If you’ve just retired, it’s not too late to implement planning strategies that can significantly reduce retirement taxes and taxes on what you leave to your heirs.
A seven-part series I recently published on Kiplinger.com on “Tax Bombs for Retirement” was a huge hit with readers. I have heard directly from many of you, who have expressed that you are still concerned about these issues but have never heard anyone discuss them or give practical advice.
If you haven’t read the series, I suggest you start with Part 1: Is Your Retirement Portfolio a Tax Bomb? You can find links to the other parts of the series at the bottom of this article.
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Many investors have expressed concerns that because they have already retired, it is too late to do anything to defuse their retirement tax bomb. However, while the first of the three strategies I’m talking about, transferring Roth pension contributions from pre-tax to after-tax, is no longer available to you, the remaining two strategies, asset location and annual Roth conversions, the are probably and could be worth implementing. .
Let’s look at a case study of a married couple who just retired at age 63. They have a total investment portfolio of $3 million, of which $1.5 million is tax-deferred, $1 million is taxable, and $500,000 is Roth. Their investments are not localized, with the same asset allocation in each tax bracket. I assume expected returns of 4% for bonds and 9% for stocks. They are invested in a conservative growth portfolio with an allocation of 60% equities and 40% bonds which has an expected annual return of 7%.
They each plan to file for Social Security at age 67 with a combined benefit of $68,000 and a 2% annual cost-of-living adjustment. They have no other sources of income.
Let’s first look at what their current retirement tax bomb looks like.
In early retirement, they will cover their expenses through dividend income and long-term gains on their taxable investments.
The base case: a big RMD problem
They are expected to have over $3.6 million in required minimum distributions (RMDs) through age 90. Remember that RMDs are taxed as ordinary income. Below, you can also see their annual RMDs at certain ages, their taxable income based on RMDs and Social Security earnings, and their projected federal tax bracket using current tax tables.
(Image credit: David McClellan)
They should also have $78,000 in health insurance, which means testing the supplements until age 90, which isn’t bad, but remember you can consider them avoidable taxes with good planning.
The couple’s children are expected to inherit $3.7 million in tax-deferred assets by the time the couple turns 90. Children will have 10 years to completely empty inherited IRAs, with all distributions taxed as ordinary income in children. marginal tax rate.
Finally, remember that their Roth IRAs will not be affected at the start of retirement to allow the tax-free account to grow as much as possible. Assuming no withdrawals from Roth accounts are made until age 90, their tax-free Roth money grows from $500,000 to over $3.3 million, although they can certainly make Roth tactical withdrawals in some years to reduce taxes (for example, to avoid bracket creep).
So what do you think of their situation? It could certainly be worse, and at least they stay in a reasonably low 24% tax bracket for most of their retirement. But could they significantly improve their situation by implementing asset tracking and annual Roth conversions? Let’s see.
Scenario 1: Implement asset location
“Asset location” is about placing your assets where they will do you the most good, specifically:
- Placing asset classes with lower expected returns (think bonds and dividend stocks) in tax-deferred accounts to limit their growth.
- Placing asset classes with the highest expected returns (think small-value and emerging-market stocks) into Roth accounts so tax-free money grows the fastest.
- And put asset classes that derive much of their growth from capital gains (think growth stocks) into taxable accounts.
Using asset location, we plan to place 100% of their bonds in their tax-deferred accounts, which will generate a 5% lower expected return than the 7% assumed in the base case. Let’s look at the impact.
(Image credit: David McClellan)
Until age 90, their total taxable RMDs drop by more than $1.1 million and they are in a lower federal tax bracket for many years. Additionally, the tax debt passed on to their children is reduced by more than $1.5 million, and the $78,075 from Medicare means that testing surcharges have been eliminated.
In the meantime, suppose they can continue to live off Social Security, RMDs, and collecting earnings from their taxable accounts so that they don’t need to withdraw money from their Roth accounts. Assuming the Roth accounts are assets located to hold more aggressive investments with an expected return of 9% instead of 7% from the base case, their Roth accounts reach $5.6 million at age 90, or an increase of more than $1.5 million over the base scenario. .
These are some pretty impressive benefits of simply implementing asset tracking.
Scenario 2: Implement asset location and annual Roth conversions
Now let’s add the annual Roth conversions to the strategy. Remember that Medicare means testing starts at age 65, but it’s based on income for the previous two years (two-year retrospective) and plans to take Social Security at age 67. Let’s expect annual Roth conversions of $150,000 from ages 63 to 66, then $75,000 per year from ages 67 to 71, for a total of $975,000 in Roth conversions. These amounts are low enough to avoid any further Medicare means-testing surcharges, although some investors may find it may be worth triggering a few years of means-testing to convert more to Roth.
Let’s look at the results compared to the base case. Until age 90, their taxable RMDs drop from $3.6 million to $1.1 million, a reduction of $2.4 million. Plus, they stay in the 22% tax bracket for at least 10 more years, so they enjoy both lower taxable income and lower tax rates in most years.
(Image credit: David McClellan)
Meanwhile, the tax debt inherited from their heirs drops from $3.7 million to $1 million, a reduction of $2.7 million.
Finally, thanks to early-retirement Roth conversions and nearly 30 years of compound growth, tax-free Roth money reaches $14 million.
An additional consideration to keep in mind is what may happen to future tax rates. Current tax rates are near historic lows and could be the lowest we will see for the rest of our lives. Consider solvency issues with Social Security and Medicare, chronic infrastructure problems, exploding deficits, climate change and pandemics. Each of these issues, taken in isolation, will require a lot of money. And that doesn’t even take into account the income and wealth redistribution agenda pursued by some in Congress.
Simply put, paying taxes today can be a bargain compared to deferring (and increasing) your tax liability in the future.
I hope this article shows that even if you’ve recently retired (or are about to retire), you can still implement planning strategies that can significantly reduce your retirement taxes and income. tax payable that you leave to your heirs.
Here are the links to previous articles in the series:
This article was written by and presents the views of our contributing advisor, not Kiplinger’s editorial staff. You can check advisor records with the SEC (opens in a new tab) or with FINRA (opens in a new tab).
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