How to Retire: Prioritize Tax Planning in Retirement

Christine Benz: Hi, I’m Christine Benz from Morningstar and welcome to the How to Retire podcast. It’s a companion to my book, which is also called How to Retire. Each episode will provide a bite-sized lesson about how to do some aspect of your retirement well.

Today’s episode will focus on the tricky topic of tax planning during retirement. To tackle this topic, I reached out to Jeff Levine, who is Lead Financial Planning Nerd at Kitces.com, and also serves as Chief Planning Officer at Buckingham Wealth Partners. Jeff is exceptionally good at explaining complex tax matters, so I knew that he would do a great job of delving into this topic.

Jeff, thank you so much for being here.

Jeff Levine: Of course, thanks so much for having me.

Why Tax Planning is Key When Withdrawing From Your Retirement Portfolio

Benz: Well, it’s my pleasure. And you are one of the preeminent tax-planning gurus in the US. So one topic I wanted to discuss with you today is tax planning in retirement. I often hear from financial advisors that they say that this is one of the key areas where they can add value for their clients. But when I talk to individual investors, I sometimes pick up on less appreciation for that. They really think that they’re going to move the needle mainly with investment selection, maybe portfolio construction. So can you talk about that—why tax planning can be so very impactful once people get into that mode where they’re drawing upon their portfolios?

Levine: Yeah, absolutely. I think one of the reasons for that disconnect is that sometimes what people think about as tax planning may not be what the client thinks about as tax planning. In other words, the advisor may look and say, “Hey, I’m selecting investments and putting them in the right account.” And they may be doing that, but the client doesn’t necessarily understand what’s going on there. So there’s sometimes an education element that has to occur here. Other times it’s on the advisor side, where what they’re calling tax planning really isn’t tax planning so much as like selecting tax-efficient investments. Is that tax planning, or is it just being efficient with your investing? I think that’s part of the disconnect, but ultimately, for those who engage in true tax planning, this is really a differentiator because we talk about the burden of healthcare costs in retirement. And every year there are those studies that come out that scare everyone and say, “It’s going to cost you $200,000, $300,000 to pay for your healthcare costs in retirement.”

Well, that may be a high expense, but if you’ve done a good job accumulating assets throughout your life, that may actually pale in comparison to the cost of taxes in retirement. And so it is really important to think about when an individual should be paying taxes, how to try and minimize that, to what extent you can swap ordinary income for capital gains, or how you can benefit from a step-up in basis. There’s a million different ways in which we can try and lower taxes, or at least it seems like it. And every situation is different, which of course is what makes it so complicated, and why it’s often best to have a professional at your side who can help with that.

Will Your Taxes Decrease in Retirement?

Benz: Many people do think that their taxes will go down in retirement. They assume that if they’re no longer earning a paycheck that that automatically will translate into a tax reduction. Can you talk about situations when—and you referenced those heavy savers, people who have been using traditional tax-deferred accounts—can you talk about situations when people’s tax bills actually go up in retirement, and then maybe you can also generalize about situations when taxes do indeed go down when someone’s retired.

Levine: Let’s start with the first of those, which is when taxes might go up. And I think one of the factors that we should really focus on here is not just taxes. To me, we should be focusing on the rate that people pay on their income. And I define rate as more than just taxes. I define rate as any cost that increases as your income increases, or any cost that decreases as your income decreases. So for instance, along with your ordinary income taxes, we might factor, in retirement, Medicare premiums. Now, while someone is working, that’s often not a factor. It doesn’t matter how much you make, because you’re not enrolled in Medicare. But once somebody reaches age 65, and they’re enrolled in Medicare, then that becomes an important factor. And just to complicate things, it actually can affect people beginning as early as 63, because Medicare looks back two years when looking at your income. So let’s say your income tax rate is slightly lower. Maybe you go from a 24% bracket to a 22% bracket. But if there are other costs that come in, like a Medicare Part D premium or maybe increased taxation on Social Security, if your rate goes up, that’s really what people should focus on.

Now, how does that happen? Oftentimes, it’s exactly what we were talking about. It’s people who have done at least what they thought was the right thing during their working years, and they have saved and saved and saved. And they’ve continuously put aside these dollars into these tax-deferred accounts. And at some point, they reach retirement where they’re going to need those dollars, and they begin to take them out either by choice, because they want to and use those dollars for living expenses, or at some point, because of required minimum distributions. And the amount of income that comes out, along with any interest they may have and taxable dividends, capital gain, income, etc., that may very well push them into a higher tax environment than they were while they were working. And that’s why just looking at the totality of one’s lifetime and trying to minimize taxes over a lifetime and not in any one year is really the important part of tax planning.

Now, you also asked about those who may see a lower tax rate in retirement. And indeed, I would say the majority of individuals in our country will have a lower tax rate in retirement. That’s because a lot of people rely primarily on Social Security income. And if there’s no other income, or if other income is minimal, Social Security is entirely tax-free. But again, for those who have done a good job saving and who may have significant other assets, it can go from becoming tax-free to being up to 85% of Social Security can become taxable, further exacerbating an individual’s tax bill in retirement.

Key Tax Strategies for Retirees Before They Have to Take RMDs

Benz: This is obviously an incredibly complicated topic, but I’ve often heard that the postretirement years—say I’ve retired at 65, but before those required minimum distributions kick in, and currently the age is age 73, so maybe I have an eight-year window there—I’ve heard that that is an especially opportune time to get some tax advice and perhaps do some strategies to alleviate tax bills during the whole of the retirement. Can you talk about some of the key strategies that might be worth considering for people at that life stage?

Levine: The reason why those are such key years is because they are oftentimes an individual’s lowest income years in their entire life. Like someone might go from 18 until they’re 65, 66 with a higher income, and then in those years between 65, 66, whenever they retire, and perhaps as late as 70 when they start to obtain Social Security and as late as 73 right now for individuals with retirement accounts when they have to start taking RMDs, those years may be incredibly low income. Now absent any action, an individual might have little to no tax bill in those years. And a lot of times I hear people come up to me and say, “It was great. I retired, and I paid zero dollars in tax last year.” And I look at those people and I say, “I’m so sorry you got such poor advice.” Now, obviously if your income and assets are fairly modest, that’s one thing. But for people who have done a great job saving and who have large IRAs, 401(k)s, taxable accounts with built-in gains, a low income tax year is a terrible thing to waste. I said it before, but it’s worth repeating here: When we’re looking at good tax planning, it’s not trying to create the lowest tax bill in any one year. It is trying to create the lowest lifetime tax bill. And often what that means is perhaps paying tax a little bit sooner, but at a much lower cost as opposed to delaying that ultimate tax bill but having it be much bigger down the line.

So specifically in those, what are often known as, gap years, the years between retirement and when individuals start Social Security and/or required minimum distributions, things like Roth conversions can make a lot of sense, where you’re pulling forward income. You know, the Roth conversion, where you take money from a traditional style retirement account and shift it into a Roth style retirement account where everything can be tax- and penalty-free, that’s sort of like waving the magic wand of taxable income and poof, you show up with income on your tax return. And again, it is accelerating it, but if it’s a low-income year, you’re accelerating at a low rate. Alternatively, sometimes we see individuals who have done a great job saving in their taxable accounts. They have a lot of built-in capital gains. Well, this year, for instance, if you’re a married couple, you can have more than roughly $100,000 of income and still find yourself in the 0% long-term capital gains bracket, which means you can sell some of your appreciated assets, pay a 0% tax, and increase your basis, which makes future sales that much more tax-efficient. So lots of little things that people can examine based upon where they have saved over the course of their lifetime, what their current income is right now, and how large they would project it to be later on in retirement absent any action.

Do Rules of Thumb for Retirement Spending Make Sense?

Benz: A related question is: Many people, especially today, are bringing multiple silos of assets into retirement. So, they’ll have their traditional tax-deferred accounts, usually their company retirement plans, they might have Roth assets, either 401(k) or from their IRA, and then the taxable accounts that you just referenced. People struggle with how to spend from those accounts, and of course it sounds like individualized advice is really important here, but there are these rules of thumb floating around out there that you should start with taxable, maybe move on to traditional tax-deferred, and leave the Roth to last. Can you address that, and maybe address whether you think these rules of thumb make any sense at all?

Levine: I think rules of thumb in general exist because they’re good from a snapshot. They’re great blurbs if you will. If you were to throw something on the back of a book and talk about what the book is in a sentence or two, that’s basically what a rule of thumb is. A common one that a lot of people are familiar with is the “4% rule.” Well, Christine, I know you and your firm do a tremendous amount of work each and every year trying to help inform investors whether or not that 4% is realistic. Is it a nice rule of thumb, yeah. It is not 10%, it is not zero percent. So 4%, it’s ballpark, but it’s probably not the best for everyone who’s listening to us today.

In the same way, thinking about accessing money from a retirement account or in retirement first from your taxable dollars, then from your tax-deferred, and then from your tax-free dollars, that is better perhaps than the opposite, right? Taking your Roth money first, and then your tax-deferred, and then your brokerage account dollars. But it is not a great rule, right? It’s a starting point. And what people should actually do is to try and smooth out income in retirement to the extent possible.

Now, there are a couple of ways to do that. If you need money for living expenses, that can come down to perhaps pulling some money out of your IRA, again, at lower rates to use in order to cover living expenses. But someone else who may have a large taxable account, maybe they have a lot of money in the bank that’s all aftertax, they may be able to use those dollars in the bank account to live on early in retirement, keeping their income very low. Well, what are we going to do with a low-income year? Well, as we just talked about, it’s a terrible thing to waste. So we’re not going to waste it. We might at the same time an individual is living on their bank account money, we might look to convert money from their traditional IRA to a Roth IRA, beefing up that tax-free account, not only for them but also for their heirs. And that’s a lot more important today than it was in the past, thanks to recent changes in the tax law that limit the amount of time a beneficiary has to take money out or so-called stretch distributions.

So there are a lot of factors there. But again, ultimately, if you were to try and create a top-down view, what you’re really trying to do is smooth out income over retirement because we have a progressive tax system. Someone who makes $1 million in one tax year will, all things being equal, pay more money and taxes than someone who had $100,000 of income each year for 10 years. So trying to spread that out smoothly is a rough approximation of what we’re trying to do.

How to Lower Your RMD Tax Bills

Benz: That’s really helpful, Jeff. I wanted to ask about required minimum distributions, which you’ve mentioned a couple of times. Retirees in my experience love to hate their RMDs. I hear a lot of complaining about the knock-on effects for their tax bills once these RMDs go into effect. Maybe you can talk about the strategies that people can use or consider to alleviate the tax bill associated with those RMDs.

Levine: I think we can start at a high level. First thing is, if you have them, you have to take them. The worst thing you could do is not take them because then you’re subject to a penalty. And although that penalty is lower than it used to be, it still can be as high as 25% if you don’t fix it. So that number one is take your RMD if you have to. Now, if we’re looking proactively into the future about how do we minimize these, well, one thing, and I know we’ve mentioned it a couple of times already, but Roth conversions can play an important role here because there are no required minimum distributions from Roth accounts, both from Roth IRAs as well as even from planned Roth accounts now. That also is different than in year’s past. The rules are always changing. And individuals don’t have to take those RMDs from the Roth-style accounts. So if you want to lower your future RMD, you can convert more money today so that your future balance is lower.

Another thing to consider here would be for those who are still working in “retirement.” Retirement used to be an event. It was a moment, a snapshot in time. Today, at least for many people, it’s not an event anymore. It’s a process, a period of time. If an individual is still working and they are past their normal, let’s call it, “required minimum distribution age”–again, today, 73. If the company they’re working for has like a 401(k) or a 403(b) or similar type of plan, that individual may be able to take their outside retirement dollars that are in, let’s say, their IRA from previous work that they’ve done and roll them into the plan where they are currently working. And as long as they’re not a 5% owner of that company or more than 5% owner, they may be able to delay required minimum distributions until the year that they retire, which could be effectively indefinitely in the future. Some people love to work, and they may continue to work until 80, 85. Keep doing that and you can delay RMDs potentially from the plan that is sponsored by the company that you still work for. But again, key here is it can’t be your company. You can’t own more than 5% of it. If you do, this rule doesn’t apply to you. So that’s another possibility here.

And then lastly, if you have required minimum distributions that have to be taken, we should look at doing so in an efficient manner. One way to do this would be to try and take your RMDs later in the year. All things being equal, that‘s better because you get the year’s worth of growth on that RMD inside your retirement account, tax-deferred. So if you have a $20,000 RMD and your account grows by 5%, if you take that money out on Jan. 1 and you earn that 5% in your taxable account, that’s an extra $1,000 of income you have to pay tax on that year. But if you leave it in your account until theoretically Dec. 31, although I wouldn’t wait until the last minute, but if you wait until later in the year, more of that income is earned in your retirement account and remains tax-deferred. And in fact, you can even use some of those distributions for withholding. In retirement, a lot of retirees or a lot of individuals go from having a paycheck where they withheld money throughout their career to needing to pay what are called estimated tax payments quarterly.

Well, one of the ways to avoid that would be to withhold money, let’s say, from a required minimum distribution, which not only has the nice ease of operation of not having to write the IRS four checks a year, but in addition, it means instead of paying money early in the year, quarterly, you can wait until later in the year to make those payments to the IRS without any penalty, letting you hold on to your money and earn more interest, etc., on those dollars before giving them to the IRS. So some things there that are big things and some things that are little but add up over time.

How Qualified Charitable Distributions Can Help Lower Your Tax Bill

Benz: And how about for charitably inclined people? Did you already mention that the qualified charitable distribution is an option?

Levine: I didn’t, but that’s a phenomenal additional item here. Anyone who’s 70.5 or older, and yes, you heard me correct, if you’re listening and you are kind of, “Wait, I thought RMDs start at 73.” Yes, they do, but you can still make these so-called qualified charitable distributions at age 70.5. That’s the ability to take money directly from an IRA, has to be an IRA, not a plan, and to move it directly to charity. And while you don’t get a deduction if you move money this way, it’s actually better because the dollars are never added to your income to begin with. And why that’s important is the way a tax return works. A charitable contribution is a so-called itemized deduction, a below-the-line deduction. The line, when we say “below the line” refers to something called AGI, or adjusted gross income. Now, so much of what is good on a tax return that gets phased out is actually based on adjusted gross income. And so much that is bad on a tax return, like the 3.8% surtax, is based on adjusted gross income, not taxable income. Taxable income is the end-of-the-line income. It‘s the income after you’ve started with your top-line gross income, you’ve subtracted some deductions to get to AGI, adjusted gross income, and then after that, further subtracted things like your charitable contributions. But the way I often explain it to folks is that AGI is like halftime on your tax return. And unlike most other things in life where the score at halftime doesn’t matter, on your tax return, the score at halftime is really important. A charitable contribution deduction is a third- or fourth-quarter expense. So it does nothing to help lower that AGI number, that halftime score. And so all the credits that get phased out based on AGI, all the deductions that get phased out based on the halftime score, all the surtaxes are unaffected. You’re not helping yourself at all by giving money to charity that way. By contrast, if you give money to charity via a QCD, it not only helps to keep that end-of-the-game score lower but also the halftime score. So you avoid all of those bad things that are tied to increased income on your tax return. Effectively, if you’re 70.5 or older and you want to give money to charity, the QCD is almost certainly going to be the best way to do that for you.

Benz: Jeff, I always learn so much from listening to you. Thank you so much for being here today.

Levine: It is such a pleasure, and congratulations again on the launch of your amazing book.

Benz: Thank you so much, Jeff. See you soon.

Key Takeaways

Here are some of the key takeaways for me from this conversation.

First, Jeff made the important point that many people’s tax bills will indeed go down in retirement, and that’s especially true if they’re mainly or only relying on Social Security for their income needs. But people who have been good savers, especially within the confines of tax-deferred accounts, may in fact see their tax rates go up in retirement. You can plan around that possibility to smooth out your tax rate.

Another key takeaway is to not just coast on low tax bills in the years between when you retire and when Social Security and required minimum distributions start. Those are prime years to consider strategies like Roth conversions.

Finally, once required minimum distributions start, you do lose a bit of control over your taxes. But I’m as enthusiastic about qualified charitable distributions as Jeff is. It’s a great way to pick up a tax break if you’re charitably inclined and you’re over age 70.5.

My book, How to Retire, goes even deeper on tax planning in retirement, with people like Michael Piper and Jamie Hopkins.

Thanks so much for being here. I’m Christine Benz for Morningstar.

Watch more from How to Retire with Christine Benz.