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Retired Investor

Keep Taxes From Cracking Your Nest Egg

Selectively choosing which accounts to withdraw from can minimize taxes throughout all your retirement years.

by Stephen M. Horan | May 2016

Retirees, have you ever wondered if there was a tax-efficient way to tap the variety of accounts your nest egg is invested in? There is. The conventional wisdom tells you to liquidate your taxable accounts first, then your tax-deferred accounts (like traditional IRAs) and finally withdraw money from your tax-free accounts (like Roth IRAs). However, there is a better way.

Odd as it may seem, minimizing taxes in any given year is not your real tax-efficiency goal. It’s to manage your taxable distributions so that you minimize taxes throughout all of your retirement years. That may mean paying a little more in taxes now in exchange for saving even more on taxes in the future.

If you only had tax-deferred and tax-exempt accounts, if tax rates never changed and if you faced a flat tax, the sequence in which you tapped these accounts wouldn’t matter. Life would be easy, but the world is not that simple. For example, in the current U.S. progressive tax rate system, marginal tax rates start at 0%. The next two tax brackets are at 10% and 15%, which are both modest.

“Yes, but those tax brackets are only for very low-income taxpayers,” you may say. Not so fast. A married couple filing jointly in 2016 taking only the standard exemptions and deductions available to everyone can recognize $96,000 of income before their marginal tax rate exceeds 15%. Married retirees over the age of 65 are entitled to an additional standard deduction of $2,500, increasing the 15% tax bracket threshold to $98,500.

That’s quite a bit of taxable income that could be subject to a modest 15% tax rate. It provides a lot of opportunity to take IRA distributions that are taxed relatively lightly. Failing to fill up these tax brackets with low-taxed income leads to missed opportunities that push retirees into higher tax brackets in future tax years.

The Low Tax Bracket Strategy

How do retirees fill up low tax brackets? The trick is to tap your traditional IRA or other tax-deferred account first (instead of your taxable accounts) until you’ve either met your desired annual withdrawal or until your low tax bracket is filled up, whichever occurs first. Be sure to account for any pension benefits or other taxable income to make sure you don’t exceed the bracket’s limits by very much.

If you’d like more retirement income, tap your standard taxable accounts next. Repeat these steps year after year until your taxable account is close to being fully depleted. Once it reaches this point, begin using your Roth IRA to top off your taxable distributions.

What is considered a low tax rate? The answer depends on the investor. A retired couple with $1 million in a traditional IRA and $700,000 in a Roth IRA, for example, would generally find it advantageous to fill up their 15% tax bracket. A couple with $2 million in a traditional IRA and $1.5 million in a Roth IRA would generally find it advantageous to fill up the 25% tax bracket as well.

This is a relatively easy and simple withdrawal strategy that can add up to 10 years to portfolio sustainability or hundreds of thousands of dollars of ending wealth over the span of 25 years.

Taking Advantage of Roth IRAs

Those who are interested in being a bit more sophisticated could take advantage of the Roth IRA conversion rules.

Taxpayers are entitled to convert traditional IRAs to Roth IRAs if they pay tax on the converted amount. If the account drops in value, taxpayers are allowed to re-characterize and switch the Roth IRA back to a traditional IRA by April 15, or October 15 if they file an extension.

If retirees decide to forgo the simple withdrawal strategy in favor of converting their traditional IRA every year and re-characterizing it if goes down in value, they can add another year or so of portfolio longevity. Doing so requires a lot of diligent attention to deadlines, however, and mistakes can be costly. So, it’s not for the faint of heart.

You can put this strategy on steroids by breaking up your IRA accounts into a series of smaller IRA accounts populated with uncorrelated assets. At the end of the year, keep the conversion for those assets that increased in value and re-characterize those assets that dropped in value. This will keep you and your broker pretty busy with a lot of paperwork, however.

Be very careful about blindly following any advice without an adviser because your situation is no doubt unique. An experienced adviser can help design the strategy, navigate the deadlines and manage the tax brackets.

Discussion

Bruce B from WA posted over 10 years ago:

this article doesn't mention the advantage of 0% capital gains tax for taxpayers in the 15% bracket. Taking capital gains in taxable accounts while staying within the 15% bracket can gains tax-free and save taxes over the long term.


Walter Curtis from WA posted over 10 years ago:

I rarely see anything that takes into account the increasing amount of taxable social security caused by withdrawing from IRA accounts. You can end up actually costing as much as 22% in taxes, not 15%. This is a problem with so-called Tax Free income as well. I am continually PO'd about the requirement for RMD that causes me to pay on more of my SSA.


Doug Peterson from CA posted over 10 years ago:

Please elaborate on the following point: A married couple filing jointly in 2016 taking only the standard exemptions and deductions available to everyone can recognize $96,000 of income before their marginal tax rate exceeds 15%. Married retirees over the age of 65 are entitled to an additional standard deduction of $2,500, increasing the 15% tax bracket threshold to $98,500. The 2016 tax rates table lists $75,300 as the top of the 15% bracket for married filing jointly. Some explanation is required.


K Zetterholm from WV posted over 9 years ago:

I would like to see a future article addressing the Roth conversion decision in depth. This is not a trivial decision due to: A. Conversion is seldom worthwhile unless the taxpayer has assets outside of qualified retirement accounts with which to pay the conversion taxes. B. The opportunity cost of using the above funds to pay taxes before required; especially, if those funds are invested in a way that would incur only long-term capital gains taxes when liquidated in the future. C. The effect of RMDs and conversions on Medicare premiums and the taxation of Social Security benefits. D. If item A above means that conversions must be performed over a period of years, is there an optimal pattern of conversions.


Robert Lassiter from IL posted over 9 years ago:

I'd like to evaluate the pros and cons of making charitable donations from the RMDs. If I take the RMD as a taxable event, I increase the AGI which can increase Medicare taxes, but then I can itemize the donations on Shed A. If I donate directly out of the IRA RMD, I don't increase the AGI and Medicare taxes, but can't itemize the donation. There has to be break points in this planning.


Burt Loper from FL posted over 9 years ago:

If you are going to itemize deductions even without any charitable deductions (e.g. still have high mortgage interest), then it doesn't matter which way you go except for the fact that your Medicare premiums could be higher (due to a higher AGI). If you would not itemize without your charitable deductions (e.g. no mortgage interest), then the Qualified Charitable Distributions (i.e. part of your RMD to one or more charities), then this will be the best.


Norma Pappalardo from FL posted over 9 years ago:

I have used a variety of strategies to lower my RMDS and keep myself in the 15% tax bracket. My problem was having done too well managing my IRA through the years. I took 125K from my IRA (maximum allowed) and bought 3 single payment annuities maturing when I am 82, 83, & 84. Each year I also make all of my charitable donations out of my IRA, this brings the IRA down more, but doesn't increase my income for tax purposes.


V.L. Genez from SC posted over 9 years ago:

For a retiree with qualified dividend capital gain income, the 15% tax bracket is really a 30% bracket. For every additional of income, you are paying a 15% tax, plus you are paying another 15% tax on a dollar of capital gain. This I s higher than the next bracket, which is 25%.


Paul from az posted over 6 years ago:

As I am finding right now, the increase in Medicare B and part D premiums is very considerable also. And one dollar over a threshold can cost hundreds of dollars in additional premiums - for most tax bracket thresholds you get to keep at least some of the overage - for medicare you can lose big time over a single dollar.


Tom B. from Delaware posted over 6 years ago:

The information in this article may be outdated with respect to the recharacterization of Roth conversions. Also, I agree with the comment above about Medicare Part B and D premiums. I have been clobbered by increases since I started taking my RMD distributions.


Dan from CA posted over 6 years ago:

This article is before the "Tax Cuts and Jobs Act" of 2017 which banned the recharacterization of Roth conversions. Check with your tax adviser.


Steven from California posted over 6 years ago:

Wonder why AAII is posting an outdated article from 2016 which does not reflect the new 2017 tax act ??? It would be more helpful to have an updated article with similar emphasis but reflect the current federal tax law.


Kurt from Iowa posted over 6 years ago:

Please pull this article until it is updated. A ten-second review shows that much of the content is now incorrect. I expect better from AAII.


Armand from Armed Frcs Europe posted over 6 years ago:

Agree with recent posters. Article is so outdated as to be useless. C'mon, AAII, you can do better.


Alan from Georgia posted over 6 years ago:

I expect more of AAII. Currency as well as completeness (impacts from/to SSA, RMDs, capital gains, Medicare premiums as examples). Please get your stuff together, folks.


Bruce from Texas posted over 6 years ago:

If I can't trust you with simple stuff like tax bracket goals (25% bracket no longer exists) and IRA conversion strategy (re-characterization no longer exists), how can I trust you with complicated stuff?


DLW from MN posted over 6 years ago:

Agree with a bunch of folks, this article is actually more like a way to sabotage your retirement strategy. Right now we are re characterizing (Tax protected) into Roth IRA's pulling the taxes forward, as some folks have noted, the RMD's get higher as you get older, which has the potential consequences of higher Medicare premiums as well as higher tax brackets. And there is another twist, thinking about leaving some cash for the kids looks like it is going to be more difficult as the latest budget suggests the distribution time periods will be shorter. In short another reason to convert tax sheltered into a Roth early rather than late. At least that appears to be the strategy of the week, lets see what the DC folks do next week!


A.D from New Hampshire posted over 6 years ago:

Outdated article... Bad advice... As others have posted - this should be pulled and a new article penned. Merry Christmas


s j h from co posted over 6 years ago:

I agree with all the recent posts - days, not years. Article extremely stale. Please post more timely info.


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