and leave the bulk of the IRA to them since the money will be taxed less in the long run, especially as the distributions will be stretched out over their actuarial lifetimes.

If your heirs are in a higher tax bracket than you are, then draw down the IRA (otherwise the distributions will be taxed at your heir’s top rates) and leave them the taxable account instead (where they will benefit from the step-up in cost basis on your capital gains). They will love your Roth account even more, since they can take the distributions tax-free.

That's the plan, Stan.  Run everything by your own financial advisor before taking precipitous action.