Monday, October 28, 2013


Tonight (October 28) at 8:00 PM Eastern Time, I will be a panelist on the Wall Street Journal spreecast discussion on "How to Minimize Your Taxes in Retirement."

As taxes is not one of my stronger areas, and as the individual who developed many of the theories about tax-efficient retirement income is a fellow panelist, I've been spending the day studying taxes in retirement.

The primary resource I have been using is Dana Anspach's excellent book, Control Your Retirement Destiny.

What follows are some notes I've made for myself today regarding taxes in retirement.

Notes on a Tax-Efficient Retirement

The complication is that you want to choose a strategy which will save you the most taxes in the long-run, or more precisely- provide you with the most spending and wealth over the lifetime, as opposed to what might minimize taxes in any one particular year. But this requires planning on a lifetime basis. Generally, the optimal solution will involve smoothing year-by-year taxable income, as this is the best way to deal with the progressive tax system. Tax planning should be thought of with regard to: State and federal taxes, AMT, 3.8% Medicare surtax, means-tested Medicare Part B HI premiums, and estate planning when relevant.

Tax Basics 

It is important to think in terms of the marginal tax rate applying to each dollar of income. With exemptions and deductions (or more with itemized deductions), individuals can have 10k and joint 20k before taxes begin, and this amount is a bit more for those over 65. Then, the 10% marginal tax rate applies for taxable income up to about 9k for individuals and 18k for married filing jointly. The 15% marginal tax rate applies for the next portion of taxable income up to 36k for individuals and 72.5k for married filing jointly. Up to this level, as well, the long-term capital gains tax rate is 0%.

In considering a contribution to a tax-deferred account vs. a Roth account: compare potential tax savings today in terms of marginal tax rates, vs. likely tax rates that would be applied in the future.

If tax rates will go down later on, which would probably result from someone being in a lower tax bracket post retirement, then tax-deferred may be better. Concerns that the government will raise tax rates will make Roth accounts look more attractive.

Social Security Benefit Taxation: 
First calculate combined income:

Combined income = AGI + nontaxable interest + ½ Social Security benefits

Individuals: 25k – 34k, tax on up to 50% of benefits; more than 34k, tax on up to 85% of benefits

Joint return: 32k – 44k, tax on up to 50% of benefits; more than 44k, tax on up to 85% of benefits

Tax-deferred withdrawals: affect Social Security tax, Roth withdrawals: do not affect Social Security tax

Worth repeating: Tax-deferred withdrawals have the disadvantage of making Social Security benefits taxable as well, unlike Roth accounts

The “tax torpedo” is that RMDs from tax-deferred accounts could have a double impact of also causing more of the Social Security benefit to be taxable, which effectively pushes the marginal tax rate up for tax-deferred withdrawals.

Delaying Social Security also has tax implications, and for many people the implications may be advantageous, especially if retirement income will be around 90k or less. The idea is to delay Social Security and spend down the tax-deferred assets (or convert them to a Roth) before Social Security begins in order to reduce the “tax torpedo” effect of IRA withdrawals. As well, greater Social Security later on will reduce the need for selling assets and therefore the need to pay taxes after 70.

Roth Conversions

If one retires before 70, delaying Social Security + Roth conversions could be a good strategy as income will otherwise be low in these years. One could also look at Roth Conversions from 65 to 70, may benefit from period certain income annuity with exclusion ratio, defer Social Security, no work income, and focus on reducing the tax-deferred accounts.

Do tax projections before the end of the year and think about matters from a lifetime perspective

Roth conversions: pay tax on traditional account to move over to Roth, but this can be beneficial in years when marginal tax rate is low. In other words, convert enough to fill up deductions and potentially even the 10% and 15% tax brackets

Take IRA withdrawals as needed to fill up deductions, 10% or even 15% tax bracket

Roth IRA: no RMDs, income doesn’t affect Social Security benefit taxation or Medicare Part B premiums, and efficient from estate tax planning perspective

Asset Location 
Taxable accounts: Assets with qualified dividends and long-term capital gains

Tax-deferred: assets with interest payments and non-qualified dividends taxed as ordinary income.

Marginal tax rates apply to interest income and qualified dividends, and long-term capital gains and qualified dividends are taxes at a lower rate

Current considerations with interest rates so low, that there may be less taxable income

If interest rates rise, holding bonds to maturity in tax-deferred accounts may benefit from reducing the value of bonds to reduce RMDs

Intelligent Withdrawal Sequencing 
Conventional Wisdom: Withdraw from taxable accounts first, then tax-deferred, then tax-free

Inefficient investing during retirement: “return drag” from paying taxes versus delaying payment

Conventional wisdom is usually fairly appropriate, with the caveat that everyone’s situation is different, and also that it can be beneficial to take from tax deferred accounts up to deductible amounts

In a worst case scenario for market returns, it may be beneficial to delay taxes as long as possible, i.e. no Roth conversions. But this point requires more research

Blanchett and Kaplan find, with many stylized assumptions, that retirement income can be increased by over 8% with a tax-efficient strategy compared to a tax neutral strategy with everything divided equally between location and withdrawal sequence.

Managing Capital Gains 
There can be benefits both from capital gains harvesting and from capital loss harvesting

3.8% Medicare Surtax 
Applies to singles with MAGI of 200k and more, or joint with MAGI of 250k or more

Tax is applied to investment income in excess of this amount (but not municipal bonds)

IRA distributions (or Roth conversions) are not directly subject to this tax, but they can push up MAGI and leave more investment income from other sources subject to this tax

Impacts: municipal bonds are more attractive, Roth conversions may be more attractive

Health Savings Accounts 
Only apply to certain high-deductible health plans, but also provide a tax-deferred vehicle which is tax deductible and comes out tax free for eligible medical expenses. Up to $6450 for families


  1. One point you mention briefly, but that I think deserves a bit more attention. I know a number of people who seemingly hate taxes so much that they would rather earn $3,500 tax-free than earn $5,000 and pay $1,000 in taxes, even though that would leave them with more money to spend. I wish that there were some way to move the emphasis from "minimize taxes" to "maximize after-tax income".

    1. Right, a lot of people may refer to these interchangeably, but there are cases where they do not mean the same thing. It's important to remember that the focus should be on getting the most after-tax income.

  2. These insights and thoughts are wonderful. Thanks, Wade.

    A couple of additional things to think about:

    (1) How does one plan for the possibility of additional "means testing" of Social Security benefits? And how much of a benefit cut could be involved? During the recent government shutdown, 50 House members signed a letter calling for this "means testing" without specifying any details. It makes a huge difference for tax and asset allocation planning purposes if this testing would apply to all non-SS income, all assets, all tax-deferred retirement assets, all retirement accounts (including Roths), etc. Any thoughts?

    (2) I have some bonds in a regular IRA that I plan to hold to maturity many years from now. I am looking forward to the prospect of interest rates going up before converting these holdings to a Roth IRA so that I am taxed on a smaller mark-to-market valuation (even though the conversion would be "in-kind," with no selling involved).

    1. Thanks.

      It's hard to imagine that Social Security would ever become means tested, as that would turn it into a welfare program, directly violating the original tenet behind its creation.

      But one reform I could envision is having Roth IRA withdrawals included in the provisional income used to determine how much of the Social Security benefit is taxed. Most people wouldn't understand the implications of that reform, though it would certainly enrage anyone who had been making Roth conversions in part to avoid this "tax torpedo."

  3. Look. If I've got more money to spend as a retiree, even after paying more taxes ( as is the case) I don't whine. I wine and dine! Bob U.

  4. This is such a very informative post. I really didn't know that if one retires before 70 years old, delaying social security + roth conversions then it could be a good strategy as income will otherwise be low in these years. Thank you very much for sharing this post.

  5. Informative and helpful post. after a retirement a man became helpless if he has no extra money . So that after retirement they have to choose a retirement plan .
    Thanks for such as an informative post .
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