Retirees’ Tax Puzzle: Pay Now or Later?

The majority of retirees pay no federal taxes. But taxes should be a concern for retirees who have retirement savings. That’s because the money they take out of their retirement accounts for living expenses will be treated as federal taxable income. It’s difficult enough to figure out how much money to withdraw – and when. Taxes are a separate but related issue.  

In this blog, we interviewed Michael Kitces, a well-known financial adviser and partner with a Maryland financial firm, who writes the “Nerd’s Eye View” blog. He discusses the basics of navigating the tax code. The challenge facing retirees is to make tax decisions today that will minimize taxes now and in the future.

Question: Do you find that new retirees are surprised by their retirement tax situation?  

Kitces: It’s usually not even on their radar screen. Pre-tax and post-tax income, different tax buckets – I don’t think most people even think about it once they’re in retirement. That’s why we’re still seeing people who are “surprised” when they turn 70½ and the required minimum distributions (RMDs) begin, and their tax bill gets a whole lot higher. They say, “Why didn’t we plan for this?” We say, “We’ve been recommending you plan for this for years!”

The reality is that while we’re working, we don’t think about taxes a lot – the first time you get your paycheck, you notice the difference between what your boss said you were going to get paid and what you take home. You get over that and then work for 40 years, and you just get used to your after-tax cash flow and lifestyle. But when you get into retirement, you have to think about whether accounts are pretax (traditional 401(k)s and IRAs) or after tax (regular bank accounts) or tax free (Roths), and how to draw them down. There’s nothing natural about it.

Q: You said the top income is $75,300 for married couples who want to remain inside the 15 percent tax bracket, after taking all deductions and exemptions. Isn’t that a fairly high dollar threshold that leaves many retirees in this relatively low tax bracket?

Kitces: Yes. And the added benefit is that if your ordinary income is that low, your federal capital gains rate on investment sales from your taxable accounts is zero.

Q: You say that the goal of retirement tax planning is fairly simple: to stay below that 15 percent threshold if at all possible?

Kitces: Yes. The trouble that people get themselves into is that they may have a traditional IRA or 401(k), and they let it sit for a while and they spend their other regular taxable savings and investment accounts first. Then they turn 70½ and the RMDs begin. Stacking RMDs on top of their Social Security and other income sources knocks many people over the 15 percent tax threshold.

Those in the higher tax brackets face a similar problem. They may be in the 25 percent bracket, and should try to stay there, but if they let the IRA grow tax-deferred too long, the RMDs can push them up to 28 percent or 33 percent tax rates.

Q: Some retirees are able to save both in regular bank accounts and mutual funds and in tax-deferred traditional 401ks and IRAs? What is the conventional wisdom about drawing down different types of accounts?

Kitces: The conventional wisdom is straightforward. IRAs are tax-deferred. Let tax-deferred accounts sit as long as possible and let compounding growth happen, and spend everything else first. That’s it.

Q: How can the conventional wisdom get some retirees into trouble?

Kitces: If you get to the point where, either due to your spending needs or your RMD, so much money is coming out of your traditional IRAs or 401(k)s, it can push you up into the next tax bracket. The good news is you’ve paid your tax bill later. The bad news is you’ll pay more in taxes because you drove your tax rate up.

It’s good to have tax-deferred growth, but there really is such a thing as being “too good” at tax deferral.

Q: So, retirees should think about whether it makes sense to pay more taxes now to avoid paying a lot more taxes later?

Kitces: Yes. Ultimately, smooth out your tax rate over your lifetime. Paying a lower tax rate now, but causing a much higher tax rate later when the RMD kicks in can result in less total retirement income and wealth over your lifetime.

Q: How can retirees keep their income – wherever it comes from – within the lowest 15 percent tax bracket as long as possible?

Kitces: The simplest way to do this is to take part of your annual spending from your IRA, which causes a tax bill, but only a modest amount that still keeps you in the same 15 percent tax bracket.

The more complicated way to do this is to keep spending from the taxable account first, but instead of taking money out of your traditional IRA to fill up your low tax bracket, do a partial conversion of that IRA to a Roth IRA, to the extent that the taxable income on the conversion does not push you out of the 15 percent tax bracket.

Q: Let’s stop here. Isn’t everybody different when it comes to taxes?  

Kitces: This framework – spend the taxable accounts first, but don’t let the unused portion of the low tax brackets go to waste – is fairly consistent across the board, whether the client’s retirement income is $300,000 or $60,000. 

Q: What should middle-income retirees with relatively small 401(k)s do?

Kitces: One of the best ways to generate retirement income in low brackets is actually to find anything that is up [in value] in the investment accounts and create capital gains for yourself – because the capital gains get a federal tax rate of 0 percent. You may pay a tiny bit for state income tax liability, but the 0 percent federal capital gains tax rate is about the best deal you’ll ever see. You might as well harvest the biggest gain possible and reduce your capital gains exposure in the future. Even if you don’t need the money, you may still want to harvest the capital gain to take advantage of this.

There are two wrinkles: harvesting capital gains is a great deal for lower-income retirees, but all of your income after deductions, including the capital gain itself, has to fall under the $75,300 threshold.

The second thing you have to watch out for is the taxation of Social Security benefits. Initially, you may think you’re in the 15 percent bracket, but if you’re phasing in the taxation of your Social Security benefits, that bracket could go to 22 percent or even 28 percent. Those initially in the 25 percent bracket may find that their marginal tax rate has increased to almost 46 percent when Social Security taxes are phased in.

Q: Would everyone agree with your strategy?

Kitces: None of this is controversial as a framework. Timing and executing it can be more complex, and that varies by the individual and their assumptions about their future tax rates and time horizons.

Q: But none of this matters for retirees who have virtually nothing saved and are living primarily on Social Security, perhaps bringing in a bit of part-time income. Correct?

Kitces: Correct. If you have no investment assets or retirement accounts, there’s not much need to optimize the taxation of those assets and your income.

Q: What should new retirees know about the RMDs lurking in their future?

Kitces: It can be a big whammy if you’re not watching for it in advance.

For a lot of people it turns out not to be an issue, because their income doesn’t cross the threshold into the next tax bracket.

But sometimes it does. What we see from a lot of people, even with fairly moderate IRAs, is that they forget how much that account can grow through your 60s and into your 70s if it’s invested, especially if you’re trying not to use it.   What seems like not that huge an account can turn into a big account with some sizable RMDs later.