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Timing Those Taxes

Adam M. Grossman

TYPE THE WORDS “safe withdrawal rate” into Google and it’ll return more than a million results. I’m not surprised by this. People debate practically everything in personal finance, but the debate around this question is particularly intense.

For at least 25 years, the conventional wisdom has been that it’s safe for retirees to base portfolio withdrawals on the 4% rule. But not everyone agrees. Some feel that percentage should be higher, while others feel it ought to be lower. This debate is ongoing, as evidenced by the number of Google results.

While this question is important, it gets so much attention that it sometimes feels like it’s the only question. In reality, it’s just one piece of the retirement puzzle. Managing taxes is, in my opinion, at least as important and, for many high-net-worth families, it’s much more important. As you plan for retirement—or if you’re already there—below are some key tax concepts to keep in mind.

For starters, think long term. Because taxes are levied on a year-by-year basis, most of us tend to think about taxes on that same year-by-year basis. But when you’re making a retirement plan, you want to think about it differently. Instead of trying to minimize your tax bill in any given year, make decisions with an eye toward minimizing your total lifetime tax bill. This is a theme that runs through many retirement income strategies, including those described below.

That brings us to required minimum distributions (RMDs). They’re a perfect example of why it’s useful to take a multi-year perspective. Under current rules, withdrawals from tax-deferred accounts must begin at age 72. These withdrawals start at a seemingly modest 3.9% of the value of your tax-deferred savings. But if you have substantial savings, that can translate into a big dollar figure. And that percentage increases each year as you get older. This can be a challenge because every dollar that comes out of a tax-deferred account is taxable as ordinary income.

As a result, some retirees find themselves back in the high tax brackets they thought they’d left behind. This isn’t true for everyone, though. It depends on the size of your account. That’s why the first step I recommend is gauging your future RMDs. The key question to ask: Will my future RMDs be less than or greater than my living expenses? The IRS provides a complete RMD table. But as a shortcut, use 5% as a litmus test. If you think your living expenses will be more than 5% of the value of your tax-deferred accounts, then RMDs likely won’t be a problem.

But if it looks like your RMDs will substantially exceed your living expenses—in other words, if your RMDs will result in unnecessary taxable income—then these four strategies might help you keep a lid on them:

No. 1: Keep working, at least a little. One little-known route around RMDs is to continue working—even part-time—at a company that offers a 401(k) plan. Provided you don’t own more than 5% of the company, any assets in that 401(k) won’t be subject to RMDs as long as you’re still working there. Note that this won’t exempt you from RMDs on other tax-deferred accounts. But you might be able to consolidate assets from those other accounts into your employer’s 401(k) if you want to shield more of your savings from RMDs.

No. 2: Early withdrawals. Suppose you have both a taxable account and a tax-deferred account. Conventional wisdom dictates that you shouldn’t take withdrawals from your tax-deferred account until you’re required to. But research has shown that it’s more nuanced than that.

Suppose you retire at age 65 and defer Social Security until 70. That means your tax rate will probably be quite low for the first five to seven years of retirement—before Social Security and RMDs start. In situations like that, high-income folks can see their tax rate drop to surprisingly low levels. After a lifetime of contending with high rates, you might relish that newly low rate. But this is a good example of when you’d want to take a longer-term perspective.

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Counterintuitive as it might seem, it can be worth taking withdrawals from your tax-deferred accounts during these low-income years, even though you aren’t required to. Yes, you would be intentionally driving up your tax rate in those years. But it could be a smart move if it helps lower your tax rate later on.

A further note on this: Even if you don’t expect to have an RMD problem, it’s worth considering taking distributions before you’re required to. That’s because the key principle here is to try to even out, as much as possible, your tax rate during retirement. And remember that your tax bracket is just one part of the tax burden facing retirees. Medicare’s IRMAA surcharges aren’t called taxes, but they effectively are. They can add more than $5,000 per year for those with high incomes—and twice that if you’re married. This is another reason to try to keep your tax rate as steady as possible in retirement.

No. 3: Roth conversions. As I described back in May, Roth conversions carry many benefits. Among them is the potential to lower RMDs and the resulting impact on your taxable income.

No. 4: Charitable gifts. If you have charitable intentions, you can avoid taking your RMD—or part of it—by sending it directly to a charity. This is called a qualified charitable distribution (QCD). You won’t receive a tax deduction for this kind of donation, but it will satisfy your required minimum distribution. QCDs are capped at $100,000 per year.

If this all sounds complicated, I don’t blame you. But as the old saying goes, don’t let the perfect be the enemy of the good. I recommend sketching out a long-term plan and then revisiting it each year. Every October or November, sharpen your pencil, especially if you’re considering a Roth conversion or early IRA withdrawals. That’s when you’ll have a good sense of your other income and can decide how much to convert or withdraw to hit your tax target for that year.

What does this all mean if you’re currently in your working years? Conventional wisdom says that you should do everything you can to look for tax breaks during your peak earning years. I mostly agree with this. But as we all know, Congress can change the rules at any time. In fact, the politicians are debating another round of tax changes right now. For that reason, it’s a good idea to try to balance your savings among taxable, tax-deferred and Roth accounts. In other words, don’t bend over backwards to cram every last dollar into a tax-deferred account. Sure, this means you might pay a little more tax this year. But in return, you could gain valuable flexibility down the road.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. In his series of free e-books, he advocates an evidence-based approach to personal finance. Follow Adam on Twitter @AdamMGrossman and check out his earlier articles.

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Greg Geisler
Greg Geisler
2 months ago

PS I apologize that I accidentally went thumbs down on one person’s comment. I meant to do a thumbs up and I could not change it after I accidentally hit thumbs down. Professor Greg Geisler

Greg Geisler
Greg Geisler
2 months ago

Great article Adam! Thanks for getting this important topic into the mainstream.
After retiring from full-time work and before beginning Social Security benefits are the “golden years” for income tax planning. Taking advantage of low tax rate brackets—instead of trying to minimize tax each of those years—is a great strategy to increase wealth in the long run!
Always enjoy reading your articles. Best, Professor Greg Geisler

Olin
Olin
2 months ago

Well said Adam! What is your position on educating younger working people vs those that have just retired and now on SS and RMDs just around the corner?

Bill Kosar
Bill Kosar
2 months ago

Adam’s comments are excellent. A key point to consider is the value of steady annual conversions (of modest amounts) from IRA accounts to Roth accounts. If you can do this and pay the conversion taxes with available cash (to maximize the amount put into the Roth) you will benefit in the long run due to tax free earnings in the Roth and lower forced RMDs.

I played with this in a spreadsheet for a few days and discussed with my accountant who totally agreed with the strategy. I hate paying extra tax today due to the conversions but in the long run I will pay much less tax.

corrupt
corrupt
3 months ago

Agee with transfer while you can. I retired at 58 and have been converting to my Roth (without claiming SS) just enough to keep out of the next tax rate. (UN)fortunately, with the market the way it is, the value of my IRA has not diminished. I guess I could have worse problems.

John M
John M
3 months ago

I’ve suddenly reached a point where cash flows no longer needs prioritization. Roth conversion analyzers have indicated that there’s no value in converting from traditional, and our income is still high, so no Roth conversions for now… but I’m curious. There is tax diversification to consider, at the very least, and it seems I can diversify at no marginal cost (unless future marginal rates decline). Roth 401k it is, then.

Last edited 3 months ago by John M
OUTinMinnesota
OUTinMinnesota
3 months ago

Hats off to Adam Grossman! His message needs repeating:

Instead of trying to minimize your tax bill in any given year, make decisions with an eye toward minimizing your total lifetime tax bill.

In the last few years before retiring, it’s a good idea to begin strategizing for decumulation. All four of Mr. Grossman’s recommendations invite us to plan for the stage-of-life when we tap into retirement savings – four recommendations that get us ready to eventually begin decumulating.

In a recent financial conversation, I unsuccessfully tried to express this point about developing a strategy for controlling a total lifetime tax bill. After all, when someone understands the importance of minimizing investment expenses (during the accumulation stage), I kinda expect them to also understand the importance of minimizing tax expenses (during the decumulation stage).

I’ll say it again. Adam Grossman’s message needs repeating:

Instead of trying to minimize your tax bill in any given year, make decisions with an eye toward minimizing your total lifetime tax bill.

Last edited 3 months ago by OUTinMinnesota
Rick Connor
Rick Connor
3 months ago

Adam, this is a very good article on a tough topic. I got a great taste of this helping manage my in-laws money in their last decade. The best thing I learned is that taxes aren’t just something you pay at the end of the year – you can plan, at least to some degree, what and how much taxes to pay. The last two paragraphs are the real gem – do a late year assessment and make decisions as available and appropriate for your situation and the current tax code.

Adam Grossman
Adam Grossman
3 months ago
Reply to  Rick Connor

Thanks, Rick. I agree. I’ve found that many people don’t give a lot of thought to how their investments affect their taxes because of the time lag. A decision in January of one year might not be paid for until April of the following year. So people rarely make the connection between investment choices and the resulting taxes due. A small amount of planning, though, can go a long way.

wtfwjtd
wtfwjtd
3 months ago

Retirement taxes is a subject I’ve been studying carefully these last few years, and I’ve come to realize a few (unpleasant) things. For those of us who’ve spent the bulk of our working careers in the bottom two or three brackets, that tax “savings” realized by putting money in a traditional IRA or 401K is mostly an illusion. Sure, if you didn’t manage to save much, it won’t make much difference either way. But if you have been diligent, and managed to put away a reasonable amount, and have had even modest success as an investor, come retirement time you will be rewarded for your efforts with a tax bracket that’s at least as high and many times significantly higher than when you were working. Turns out, when forced to take those retirement account distributions, wanted or not, needed or not (via that poison pill known as RMD’s), many savers are “rewarded” with permanently reduced Social Security payments via higher taxation, and those nasty Medicare IRMAA charges can add further insult to injury. It’s that marginal tax rate that’s so important, and for many who faced a 12 or 15 percent bracket for most of their income during their working years, this can soar to 22 or 25 percent (or more, depending on the whims of Congress). Those Roth accounts (and conversions) start looking pretty good, once this is realized. But alas, now it’s *too late*, and those high tax rates are baked in the pie.
If only someone would have told me…but I doubt I would have listened, as minimizing the current year’s tax bill is so ingrained in us that we have a very hard time thinking tactically and long-term as Adam is so wisely advising here (especially when we are younger!). Deferred accounts for many working people are a hoax, a cruel lie that will force them and/or their families to pay big tax bills when they can least afford to do so, in their late retirement years. I can’t believe that I am actually expressing such heresy out loud, but hey, somebody needs to do it, lol. Anyway, FWIW, think it’s much better to pay that tax bill in smaller increments during our working years, than delay it and pile it all up on ourselves late in our retirement years. Because as far as I’m concerned, that’s basically all our traditional retirement accounts are good for.

Ginger Williams
Ginger Williams
3 months ago
Reply to  wtfwjtd

The immediate tax savings helped lure me into increasing my retirement savings regularly, as I didn’t want to move into a higher tax bracket. If I had understood earlier how tax brackets worked, it might not have worked. But it did work, with the added advantage of encouraging me to keep my standard of living reasonable so I could save and invest.

A wise older friend told me several decades ago to make a point of learning a little more about personal finance every year. She pointed out that not only do rules change, but my interests would change, making different areas more understandable as they became more relevant. Being within five years of retirement makes retirement cash flows and taxes fascinating.

wtfwjtd
wtfwjtd
3 months ago

Agreed, I was probably a little harsh with my last statement. As you rightly point out, that initial tax deduction can be a motivator to actually put some money away for retirement, which in and of itself is very worthwhile. I still think we’ve greatly over-sold the idea of “tax savings” and their ultimate value for retirement accounts over the long haul, but I guess if that’s what it takes to get us to save…and your friend is spot-on–the more we know, and the earlier we know it, the better off we are going to be.

Ginger Williams
Ginger Williams
3 months ago

I recently laid out my expected cash flow in retirement and realized I may move into a higher tax bracket. Currently, half of my salary is on a pre-tax basis, but when I retire in a few years, I’ll lose that advantage. I planned to be able to replace my gross income, plus a little extra as an inflation safety cushion, using a mix of defined benefit pension, social security, and 403b income.

I’m pleased that I’m on track to have monthly income in retirement greater than my gross salary, but dismayed at the prospect of moving into a higher tax bracket. Thank you for identifying options to avoid moving into a higher tax bracket due to RMDs. I can probably manage Roth conversions before starting social security, but will need to time them carefully.

Ormode
Ormode
3 months ago

As I retiree, you won’t have to pay FICA, saving you 7.65% in tax right off the top.

Ormode
Ormode
3 months ago

Yes, if you have $5 million in your IRA, you first RMD at age 72 will be $195,000. Yes, you’ll pay tax. Retirement accounts are meant to allow you to retire, not to protect huge amounts of capital and income from ever being taxed.
Consider the alternative – you are 72 and have $10,000 in your IRA. Sure, you don’t pay any tax, but you have no money either.
I don’t know about you, but give me the $5 million and I’ll gladly pay the tax!

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