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Tax management for early retirees

Tax management for early retirees

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This article was posted October 1, 2021.

A while back, a reader asked me how I reduce and "optimize" my income taxes while retired.

What I've found after doing this for over 25 years now, is that you're better off with money in varied accounts (i.e., taxable, traditional IRA, and Roth.) I then withdraw money from whatever bucket gives me the lowest average tax liability over the next 10 year period (taking into account Federal income taxes, IRMAA penalties on Medicare premiums (both Part B & D), and the Net Investment Income Tax.)

Your goal is to minimize your lifetime taxation (and I'd add, maximize the amount of any refundable tax credits you may qualify for.)

The bedrock of this analysis is the fact that there is no requirement that any taxes be paid on your taxable account. You can opt to only invest in vehicles that don't spin off interest or dividend payments and you will never pay any taxes until you sell something in the account.

Conversely with "tax advantaged" accounts like an IRA/401k, you are forced to start paying taxes at age 72 when RMDs kick in. That's not a problem as along as your IRA account is small enough that the RMD is only providing an amount of money you can actually spend. Let your IRA get "too large", and the RMD may force you into a higher tax bracket, and the RMD amount may be more money than you can spend -- better to have that kind of wealth in your taxable account where it can remain "untaxed".

Also, the bargain you made way back in your 20's and 30's when you started making IRA/401k contributions was that, "I'll take the tax deduction today, in exchange for giving up the opportunity to get qualified dividends and capital gains taxed at a lower rate in my taxable account." As your IRA account grows in value and investment gains become a larger portion of its year-end balance, that bargain starts to look a lot less attractive.

When I early retired back in 1994, my assets were roughly evenly split between my IRA and taxable account. The IRA happened to have my two biggest winners (i.e., DELL and Pfizer.) By the late 1990's my IRA was several times the size of the taxable account (and the taxable account had done well in the bull market, too.) At age 40 when I forecasted the account value out to age 70, I realized that the RMDs would put me in the highest tax bracket and likely provide more money than I could reasonably spend. See link:

Should I tap my IRA first in retirement?

To address the RMD "problem", I decided to start tapping the IRA at age 40 using a 72(t) SEPP and left my taxable account to grow untouched (other than the small amount of dividends it was spooling off.) With continued growth in the IRA over the subsequent 20 years to age 59-1/2, the SEPP withdrawals were also were providing "more money than I was spending", but it would have been worse if I did nothing.

Qualifying for Refundable Tax Credits

When Obamacare was signed into law in 2010, I was apparently one of the few people that actually took the time to "read the bill". I was astonished to find that there was no "asset test" in the legislation, Congress just looked at income. You could own $100 million worth of Berkshire Hathaway and qualify for free health insurance if you were able to keep your taxable income low enough.

Since I had budgeted $20,000/year for health insurance premiums from age 60 to 65, the prospect of "free Obamacare" looked appealing. While others ranted on FoxNews about the "evils of Obamacare", I got to work on the project of making my taxable account "Obamacare ready" by minimizing that last bit of interest and dividend income the taxable account was spooling off. When I reached age 59-1/2 and was able to end the SEPP withdrawals, the remaining interest and dividend income I had left put me comfortably in the ballpark for a big refundable tax credit. I was able to fund the rest of my annual spending needs by matching the sale of winners and losers in my taxable account, and spending down a portion of my fixed income account which generated very little in taxable capital gains. During my last few years on Obamacare, I was able to get my monthly premium down to $1.43/month -- less than $20/year. Big difference from $20,000.

Obamacare Repeal? My amazing story of drastically lower premiums.

Roth Conversions

I started Medicare in 2021, so my income is no longer restricted by Obamacare. My plan is to do Roth Conversions for the next 7 years to age 72 to continue to whittle down the size of my IRA with the goal of leveling out my tax liability in the future. I'll likely still get a jump in tax bracket when the RMD begins, but hopefully it will be a lower one. (Also, my plan is to delay SS to age 70.)

What to conclude from this analysis

So that's it. Optimizing your taxation is a fluid project. The biggest danger I see is letting your IRA/401k grow too large. But there may be other opportunities that spring up like the tremendous "gift of Obamacare" that brought me $20/year insurance premiums. You're better able to capitalize on these opportunities if you have several buckets of cash & assets to draw from. You want to tap the account that at any given point in time does the most to reduce your "lifetime taxation".

I'm currently in the market for a new automobile, but now I think I'll wait for the $12,500 tax credit on electric vehicles in the proposed "Infrastructure" bill. It pays to keep up on your reading.

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