Jonathan Guyton is principal at Cornerstone Wealth Advisors Inc., a fee-only advisory firm in Minneapolis.
Retirees increasingly realize the importance of good tax planning to maximize the spending power of savings accumulated over many decades.
After all, mediocre tax planning can have a slew of unintended consequences, including having more Social Security benefits be taxable than necessary, pushing you from the 12% tax bracket into the next bracket (22%), and/or causing a surviving spouse to unnecessarily pay taxes at a much higher rate than he or she ever did as a married couple.
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All told, unnecessary taxes can rob nearly 1% yearly from your investment returns, according to a report from Morningstar.
But the planning for taxes that you may or may not pay on income you have not yet earned can be a difficult exercise. And paying the least amount of income tax in the current year won’t always help you to pay the lowest total tax throughout retirement. That’s because dollars you choose to not have taxed at lower rates today can end up being taxed later at markedly higher tax rates.
What does good tax planning entail? To me it’s about making smart decisions about when tax-deferred assets become taxable. And preparing hypothetical tax returns for different points in retirement can help you identify some potential tax liabilities–and plan for ways to mitigate them.
The first draft tax return should be for the current year. If you are retired but not yet 70-years-old, required minimum distributions (RMDs) from traditional IRA and 401(k) accounts aren’t yet in play, and you may not yet be collecting your household’s full Social Security benefits if you have after-tax brokerage or savings assets from which to draw. Thus, your adjusted gross income (AGI) and taxable income may be much lower than what you’re actually spending.
Let’s say you’re 65, retired and take the standard deduction (for the 2019 tax year, that’s $27,000 for married couples and $13,500 for singles, including additional increases for those 65 and over). If your AGI is below $106,000 for married couples ($53,000 for individuals), then taxable income is below $78,900 ($39,450 for individuals). At these levels, the tax rates on your taxable income is 12% or less. That’s the lowest in the tax code.
We will assume that you’re at these attractive lower rates, at least for now. Ordinary income above these levels is taxed at 22% or higher.
Next, we’ll fast forward to the year you turn 70 1/2. This is the time you must start taking RMDs and you also will be collecting Social Security benefits. Complete another draft tax return for this period. Your adjusted gross income and taxable income are almost certainly higher now–and will be hereafter.
Consider how these new income sources affect how much of your Social Security benefits are taxable. If your taxable income exceeds $168,400 ($84,200 for singles) in this second phase, you’re now in the 24% federal bracket.
Lastly, draw up a tax return after a major life change. For this example, we will assume that one spouse has died and the return will be for the surviving spouse. The surviving spouse’s Social Security income will decline, but RMDs don’t. The key here is that the retiree’s filing status becomes “individual,” causing a cruel tax increase. If taxable income exceeds $160,700, the survivor is now in the 32% bracket. Ouch.
While not an exact science, these analyses have clarified potential problems–while you still have the time to do something about them.
In the example above, for instance, since some future income will be taxed at a rate of 24% to 32%, it makes sense to do annual Roth IRA conversions to fill the 22% bracket before your first RMD year arrives. This will lessen both future RMDs taxed at 24% and income taxed at 32% to the survivor.
Then, you could shift your overall portfolio assets to “locate” equities/stocks in your Roth account(s), where they grow tax-free. (That means your traditional IRA will have a higher percentage of bonds because some of its equities are now in the Roth.) With a bigger bond/fixed-income portion in remaining pretax assets, their growth rate will slow, which further lowers future RMD amounts.
Mr. Guyton can be reached at reports@wsj.com.
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