R101 #13 - Lifetime Tax Planning

When thinking about retirement and taxes, people are often fixated on retiring to states with no income taxes. Although this is something you definitely need to think about, it’s only one piece of the tax planning puzzle in retirement. This post will discuss the moves you should consider when saving for retirement, how to manage your tax bracket during retirement, and ways to position your investments to pay less taxes.

Income Tax Basics

I’m continually surprised how few people understand how their taxes are calculated. You don’t need to be a CPA or study the millions of pages of tax code to have a basic working knowledge of how the Federal Income Tax system works. So we’ll start there.

The main income tax system in the U.S. is progressive - this means that as you have more taxable income, the percentage of that additional income that is lost to taxes increases. Your first dollar of income results in very little (if any) taxes, while having income over a couple hundred thousand dollars may result in paying 30-40% in taxes. The dollar amounts that comprise each tax bracket level usually change each year. There are different levels depending on your filing status. The percentages of tax at each level are set by congress and are adjusted occasionally with the last big change happening in 2018. Who knows what will happen in the future.

The higher percentages at the higher income levels are only charged for that portion of higher income. This is why your total tax is always a lower percentage of total income (effective tax rate), than the percentage of tax for that last dollar of income (marginal tax rate).

Quick Aside - many working people think that their taxes withheld from their paycheck are the taxes they are paying. The withholding has very little to do with what taxes are actually due when you file. Your employer’s payroll software does the best it can (based on inputs from you on the W-9 form) to withhold the correct amount. But there’s very little else the payroll software can account for. That’s why I always help my clients adjust their employer withholdings to account for their projected taxes due. It’s an inexact science. The actual taxes due can only be calculated at the end of the year after all of your income/deductions/credits/exclusions/inclusions/gains/losses/and any other special circumstances are accounted for.

One more aside - whether or not you get a refund has nothing to do with whether you paid a lot of taxes or a little. Getting a refund only means that you paid in more throughout the year than your calculated taxes are. It’s an interest free loan you gave the government.

In addition to the progressive income tax bracket system, there is another set of brackets/rates that are applied to long-term capital gains, and a whole ‘nother tax system called the Alternative Minimum Tax system (AMT). You may not need to know the details of all of this, but it’s important to know they exist.

Savings, Investment Accounts, and Taxes

Ok, so now you have a basic idea of how taxes work (or at least an appreciation for how complicated the calculation is), let’s talk about how that impacts retirement.

Before you ever think about retiring, you’ll likely need to save. There are lots of different ways to save for retirement. You could stick cash under your mattress and plan to pull it out 20 years later. I would argue that’s not the optimal way since your cash is unlikely to have the same spending power 20 years from now. For most of your life, saving for retirement is a long-term goal. That’s your time horizon.

Instead of sticking your cash under your mattress, you’d be better off putting your savings into an “investment” that will grow over time and be what you need it to be when you start spending money in retirement. There are three kinds of account categories from a tax perspective. Those that are “Taxable Accounts”, those that are “Tax-Deferred”, and those that are “Tax-Exempt”.

Taxable accounts are funded with money that you already paid taxes on. These kind of accounts impact your taxes going forward because they can produce interest and dividends while they are growing. When you take money out, you may have to pay capital gains on the growth only, and that is calculated compared to the “tax basis” of the investment. There aren’t restrictions on how much you can put into this type of account, or when you can withdraw it, or how much you can withdraw. This account offers a LOT of flexibility.

Tax-Deferred accounts are funded with a portion of your income before it’s taxed. “Traditional IRA” and “Traditional 401k” contributions are in this category, but there are lots of other kinds of accounts that are in this category. Contributing to these accounts allows you to reduce your income in the current year (subject to limits imposed by the IRS). Yay! You can save on taxes this year. However, you pay taxes when you withdraw the money later. Boo! And if you don’t follow the rules for when and how you withdraw it, you could owe a penalty in addition to any taxes owed. This account also grows with no tax impact during the time you contribute and when you withdraw.

Tax-Exempt accounts are funded with money that has already been taxed (like Taxable accounts), but are allowed by the government to grow with no tax impact (like Tax-deferred accounts). “Roth IRA” and “Roth 401k” accounts fall into this category. To get the best of these both worlds, there are restrictions on this account governing how much you can put in, and when and how much you can take it out without penalties.

I’m grossly over-simplifying this. Here’s the deal. You have a choice what kind of account you put your money into. Each type has pros and cons today and into the future. There is no such thing as a “Retirement Account”. Retirement is a time horizon/period of time. It is not an account type. What you need to take away from these few paragraphs are that “Tax Allocation” and “Tax Diversification” matter. It’s the ability to spread your dollars over different types of accounts to take advantage of some of the tax benefits today, and plan to take advantage of some of the future tax benefits in retirement.

What is Asset Location?

Now that you know you should have various accounts based on how they are taxed - i.e. “Tax Allocation”, let’s talk about what kinds of assets should be in those accounts. This is called “Asset Location”.

Each type of asset/investment inside the account has various characteristics that make it more or less tax-efficient. Assets that produce lots of interest and “distributions” that are classified as income are less tax-efficient. Assets like stocks that may only produce qualified dividends are more tax-efficient.

Asset Location is a nice-to-have. It’s more important to make sure your whole portfolio is correctly allocated between less-risky and more-risky assets based on your risk-tolerance (“Asset Allocation”), than it is to make sure assets are in the most tax-efficient accounts.

Managing Your Tax Rates During Retirement

Ok, so now you’ve got various accounts with different tax characteristics, along with various investments inside of them that are either tax-efficient or not. How on earth do you decide where to take money from when you need it in retirement?

First, you need to know what other income you have in retirement outside of your investment portfolio. This could be income from working, pensions, rental income, or something else. That sets the baseline.

As I mentioned above, you need to know which tax bracket this baseline income puts you into. You need to know how much room you have in that bracket before your marginal tax rate increases. Based on this analysis, there will be a specific sequence of withdrawing money from your portfolio that will minimize your taxes this year. Looking at this over the rest of your lifetime, there could be a different withdrawal sequence recommended depending on whether you want to minimize lifetime taxes, maximize lifetime income, maximize legacy for your heirs, or have other financial goals. Doing this in an optimal way can make a big difference in how long your money lasts and how much you can spend.

For example, suppose you need $5,000 after taxes from your portfolio. If you take the money from a Roth account, you pay no taxes - $5,000 withdrawal means $5,000 in your pocket. But that means you lose the benefit of the deferred growth over the rest of your lifetime. Hmmm. Ok, what if you take the money out of your taxable account. Let’s assume your capital gains rate is 10% and you have $2,000 of gains. So you need to withdraw $5,200 to net $5,000. Ok. That seems like a decent option. What if you took it out of your tax-deferred account and your marginal tax rate is 22%? You have to withdraw $6,410 to net $5,000. Yikes!

This example is WAY simplified to show you why it matters which account you spend from. Now let’s add in the complexity that Social Security may or may not be taxable based on your taxable income, Medicare premium costs can jump based on your income, you may end up paying additional tax on your investments (Net Investment Income Tax - NIIT) based on your income, and various other deductions and credits could be phased out based on your income, and you see how complex these analyses can get during one particular tax year.

Add to that the timing decisions of whether it is better to pay more taxes today because you expect tax rates in general, or your tax rate, to increase in the future, or you want to leave your heirs in the best possible tax position as possible, and there are an infinite number of ways you could structure your retirement withdrawal strategy. We don’t know what the future holds. We can only make reasonable assumptions and try to make the best decisions we can, today.

I think this is the hardest part of managing your retirement finances on your own. It really could make sense for you to bring in an expert to help you make these decisions in the short and long-term.

Singles v. Couples

One other complication needs to be addressed. There are different tax brackets depending on whether you are filing as a single person v. a married person. This can come as a surprise to people who get divorced or their spouse passes away before they do. It’s important to consider this in your retirement plan.

Back to the Big Picture

Remember how we talked about how funded your retirement is, and how much money you need to spend to support your lifestyle? If your retirement is well-funded and you have several guaranteed sources of income already, tax planning may not be as important to your overall retirement plan. Then you can start thinking about tax planning for your heirs - they’ll thank you for it!

If you are like most retirees though, you can benefit from Tax Allocation and Asset Location. You can benefit from thinking about how and when to withdraw money to avoid surprises like being taxed on your Social Security or having your Medicare premiums increase in a few years. Every dollar saved on taxes over your lifetime is one more in your pocket that you can use to enjoy life!

But back to the heirs. Next up is a discussion of legacy.