Tax-Efficient Retirement Planning

Tax-Efficient Retirement Planning

Why would anybody pay taxes when they really don’t have to?  This is a question that financial advisors are hearing from their retired clients, who are taking their living expenses out of taxable and tax-deferred accounts like IRAs.

The whole idea of tax planning during retirement is a relatively new one in financial planning circles, and it has created some debates.  No doubt you’ve heard the conventional wisdom: when you retire, take money out of your taxable accounts first, which allows the money in your conventional IRA and Roth IRA to compound on a tax-free basis for the longest possible time.  When the taxable account finally runs out, start taking money out of your conventional IRA, which will cause you to pay ordinary income taxes, and let the money compound in the Roth IRA.  If there’s any money left over, the Roth IRA is the best vehicle to pass investment assets on to heirs, since the money won’t be taxed when it is taken in distributions that can be deferred over their lifetime.

The conventional wisdom works in many instances but is quite often not optimal. If you take all your income out of taxable accounts first, you might end up in the 15% marginal tax bracket—less than $72,500 of taxable income if married filing jointly—or less.  What’s wrong with that? 

Take for example a couple both age 60 that recently retired. They did a good job of saving and investing over their careers and find themselves with $1M in IRAs and $1M in taxable accounts at retirement. They follow the conventional wisdom and take money from their taxable accounts first while the IRAs continue to grow. Over the next ten years, they achieve a 7% return and their IRAs double to $2M.

They will have to start taking mandatory distributions at age 70 ½ even if they don’t need the income. This equates to about 4% of the $2M or $80K of income that will be fully taxable. Those distributions could push them into significantly higher tax brackets.  And the tax brackets in the future might possibly be higher than they are today.  Raise your hand if you think tax rates are going to go down in the next 10-15 years.

A better approach is to gradually let some of the air out of the IRA in the years before mandatory distributions come due and pay at the lowest possible tax rates.  That might mean taking out enough IRA money to offset your standard deduction and personal exemption and fill up the 15% tax bracket, meanwhile taking the rest of your living expenses from the taxable account.  Paying at a 15% rate today could mean not paying at a 25% rate or higher in the future, depending on your need for cash and the whims of Congress.

Alternatively, for people who don’t need the income, you could make a partial conversion of assets from the IRA account to a Roth IRA–just enough to offset the various deductions and fill up that 15% bracket.  You pay taxes on some of those converted assets at 15% today in order to avoid any future taxation on them down the road.  Since Roth IRAs don’t have any mandatory distributions for the original owner, you’re free to take the money out tax-free or not as you desire in the later retirement years or leave that money to your heirs.

An advisor who looks at the retiree’s total tax picture might also use your lower tax bracket to sell some stocks that have significant appreciation and take the capital gains at a 0% rate, if realized within the 15% marginal tax bracket or less. This could avoid paying a capital gains tax rate of 15% to as much as 23.8%, if the stocks were sold when mandatory distributions are pushing you into the upper brackets.

So what does this added complexity get you? In an August 2013 Journal of Financial Planning article quantifying the benefits of tax-efficient retirement withdrawal planning, it was found that a tax-efficient strategy can add as much as 16% more to ending account values than the conventional wisdom. This may mean $320K more for the couple in our example above. These benefits can be viewed in the context of being allowed to spend more, retire sooner, give more to charity or your heirs, or whatever goals you may have.

The situation becomes more complex yet more value may be added when you begin to consider timing of pensions, Social Security, deferred compensation payments, stock options that have not yet been exercised, or the sale of a business. They key is be proactive. For most, the maximum tax planning flexibility will be attained in the early years of retirement. If you’re already in your 70s, it is not too late but required distributions may limit planning flexibility.

So the answer to the question: “Why would anybody pay taxes when they don’t have to?” The goal is to maximize after-tax wealth, which is not necessarily the same as paying the least amount in taxes in any given year. Every situation is different, every year is different for every situation, and many are beginning to realize that planning for a tax-efficient retirement is more complicated than most of us realized.  But careful planning can also be more beneficial for people who want to get the most value out of their retirement assets.


Kevin Kroskey, CFP®, MBA is President of True Wealth Design, an independent investment advisory and financial planning firm that assists individuals and businesses with their overall wealth management, including retirement planning, tax planning and investment management needs.