This article will only discuss retirement income tax issues on the federal level. Keep in mind that each state has different tax laws for state income taxes that are levied on various forms of retirement income, as well tax laws concerning other matters in retirement. I encourage you to do your due diligence on your current resident state as well as other states you’re looking into possibly retiring to.
There are lots and lots of rules about taxes regarding retirement accounts. There are rules that apply to things like Required Minimum Distributions (RMD) from IRAs, inherited IRAs when the beneficiary is not a spouse, situations when a retiree’s nest egg is made up of a large quantity of employer stock, etc. However, this article is going to cover a handful of taxation issues that help you squeeze out a bit more spendable retirement income out of your nest egg.
For each dollar of Social Security income that you (and your spouse) receive in retirement, anywhere from 0 to 85 cents on this dollar is considered taxable income. Compare this to 100 cents on every dollar that you withdraw from your IRA is taxable income. So, it would make sense to maximize the amount of Social Security income you get to provide for your income needs so you can replace those dollars with those you would otherwise withdraw from your IRA.
So how much tax do you have to pay on your Social Security income? 0 to 85 cents is a pretty big range. Well, first you have to calculate something called provisional income. The variables that go into calculating your provisional income are: whether you’re single or married, your total household Social Security income, your other taxable income such as IRA withdrawals and any earned income, and any tax-free income you receive like municipal bond interest. Put these numbers into a somewhat complicated formula and it will tell you the percentage of each dollar of your Social Security income that is taxable. Replacing fully taxable retirement income dollars with partially taxable Social Security income dollars can save you thousands of dollars each year in income tax.
You may be familiar with the term asset allocation, however you may not have heard of asset location. Asset allocation has to do with the way your total amount of retirement assets are divided between different asset classes like stocks, bonds, cash, CDs, deferred annuities, etc. (Although deferred annuities are technically not a separate asset class, they help to diversify a retirement portfolio so they behave like a separate asset class). Often a broad asset class will be further subdivided up into categories like large cap stocks, small cap stocks, and international stocks. Asset location has to do with where these different asset classes are located within your different tax-type accounts like tax-deferred IRAs, tax-free Roths, and taxable brokerage accounts like an after-tax funded Scottrade account.
Assets should be located differently in the accumulation phase compared to the decumulation phase. I’ll explain why in the next section about decumulation. During accumulation, once you decide your overall asset allocation, you should keep as much of your stocks as possible in your taxable accounts first before you place the remainder in tax-advantaged accounts like your IRA or Roth IRA. Why? Well, first of all if you hold any stock investment for one year or longer, any gains qualify as long-term capital gains (LTCG). LTCG are taxed much more leniently than ordinary income, as are the dividends that stocks generate. If you’re working and in the 15% federal tax bracket or lower, you will pay no taxes on LTCG and dividends. Even if you're in a higher tax bracket, you will pay lower tax rates on LTCG and dividends. See the chart below for the exact amounts:
The next thing to consider is that stocks are a much higher risk-reward investment compared to bonds and other investments that yield ordinary income. Larger gains mean larger potential for larger capital gains. Also, if you happen to sell a stock or stock mutual fund at a loss you can claim some or all of this capital gains loss, which lowers your tax burden for that year. You can’t “harvest losses” like this within an IRA.
Another consideration is that the tax basis of any security that’s not in a tax-deferred account is stepped up at death. What in the world does this mean? This means if you happen to pass away earlier than expected and your loved ones inherit the securities in your taxable account, they inherit them as if they bought them at their value on the day you die. To keep it simple, basis is considered the value at which you purchased a security. It’s used to calculate how much tax you owe when you sell it. If you buy stock at $40 per share, and you sell it at $60, then your basis is $40 and you owe capital gains of $20 per share. However, using this same example, if your kids inherit this stock, their basis becomes $60. They could sell it right away and not owe any capital gains tax; or they might sell it years down the road at $90 and owe a capital gain of $30 per share, rather than a gain of $50 per share.
The reason asset location recommendations change once you start drawing from a retirement portfolio is because of what I call retirement income ‘withdrawal theory’. Although this is my term for these concepts, I did not come up with them; mathematicians, economists, and other guys with advanced degrees smarter than I have spent years doing research in this field of retirement income planning. This ‘withdrawal theory’, as I call it, is twofold:
- First, you want to withdraw from different tax type accounts in the following order: taxable, tax-deferred, then tax-free
- And second, you want to invest the most conservatively in accounts that you will withdraw from first, and most aggressively in accounts you draw from last
So let’s see how this applies to asset location. If we want to withdraw from taxable accounts first, then we want to invest the most conservatively in these accounts compared to IRAs. So having all stocks, or even a majority of stocks, within taxable accounts is no longer appropriate. We should start replacing stocks with more conservative investments like bonds, annuities, or cash in taxable accounts; and in order to keep the same overall asset allocation we can then start allocating more stock to your IRA and especially a Roth if you have one.
Maxing out your stock allocation within a Roth would be best because we’re going to be withdrawing from the Roth account last in our withdrawal sequence. Having aggressive investments in a Roth is more appropriate than in a taxable account or even an IRA because depending on how much you have in each tax-type account, you may not even need to start drawing income from your Roth for 10 or 20 years.
If you look at the reasons for these two rules, they’re based both on tax implications and on minimizing your sequence of returns risk. They take advantage of friendly tax rules because they recommend that your most aggressive investments, and thus those investments with the best chance for large gains, be located within the most tax-advantaged accounts. And they also help minimize sequence of returns risk because they recommend placing the most conservative investments in accounts where they will be sold and used for spending needs first.
While you’re still working and trying to figure out whether to contribute to a regular IRA or a Roth IRA, the main question that matters is “do you expect taxes to be higher now while you’re contributing, or later when you’re withdrawing?”. You can ask the same question as you consider whether or not to do a Roth conversion during retirement. A Roth conversion is when you take some or all of the funds in your IRA and basically move them from the IRA account to the Roth account. This amount gets included in your taxable income for that year, but then these funds are now in a Roth IRA where they will grow and can be withdrawn later tax-free.
This is a viable strategy if you are in a low tax bracket now and plan on being in a higher tax bracket later, or for retirees who don’t have a high enough Adjusted Gross Income (AGI) to pay any taxes at all yet. Consider a retired couple both age 65. If they don’t itemize deductions when they file their taxes, in 2016, their standard deductions total $12,600, their personal exemptions total $8,100, and their exemptions for being over 65 total $2,500. These numbers together total $23,200. This means their first $23,200 of their AGI is not taxable. The next dollar after this will now be taxable at 10% as they would then be in the 10% bracket.
So let’s say this couple has a combined household Social Security income of $36,000 this year, and they withdraw $10,000 from one of their IRAs. They will pay $0 in federal taxes because none of their Social Security income is taxable (I did the calculations using the formula that calculates the percentage of your Social Security income that is taxable), and their $10,000 AGI is well under the $23,200 amount. So, they can enjoy $46,000 in after-tax income that year. What they can also do is do a Roth conversion on about $10,000 more from their IRA and not pay any taxes. A $10,000 increase in their AGI will now cause $3,000 of their Social Security to be taxable. So their AGI will now be about $23,000 total. This couple can take advantage of the tax code and move $10,000 this year from their IRA into a Roth IRA and not be taxed. If they have $200,000 in their IRA, they can take advantage of this by converting a little bit every year and likely have their entire balance moved to a Roth by the time they both pass.
This is an important point because if taxes go up in the future, then a significant portion of their retirement assets is now completely tax-free in the Roth. Another thing to consider is that their loved ones inherit a Roth IRA tax free, where they would owe taxes on withdrawals from the regular inherited IRA balance. Just to throw out a word of caution, this strategy doesn’t consider the income tax of the state that you’re in. Also, this is not a full disclosure on the tax treatment for beneficiaries of Roth IRAs, as there are other rules you have to be aware of. But I just want you to understand this overall concept.
Also, the retiree who plans to be in a higher tax bracket later can always do a Roth conversion now while they’re in a lower bracket. Continuing on with the example of the same couple, let’s say they plan on being taxed at a higher bracket later in retirement because income taxes are increasing and they know they’ll inherit a significant IRA from the wife’s parents when they pass. Using the same calculations, they could do a Roth conversion of $11,000 more in order to fully take advantage of the 10% tax bracket. They would owe a bit more than $1,800 in federal taxes. But why do they owe that much if they’re converting $11,000 more and they’re still in the 10% tax bracket? Because the higher their taxable income is, the higher percentage of their Social Security becomes taxable.
Typically, you have to be very careful when considering doing Roth conversions on any funds that would cause you to pay any additional income taxes now. Oftentimes the benefit you get by converting funds into tax-free Roth funds does not offset the fact that you’re spending more immediately to pay taxes. This strategy could come back to bite you if your investment returns are poor for an extended period of time in retirement. You’ll wish later than you had these additional funds in your portfolio, even if they’re still in your regular ol’ IRA.