Retirement Income Tax Strategies

Retirement, finally!  The time has come to stop working and start enjoying your retirement.  Over the years, you’ve made significant contributions to your retirement account, you have other assets, and, of course, Social Security at some point.  But, like most things, the transition from Saver to Spender is not as simple as turning off your salary and living from your retirement nest egg, there are a lot of questions that need to be addressed:  

  • From which accounts should I draw my retirement income?
  • When should I start collecting Social Security?
  • When does it make sense to draw from taxable accounts versus tax exempt retirement accounts?
  • Married? Who should claim Social Security first?
  • What’s an RMD and why am I being forced to withdraw IRA money?
  • What!? I still have to pay taxes?!?!

Luckily, as a client of Coldstream, you have professional advisors to help you sort through these issues.   What I specifically want to address is a strategy to manage your income tax bracket during the early retirement years to make efficient use of your assets.

A retirement strategy many individuals use is to file for Social Security as soon as they are eligible and withdraw funds from their taxable accounts to fund their retirement cash needs.  At age 70 ½, when they must start taking required minimum distributions (RMDs) from their retirement accounts, these individuals will only take the minimum distribution and fill in the additional income requirements from their taxable accounts.  The rationale for this strategy is to defer IRA withdrawals as long as possible.   This is the typical strategy because it makes sense to continue to allow the retirement assets to grow tax deferred and because it is an easy solution.  As a high net worth client, the easiest solution is not necessarily the most tax efficient.

As an alternative, managing your retirement income by taking funds from both your retirement and taxable account gives you the flexibility to take advantage of lower tax and capital gain rates that could reduce your overall tax liability and thereby increase your retirement income.  We call this strategy Tax Arbitrage.

First, consider delaying Social Security until full retirement age or, even better, age 70.  This not only lays the necessary groundwork for an initial lower base income, but by delaying until 70, you will receive the maximum benefit available to you.

Consider using the retirement accounts for the first $90,000 of your annual retirement income.  Why? Depending on your filing status, deductions and investment income, you can withdraw up to $90,000 from your retirement accounts and pay an average income tax of less than 11%!  In addition, if your total income in 2012 is under $90,000, long term capital gains rates on taxable investments could be taxed at a rate as low as 0%.  If you have taxable income over $90,000 the long term rate will increase to a maximum of 15%.  Imagine completing a tax return that Governor Romney would be proud of.

If you don’t need the retirement assets, consider converting some or all of it to a Roth IRA.  Once in a Roth account that money will be tax deferred over your lifetime and inherited income tax free to your heirs.  The amount that makes sense for you to convert will depend on your specific circumstance; it doesn’t normally make sense to bump into a higher bracket unless you fall into some very specific situations.   If a Roth conversion makes sense, it will allow you to take advantage of the current low tax rates and decrease your sensitivity to future tax increases.

At age 70 ½ you must start taking minimum required distributions from your retirement assets.  If you have tapped your retirement assets prior to age 70 ½, the lower value of the assets will reduce your RMD. For example the first year RMD on a $1.5M retirement account is about $54,700 but if the account is worth just $1.1M (the approximate value after taking $90,000 withdrawals during your early retirement years) the first year RMD is only $40,185.  That difference is meaningful when you couple the RMD with your Social Security income; the lower RMD provides more flexibility to receive favorable tax treatment for long term capital gains held in your taxable account.

Using your retirement assets while you are alive is also a good estate planning tactic. Retirement accounts inherited by non-spouses will have to begin their own required minimum distributions and will be subject to the income tax rates of the heir.  On the other hand, under current law, there is a step up in basis for your taxable account and heirs are not required to make withdrawals.  By withdrawing from your IRA account as tax efficiently as possible, you could potentially reduce the future tax liability for your heirs by leaving a smaller IRA account and a larger taxable account that receives a step up in basis.

The goal of these strategies is to manage your marginal tax bracket during retirement in order to receive the maximum benefit of tax deferral, long term capital gains rates, and Social Security benefits.  By realizing retirement account withdrawals early in retirement, and at a time when your income is potentially the lowest, you open the possibility of having better control of your unknowable future tax rates. You’ve worked hard to create your retirement nest egg, now learn how to make efficient use of it and enjoy some time off.   As always, we recommend that you consult with your Relationship Manager to build a financial plan that consists of more than just saving money and deferring taxes, and a tax expert prior to implementing any of these suggestions.



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