Thoughts on Retirement Tax Efficiency Planning

By Alan Silverstein, Fort Collins, Colorado. Email me at ajs@frii.com.
Last update: January 28, 2018

Here are some thoughts about tax efficiency planning (and obstacles) for retired people, at least in the US. This is a "forest" of which I often lose track while exploring among the "trees".

Contents:

Why bother considering this issue at all?

Tax difficulties

Here are examples of "tax systems" I know about that make modeling, prediction, and optimization difficult (arranged approximately least to most complex):

Some additional points emailed to me by a friend

Lifetime consistent tax bracket

I've come to realize, and now advise people, that:

In a progressive income tax system like we have in the USA (more on that in a bit), you want to be in the same tax bracket every year of your life.

Not necessarily have the same exact tax dollar liability every year, just be in the same real or effective tax bracket. Otherwise, you have spike or high-income years that push more of your taxable income into higher brackets, and that's (sometimes terribly) inefficient over your lifetime.

A big part of this is maintaining a relatively level taxable income, really AGI = adjusted gross income on Form 1040; always enough to fill your exemptions and standard/itemized deductions ("free income"), and beyond that minimizing "spikes" into higher brackets in some years.

So what does this mean? Well ideally during all of your earned-income years, you'd defer as much taxable income as possible in 401k's, tIRAs, etc; and beyond that, buy long-term-growth capital assets with minimum present taxable returns.

Plus during all of your low/no-earned income years, including in full retirement, you'd carefully increase your AGI (adjusted gross income) => TI (taxable income) to "fill your bracket" by voluntarily selling appreciated assets, making Roth conversions, increasing tIRA distributions, etc.

In this context, a qualified (tax-deferred) retirement account (or equivalent) is a way to time-shift some taxable income from working years into non-working years. And Roth (including Roth 401(k)) contributions or conversions can be counter-productive during working years if you're in higher tax brackets at that time, because it time-shifts taxability forward rather than deferring it.

In particular, if you have a large tIRA or equivalent, it's a good idea to make annual distributions and/or rIRA conversions before reaching age 70.5 and starting RMDs (required minimum distributions). This includes using distributions to supplement your spending accounts while deferring Social Security benefits (at least those worth deferring, but that's another topic). Vanguard published a nice analysis of this a while ago (that I can't find now).

One way to think of this particular tradeoff is, "if I need or want to feel richer now, I should take dollars out of my tIRA and pay income tax on it, before prematurely starting SS benefits." This can save $10Ks in taxation over your lifetime.

Another example, of a mistake I made and you should avoid, is enjoying very low income taxation during some (early) years of retirement by living only off post-tax or low-tax assets. In my case I was not yet 59.5, I had adequate non-IRA money stashed, and I should have done bigger Roth conversions during those years.

As for real or effective tax brackets: Most of us understand the real ones (including the changes in 2018), but there are many subtle effective/additional "brackets", including:

One way to think about this is that if you "screw up" and voluntarily raise your taxable income a lot (or involuntarily with unavoidable RMDs that you should have partially prepaid in earlier years), you might not only go into a higher tax bracket, you can also pay a lot of "hidden additional tax" due to the higher AGI.

Another example: As a volunteer tax preparer, I had one client who purposely pulled a substantial amount out of their tIRA one year, without penalty (over 59.5), for a home remodeling project. This "income spike" pushed them quite far into the 25% tax bracket. They knew the distribution would be taxable, but did not appreciate how much of it would get an extra 10 ppt federal "ding" (plus nonlinear state income tax effects too). Several $K could have been saved simply by pulling (distributing) half the money on Dec 31, and the other half Jan 1 of the next tax year.

Traditional IRA: Distribute or convert?

I think that at least in the age 59.5 - 70.5 range, you should almost always do Roth IRA conversions, and later Roth distributions to refill your short-term spending buckets, instead of direct traditional IRA distributions for spending money. Here's why:

Post-59.5 conversion clock

Someone asked me how I determined that once you're at least 59.5 there are no longer concerns about 5-year conversions clocks. The answer wasn't simple or airtight. First look at 26 USC 408A that I found, which is the actual law. Here's one legible source for it.

It says in part:

  (d) Distribution rules -- For purposes of this title.
    (1) Exclusion
    Any qualified distribution from a Roth IRA shall not be includible in gross income.
    (2) Qualified distribution -- For purposes of this subsection.
      (A) In general -- The term "qualified distribution" means any payment or distribution.
        (i) made on or after the date on which the individual attains age 59.5...

But later (look for "5-taxable year") it talks about section 72 versus rollovers, which is another (ambiguous) name for conversions here. It doesn't actually say, "except if you're over 59.5," but this is inferred from strict reading.

Then there's the IRS Pub 590-B, figure 2-1 flowchart. (The previous link goes to the 2016 version in particular. If that ages out and doesn't work, start with just Pub 590 here and scroll down about halfway to Figure 2-1.)

And in fact numerous reputable sources come to this same conclusion; see for example:

Miscellaneous other considerations