Thoughts on Retirement Tax Efficiency Planning
By Alan Silverstein, Fort Collins, Colorado.
Email me at email@example.com.
Last update: January 11, 2017
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".
Why bother considering this issue at all?
The goal is to model and predict tax consequences of financial
decisions in order to optimize net money left in your pocket (that
is, be tax-efficient) during retirement. All in order to minimize the
risk of outliving your money, maximize your spending potential, and/or
maximize the size of your inherited estate.
The problem is there are many complex, often non-linear,
tax-related algorithms that virtually demand software to
explore. Plus, reliable tax software (or underlying IRS publications
and forms) often isn't even available until after a tax year is over.
Plus, tax laws can and do change occasionally and unpredictably.
In some sense, the problem looms larger with the more control you
have over your income sources.
While working and earning W2 or equivalent wages, people
usually feel little flexibility, mostly just finding the best (paying
and/or acceptable) jobs they can, then taking for granted their
resulting income streams and tax consequences. Even in retirement,
after you decide about setting up perennial income streams (like
interest, dividends, pensions/SS, annuities, rents, royalties,
IRA/401k RMDs, etc) you are somewhat locked into your existing
But whenever you need additional retirement cash from
liquidating retirement investments, there are many degrees of freedom
-- and opportunities to "screw up" in ways you don't realize until
it's too late. Or conversely you can always say, "I don't care enough
to deal with this," and "pay a premium" (in lost savings if nothing
else) for the extra simplicity. In those cases it's nice to at least
know the magnitude of the premium!
And some more thoughts: It's legal, but is it fair and ethical to
game the tax system to your own advantage? I have mixed
feelings. Hardly anyone ever blames you unless they think you are,
"filthy rich and dodging too much tax through loopholes." There's a
lot of money on the table that can improve your lifestyle (and even
generosity) if you're smart and dedicated enough to figure out how to
legally keep it away from the IRS plus state Departments of Revenue.
Then again, there's a lot of inherent unfairness commonly built into
systems that only income-test and do not means-test. The game
is rigged to favor people with assets over income.
Also as you can find for yourself, there are many websites available
that blithely give advice (or even offer paid services) relating to
gaming/optimizing the system for personal advantage.
Here are examples of "tax systems" I know about that make modeling,
prediction, and optimization difficult (arranged approximately least to
Tax-exempt sources of income, that are still added back for
some purposes like SS taxability, plus some "tax exempt funds" are not
100% tax-free either (surprised me after I didn't read the entire
Preferential income = lower rates for each tax bracket
(0/0/15/20% instead of 10/15/25/28% etc). This includes LTCG = long
term capital gains (assets held over one year), CGD = capital gain
distributions (from mutual funds), and QD = qualified dividends
(generally from US stocks or stock funds).
Social Security taxability. See
this webpage I wrote on the topic.
Qualified account (401k, IRA, HSA, etc) contributions and
distributions/conversions; pre-tax, post-tax, or even tax-free (never
mind penalties and exceptions).
ACA PTC (premium tax credits) if your MAGI (modified adjusted
gross income) is < 400% of FPL (federal poverty line) for the
previous year. There's a new 9.5-18%
"marginal tax rate" as your MAGI rises, with a severe step
function (entire loss of PTC) at 400% of FPL.
State versus federal income tax concerns (easy to overlook),
including state exemptions for some or all 1099-R (retirement) income.
Selling certain assets, including rental houses in particular
(Form 4797, section 1250 accumulated depreciation recapture,
nonrecaptured section 1231 losses). Basically capital gain/loss = net
proceeds - sales expenses - ACB (actual cost basis), where ACB = OCB -
AD (original cost basis minus accumulated depreciation). A net loss
is just ordinary income/loss, but a net gain can be taxed at some
murky combination of LTCG (often 0%), ordinary, or 25% rates.
Some additional points emailed to me by a friend:
The Medicare deduction from your Social Security payment
depends on a previous year's income tax form -- which might not be
last year's return due to timing issues. The first step is for fairly
high income; see
To make this worse, Social Security
calculates your income (MAGI = modified adjusted
gross income) differently than the IRS does. [ajs: I once read a
website claiming there are at least 40 different definitions of MAGI,
in different contexts, although each well-defined of course, somewhere
in the US Code.]
Converting traditional IRA dollars into a Roth IRA, in addition
to the obvious tax hit for the year, also affects that Medicare
deduction. Social Security's system thinks that you now have a
good-paying job and are not really retired.
People on Social Security (below full retirement age) who work
part-time perceive that they get punished if they work a little
bit too much. They carefully limit their work to avoid creeping over
a threshold that apparently causes net-income-after-taxes to drop.
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:
The right time to do tax-efficient distributions and conversions is
late in the year, like December, when you have a pretty good
handle on your estimated income and taxes for the year and can weigh
the tax consequences of various withdrawal amounts. Especially if
you're early-retired without employer health coverage, too young for
Medicare, on a healthcare exchange, and trying to keep your MAGI below
400% of FPL = federal poverty line for the ACA PTC = premium tax
credit. (See also
Just like starting social security instead of deferring it between
ages 62-70 (see also
this webpage), if you
need the money sooner and can't get it from sources other than
trad-IRAs or equivalent (or SS), you don't have much choice but to do
ordinary distributions. (Taxable, and if you're not yet 59.5 and
don't have a qualified exception, penalized too.) However if you can
wait even the better part of a year, plus if perhaps you won't need
all of the converted amount by one year later when you repeat the
cycle, the benefits of doing a conversion rather than a direct
Leaves the door open to recharacterize part or all of the
conversion before the deadline (October 15 of the next year,
although an amended return is required if you've already filed), for
a variety of possible reasons including post-conversion investment
losses, or needing to retroactively reduce your MAGI.
The converted amount grows tax-free, ideally more the longer
you can leave it untouched. (Although all else being equal, it
shouldn't matter if earnings occur in a traditional or Roth IRA.
But Roths are generally considered superior for additional reasons,
like no RMDs.)
A neutral point: Once you're at least 59.5 there are no longer
concerns about 5-year conversions clocks (see below). You can
withdraw (distribute) any amount from your Roth IRA any time you
want, meaning you can treat it as one of your short-term buckets,
especially if some of it's invested in relatively stable assets.
(So far I'm OK with broad, high-quality intermediate term bond funds
because they really aren't too volatile.)
One minor negative point: A conversion followed by a Roth
distribution can result in one extra 1099-R from the tax
year, although it seems most trustees lump multiple distributions
(from one IRA) during the year into a single tax statement.
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.
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
And in fact numerous reputable sources come to this same conclusion; see
Understanding the Two 5-Year Rules for Roth IRA Contributions and Conversions.
Which says in part:
...worth noting that because the 5-year rule for Roth conversions merely
leaves the withdrawal of conversion principal potentially subject to the
early withdrawal penalty, any other exceptions to the early withdrawal
penalty can still shelter the Roth conversion amount from the penalty.
Thus, withdrawals within 5 years of conversion by someone who is already
over age 59 1/2 are not subject to the early withdrawal penalty,
regardless of the 5-year conversion rule, simply because being over age
59 1/2 itself is an exception to the penalty!
Distributions After a Roth IRA Conversion
Which says in part:
...the penalty doesn't apply if you are over age 59.5, or if you can
fit within any of the exceptions to the early distribution penalty...
Roth conversion subject to five-year rule?
Which says in part:
Since you are older than 59 1/2 you did not have to pay the 10 percent
additional tax on your distributions.
Miscellaneous other considerations:
Someone said to me, "Leaving Roth IRA dollars for your children to
inherit is likely the best way to give them money in an estate."
I somewhat agree, but actually even better are appreciated capital
assets due to the step-up of cost basis, a death gift from the
IRS. For example, my wife inherited a few rental houses and we got
the step-up on them. The longer we own them, the less we ever want to
sell them because they're "worth a lot more to our heirs than to us,"
especially considering single-year ordinary-tax recapture of
accumulated depreciation upon sale (or other disposal) by us.
Anyway the comment above one of the many reasons why financial
experts recommend Roth IRAs even if all else being equal (which it
never is) it shouldn't matter if you pay income taxes now or later.
Other reasons that come to mind are: No RMDs on Roth IRAs for you,
and generous for your heirs; more annual portfolio withdrawal
flexibility (income tax optimization) if you have substantial assets
in both traditional and Roth IRAs; and somewhat more certainty about
future tax bites -- whether rates go or down, kind of like buying a
futures contract to minimize risk.
The same person also said, "Which leads one to want to leave Roth
IRA dollars untouched, as a gift to your children."
Sure, but remember to always save and spend for yourself first,
including even considering kids' education expenses. If you can
afford to leave your Roth IRA untouched, great, but only if the
"premium" you pay for that during your lifetime is worth it to you.
Also consider that my suggestion to convert rather than directly
distribute isn't necessarily to convert-and-forget, merely to
Personally in early retirement I'm likely to start soon needing to
largely fund my future living expenses from my traditional IRA (at
least until I start SS), at a rate that might get uncomfortably large
compared to tax brackets, especially ACA PTC (until age 65 and
Medicare anyway), and to the Colorado pension/SS income exclusion. So
I might pump money from my traditional into my Roth, but mostly/all
back out again within a year. But that still seems preferable to
directly distributing from the traditional for the reasons I
There are many factors or variables that are intangible, or at
least hard to evaluate in comparative dollar terms (although it can be
instructive to try). For example, "what's my time worth to me?" if I
must spend much of it dealing with financial wrangling.
Someone also said, "If you have traditional IRA that may be worth
converting, why 59-1/2 but not earlier?"
Certainly earlier too! I don't mean to imply otherwise. It's just
that pre-59.5 you have more incentive to convert than to
distribute, due to penalties. See also for super-early-retirees:
Climbing the Roth IRA Conversion Ladder to Fund Early Retirement.
I mentioned the 59.5 - 70.5 range because after 59.5 you have no
penalties on any distributions (from traditional or Roth IRAs), but
converting first still might make sense although intuition
would suggest just starting (penalty-free) distributions. After 70.5
it appears you can still do conversions, but only after you take your
RMDs first, and you cannot convert those amounts.
Of course there are many other possible considerations that
cause many financial advisors to prefer Roths to traditional IRAs;
hence for you to do conversions even of amounts not needed for
short-term spending, whenever your tax situation makes it reasonable.
I found a nice (long)
about this on the Bogleheads site.
Rambling further on this topic: In general and simple terms I think
the main goal is to minimize your total lifetime income tax
liability, given annual accounting and a progressive tax system
(in the US anyway). 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.
In this sense, 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 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
Something from this model I still have trouble accepting is that
ideally I should continue (for life) paying income taxes at
about the same rate/amount as I did while employed. If not, it sort
of means I overpaid earlier and should have saved/deferred more until
now -- if only I could have saved more pre-tax (hence spent less) for
several decades, given practical and legal limits. Now that I'm
living off savings and perennial income streams (and in particular no
longer paying for a mortgage), it's easy/tempting to spend less, hence
cash in and pay less tax on taxable income. Although income taxes I
already paid during my youthful innocence are water under the bridge,
a sunk cost.