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Tax-Efficiency Planning for Recent Retirees

  • Published on Oct 8, 2018
  • by Wade D. Egmon, CPA, CFP®

As a CPA who was previously in public practice on the tax side, I know first hand how helpful it was when we could work together with the other financial professionals in working with our clients to make tax planning more effective and return preparation easier.  Investment advisors, in particular, are well-positioned to be a valuable resource to CPAs since so much of what they do affects the client’s tax situation. From developing tax-efficient asset allocation strategies to deciding which assets with certain tax attributes to place in which accounts based on account tax status, a client’s investment advisor can work with their CPA to meet the client’s tax goals.

Helping clients develop a tax-efficient distribution strategy during retirement is one area in particular that can have quite an impact on a client’s tax situation. When looking at this, you should view planning opportunities during three different time periods:

Distributions Prior to Age 59.5 – Pre-59.5 distributions from non-Roth retirement accounts typically incur a 10% early distribution penalty unless they meet one of a few exceptions, so careful planning is required in order to avoid unnecessary taxation and penalties.

Distributions After Age 70.5 (Required Minimum Distribution “RMD” Age) – Most non-Roth retirement accounts typically require taxable distributions in the year a person turns age 70.5  and beyond.  These RMDs can be sizable, depending on the balance of the accounts.

Distributions After Age 59.5 but Prior to 70.5 This time period, which is the focus of this article, can be a period of reduced taxable income, and as a result can be rife with planning opportunities.The years leading up to retirement are typically a taxpayer’s peak earning years, and therefore typically land the taxpayer in the highest tax brackets they have or ever will be in.  

Also, as people tend to have at least half of their assets in pre-tax qualified plans (401(k), 403(b), etc.) or traditional IRAs during retirement, they typically find themselves subject to larger taxable RMDs once they reach age 70.5.  This creates a “valley” in taxable income levels in the years between retirement and RMD age.  See the table below for the tax brackets of a married retiree filing a joint return as an example of this income “valley.”  

Screen Shot 2018-10-04 at 10.57.44 AM

In this example, the client had $325,000 of taxable income prior to retiring at 65,
consisting mostly of wages and a smaller amount of portfolio income.  From ages 65-69, their baseline taxable income before considering portfolio distributions was $20,000, consisting solely of portfolio income.  At age 70, in addition to their portfolio income, the client began taking Social Security Income and RMDs, resulting in baseline taxable income of $125,000.

For the retiree in the graph, being in the 12% tax bracket for the 5 “valley” years represents an opportunity to save 10% in federal income taxes on taxable IRA distributions taken prior to age 70.5, to the extent he/she remains in the 12% tax bracket. They can supplement their IRA distributions with tax-free distributions from their after-tax savings to cover overall cash needs. 

Additionally, and perhaps more significantly, long-term capital gains (LTCG) or qualified dividends (QD) get even more favorable treatment under current tax law for taxpayers in the lowest tax brackets.  Currently, LTCG and QD are taxed at 0% for taxpayers with taxable income of less than $77,200 for MFJ or $38,600 for single filers – essentially the bottom two ordinary tax brackets (10% and 12%). LTCG and QD are taxed at 20% for taxpayers with taxable incomes over $479,000 for MFJ and $425,800 for single filers, and 15% for all other taxable income levels. 

To the extent that the taxable income below the low threshold amounts listed above consists of long-term capital gains or qualified dividends, that tax-favored income will be taxed at 0%, resulting in a tax savings of 15% on these capital gains and dividends.  Clients in these situations have a number of planning options available to them, from initiating Roth conversions at low tax rates to harvesting capital gains with little or no associated tax liability. 

There are complicating factors that don’t make this analysis so cut-and-dry. For instance, assume our taxpayer is in these valley years, but has begun receiving Social Security benefits.  Generally, for married taxpayers with base income of $32,000 for Social Security purposes, none of the Social Security benefit is taxable; taxpayers with base income in excess of $44,000 have 85% of their benefits taxed, and taxpayers between base incomes of $32,000 and $44,000 can have up to 50% of their Social Security benefit taxed.  Triggering IRA distributions or capital gains for our client in the example above would have the effect of making previously nontaxable Social Security benefits now taxable. This reduces the tax benefit of triggering the additional taxable IRA distributions or long-term capital gains.  Additionally, any potential tax law changes could change the results of this analysis.

Being tax-efficient in distribution strategies as well as portfolio construction can add years to an investment portfolio, so reach out to your client’s (or your own) investment advisor to work with them to identify situations where you can provide that value to your client or yourself.

Wade D. Egmon, CPA, CFP®. As Client Service Manager, Wade’s responsibilities include meeting with clients to discuss their financial plans and investment portfolio as well as providing ongoing client service to address any issues or needs. For more information about Goodman Financial visit there website here.