My client, Alice, came in for her semi-annual review meeting recently and said (as many clients do), “I don’t like paying taxes.”
Good news: You only pay taxes when you’ve made money. But that does not mean you should not try to minimize your taxes as much as possible. In Alice’s case, she was transitioning into retirement from a long career in the tech industry, and the retirement transition planning would cover a wide range of issues. We had already figured out that she had enough money. Over time we would need to deal with how to do the actual retirement transition, the timing of claiming Social Security benefits, analyzing pension options, and how to replace her paycheck and sustain her retirement spending. And we’d do all of this while balancing her desire to help her two daughters now and leave a legacy for them when she was gone.
In that day’s meeting, however, we focused on the exciting world of the tax efficient liquidation of her investment portfolio. (As she said, “I don’t like paying taxes.”) Our primary focus was on coordinating the liquidation of the retirement accounts (e.g., IRAs, 401ks, and Roth IRAs) and her taxable brokerage account.
The rule of thumb is that taxable investment accounts should be liquidated first allowing tax-deferred accounts to continue to grow. It makes sense, since otherwise you would be drawing on the IRA first, forcing you to pay income taxes earlier than you otherwise would. Then you would start drawing on your brokerage account, but that would not have grown as quickly because of the annual drag of taxation on interest, dividends, and capital gains. If the retiree draws from the brokerage account first, then they are not paying any additional taxes early, so the portfolio can maintain spending for a lot longer.
Rules of thumb often provide simple, easy to follow methods that generally work. They do not, however, necessarily offer the most effective approach. It is one thing to delay paying taxes, but it is quite another to simply pay less in taxes (near and dear to Alice’s heart). By taking the blended approach of drawing from the IRA when you are in lower tax brackets, coordinated with the draws from the brokerage account to avoid adding too much income and ending up in a higher tax bracket, the portfolio can last even longer.
In addition, when many people with large IRAs turn age 70.5, they are forced to start drawing from them, suddenly moving them into a higher tax bracket. By reducing the IRA amount at earlier ages, you potentially lower the tax bracket you will be in at age 70.5 and beyond, as well.
This coordinated strategy still means that you are depleting a tax-deferred asset, so an even better option might be to convert IRA dollars when you are in a low tax bracket to a Roth IRA. This couples the potentially lower tax brackets pre and post age 70.5 with tax-free growth on the new Roth IRA dollars.
Since Alice was a good saver who lived within her means, she was happily retiring early at age 60. This gave her at least 10 years to control her tax brackets and implement these strategies. But it is important to note that this is an annual process of managing tax brackets. First of all, what tax bracket is “low” is dependent on one’s overall wealth and income. For some, they can target always trying to just fill up the current 12% bracket and try to avoid ever being in the 22% bracket. With Alice’s good fortune of having one of the few remaining private pensions, she would always be in at least the 22% bracket, so avoiding the 24% (and certainly the 32%) brackets becomes ideal.
In addition, taking more income in a given year can have unintended consequences on other income—especially in the lowest tax brackets where otherwise non-taxable long-term capital gains can suddenly become taxable at 15%; or Social Security that would not have been taxed suddenly is. Alternatively, years with very high medical costs or business losses could create opportunities in very low tax brackets. It is critical to truly understand the tax rate on the dollars you convert or draw from the IRA to properly implement these strategies.
Alice could have followed the rule of thumb and just taken her income from her brokerage account first, but in reality you can actually be too good at deferring taxes. The IRA can grow so large that it pushes you into higher tax brackets. Instead, she is focused on maintaining the tax advantages of her retirement accounts in an optimal approach of filling her lowest possible tax brackets early on, balancing taxable brokerage account withdrawals with annual partial Roth conversions, while always being mindful of ancillary tax impacts.
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