By Alan Silverstein, Fort Collins, Colorado.
Email me at ajs@frii.com.
Last update: April 16, 2020
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:
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 infrastructure.
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!
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 most complex):
Sidebar; as I summarize it:
OCB = original cost basis AD = accumulated depreciation (after the end of the latest tax year) ACB = adjusted cost basis = OCB - AD (drops every year) GSP = gross sales price (my acronym), estimated from Zillow/etc NSP = net sales proceeds = GSP - sales and closing costs (estimate 7% total sales costs => NSP = GSP * 0.93) LTCG = (taxable) long term capital gains = NSP - ACB
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 (or later, age 72.0) 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.
I think that at least in the age 59.5 - 70.5 (or later, 72.0) 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:
Warning: The 2017 tax bill removed recharacterization as an option!
Someone asked me how I determined that once you're at least 59.5 there are no longer concerns about 5-year conversion clocks. (Note that the first-rIRA-open 5 year clock still applies.) 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:
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!
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...
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.
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.
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.
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 elaborated previously.
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 (or later, 72.0) 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 (or later, 72.0) it appears you can still do conversions, but only after you take your RMDs first, and you cannot convert those amounts.