Tax Planning: Preserve your Wealth by Reducing your Taxes
If you searched online for “retirement tax strategies”, you would quickly find countless articles, blogs, and videos detailing a wide array of tax planning ideas and tax-advantaged financial products. However, the challenge is identifying which of these tax planning ideas make the most sense for you.
In the years leading up to retirement, it can be quite helpful to develop a personalized tax plan as income taxes and property taxes will likely be the single largest expense for most retirees. Therefore, by working to reduce what you will pay in taxes over time, you can lower your retirement expenses and preserve your wealth along the way.
Another unique benefit of tax planning for retirees is that realizing positive results is entirely within your control. Unfortunately, when it comes to retirement, there are many uncertain variables that range from fluctuating inflation trends to unknown life expectancies to unpredictable investment returns. Since these uncertainties cannot be controlled, a retiree’s only choice is to manage these variables by adjusting their plan over time.
However, building a personalized tax plan is one way to exercise greater control over your retirement finances. After all, reducing your taxes with a personalized tax plan does not require good luck or fortunate timing as it is often the case with inflation trends or investment results. It only requires the right knowledge and some ongoing effort to achieve the results you want.
In this article, we will discuss the planning framework that we use when building and implementing personalized tax plans for clients as they enter their retirement years.
Are you ready to get started? Let’s go!
Defining & Measuring Tax Savings
The best way to start a tax planning conversation is by discussing how we define tax savings and how we measure tax savings. The reason to start here is that “tax planning” is often viewed as those last minute tax moves you make to reduce the taxes owed in the current year. While it is certainly helpful to save money on this year’s tax return, realizing the sizable levels of tax savings that we all desire often requires a longer term plan.
How we define tax savings
While we frequently think about tax planning from a federal tax perspective, the universe of tax planning opportunities should really extend beyond federal taxes and include state taxes as well as other public benefits in which eligibility or cost is based on your annual income level. After all, paying a Medicare premium surcharge or losing a property tax rebate because your income level was too high is just another form of tax.
By broadening your definition of tax savings beyond your federal taxes to include state taxes, Medicare High-Income Premium Surcharges, and New Jersey property tax rebate programs, you dramatically expand the universe of tax planning opportunities.
An Illustration: A 66-year-old couple has $180,000 in annual retirement income. The couple wants to sell some stock that will result in a $75,000 long-term capital gain. Irrespective of the year the stock is sold, the couple would pay a 15% federal tax rate on the extra $75,000 of capital gain income. Therefore, from a federal tax perspective, it doesn’t matter when the stock is sold as the tax rate will be the same.
However, the federal taxation of this income isn’t the only consideration. If the stock was sold in any one tax year, it would increase the couple’s income to $255,000 of total income which would trigger a nearly $2,000 increase in the couple’s Medicare Premiums as well as the the loss of a $1,250 New Jersey Anchor Property Tax Rebate. Therefore, the right tax planning move is selling the stock over several tax years to maintain a lower level of income for Medicare and property tax rebate purposes.
The key point is that every tax planning move needs to be evaluated from every angle to avoid costly errors or missed opportunities.
How we measure our tax savings
When we think about any tax planning strategy, we would ideally like to realize immediate tax savings. While many tax strategies create those immediate tax savings, there can be instances where the best tax planning move is to pay more tax than necessary in the current year to capture a more favorable tax rate that may not be available in the future.
An Illustration: Let’s say you recently retired at Age 62. You have an $80,000 company pension starting at Age 65 and you decide upon claiming your $40,000 Social Security benefit at Age 67. Between Age 62 and the start of your pension at Age 65, you will need to fund your living expenses by withdrawing $100,000 annually from your savings and investments.
One funding option would be to withdraw cash from your savings account which would result in $0 taxes. However, a second option might be to withdraw funds from a fully taxable IRA account and pay 10% to 12% tax rate on up to $120,000 of IRA withdrawals each year (if married). While electing to pay more in taxes may seem counterintuitive, this 3-year time period prior to starting your pension allows you to pay only 10% to 12% tax on $300,000 of IRA withdrawals that would otherwise be taxed at a 22% tax rate or higher in the future - a tax savings of more than $30,000 over time.
In the example above, we illustrate the importance of measuring your tax savings over time. After all, the valuable tax strategy detailed above wouldn’t look very good if success was measured in those earlier years alone. However, when savings is measured over a longer time period, it is much easier to see how substantial wealth was preserved by capitalizing on the low tax rates available in those first few years of retirement.
The Tax Planning Process
We started our discussion by more broadly defining the universe of potential tax savings opportunities and then highlighted the importance of measuring our tax savings over time.
Now let’s review the three distinct parts of the tax planning process.
Understanding your personal tax planning profile
Developing your long-term strategic tax plan
Implementing your tax plan.
Identifying Your Tax Planning Profile
While accessing potential tax planning ideas is quite easy these days, the challenge is identifying the right tax strategies for your unique planning needs. This is where your tax planning profile matters.
Integrating your Tax Planning with your Financial Plan
The reality is that everyone has a unique tax planning profile which will be driven by:
Your sources of income
The type of financial assets you own
The age at which you retire
Your desired spending level
Your interest in funding certain unique financial goals
The tax efficiency of your investment strategy
And the intended beneficiaries of your estate at death
This means that any high-quality tax plan is often tightly integrated with your financial plan. It also means that most financial decisions need to be analyzed from a financial planning, investment strategy, and tax planning perspective to arrive at the right course of action.
For instance, if you want to spend more each year in retirement, you may need to withdraw more funds from your IRA and this would result in higher taxes as well as Medicare premium surcharges. It might also require you to invest more aggressively to fund the higher rate of spending. Therefore, dialing in the right level of retirement spending involves analyzing many more considerations than a household budget alone.
Understanding the Rules & Regulations
The next step in the development of your tax planning profile is understanding the federal and state tax rules and regulations that will apply to you. Once again, we identify these relevant rules and regulations by studying your unique financial profile as different income sources, specific financial assets, and the future taxation of your estate will all play a role in shaping the relevance of different rules and regulations.
The most common examples would be:
Complying with required minimum distribution rules on retirement accounts
Understanding how different inherited assets are taxed (ex. parent’s IRA or annuity)
Avoiding Medicare Premium Surcharges triggered at certain income levels
Understanding how your income will be calculated on your federal and state tax returns
Evaluating your eligibility for public benefits and property tax relief programs
Ultimately, by understanding the tax rules and regulations that apply to your unique financial profile, you can avoid costly errors and capitalize on a wide array of planning opportunities that might otherwise be overlooked.
Developing Your Strategic Tax Plan
Whether you are building a retirement plan, a business plan, or a personal tax plan, any long-term planning process will have two distinct stages.
In the first stage, you develop a long-term strategic plan that identifies the strategies you plan to use in the future based on the knowledge you have today. In the next stage, you begin implementing the various strategies outlined in your strategic plan while continuing to adjust and optimize these strategies as new information presents itself (ex. change to the tax code).
Within any strategic tax plan, there are three high-value planning opportunities that are tightly integrated with both your financial plan and investment strategy.
These three high value planning opportunities are:
Income and Deduction Planning
Using a Tax-Smart Investment Allocation
Reducing Wealth Transfer Taxes
Income and Deduction Planning
Income and deduction planning involves building a plan to recognize large income events in your lower income years while taking sizable tax deductions in your higher income years when higher tax rates will apply.
An Illustration: A 65-year-old earns $400,000 per year and plans to retire on December 31st. In addition to her retirement goal, she also wants to donate $50,000 to her favorite charity and reduce her investment risk by selling $300,000 of highly appreciated company stock. In this example, she would be best served by making the large donation in her final high income year to maximize her tax savings on the donation. However, she should wait to sell her company stock until her first year of retirement when her income will be much lower and less tax will be due on sale.
Clearly, the transition from your working years into retirement provides many planning opportunities due to the significant changes in your income level during this time period.
Using a Tax Smart Investment Allocation
The next tax planning opportunity involves managing your investment-related taxes over time.
In retirement, your main investment objective is to adopt a sensible investment strategy that can deliver the long term returns you need after accounting for all expenses and taxes. With this goal in mind, it is important to manage your investment-related taxes which can range anywhere from 0% to upwards of 55% for some taxpayers.
However, tax-smart investors aren’t solely focused on reducing their taxes as they recognize that very successful investments often result in sizable tax bills. With this point in mind, tax-smart investing involves evaluating an investment’s return potential, its potential risk of loss, and the manner in which it is taxed. For instance, interest on a corporate bond, a stock dividend, a gain on a stock sale, and interest on a municipal bond are all taxed at different tax rates which will impact the after-tax return of each investment type.
It is also important to understand how different investment accounts are taxed. For instance, investments in a Roth IRA grow tax free whereas investments in a tax deferred IRA or 401k are only taxed when funds are withdrawn. This matters because the different tax rates noted above only apply to investments made within a taxable brokerage account.
Therefore, a tax-smart investor who understands the tax code will generally place investments subject to lower tax rates like stocks, treasury bonds, and municipal bonds in their fully taxable brokerage account while placing investments subject to higher tax rates such as corporate bonds in tax-deferred or tax-free accounts.
An Illustration: A retiree has $1M in a regular brokerage account and $1M in a tax deferred IRA account. The retiree wishes to invest 50% of their savings into U.S. stocks and 50% in various bond funds that pay 5% in annual interest. The most tax efficient asset allocation would be locating the stocks within his regular brokerage account where lower tax rates will apply to the stock dividends and capital gains earned. The retiree would then locate the bond funds within his tax deferred IRA account where all $50,000 of interest income would be deferred into future years.
Reducing Wealth Transfer Taxes
While most Americans are not subject to the Federal Estate Tax, there are still significant tax considerations that need to be managed as part of the estate planning process.
For some, the significant tax considerations may include paying estate or inheritance taxes to their resident state. For example, in New Jersey an estate tax is no longer imposed, but an 11% to 16% inheritance tax is still levied on any asset transfers to non-lineal descendants such as siblings, cousins, and friends.
In addition to the taxes levied on the value of one’s assets at death, there are also a multitude of income tax considerations that apply to inherited assets.
For instance, certain assets such as real estate, collectibles, and any investments held in a taxable account are inherited with a tax basis equal to the asset’s fair market value on the date of death. However, other inherited assets such as pre-tax IRAs, 401Ks, and non-qualified annuities pass to beneficiaries with a tax basis equal to the decedent’s original tax basis which is often $0 for pre-tax IRAs and 401Ks.
An Illustration: An elderly mother passed away and left her home worth $750,000 and a pre-tax IRA worth $1M to her two sons. If shortly after the mother’s death, the sons sold her home for $750,000, there would be no tax due on the sale as the inherited cost basis was $750,000. However, the $1M IRA would be inherited along with the mother’s $0 cost basis. This means that any future withdrawal from the IRA would be subject to income taxes.
From a strategic planning perspective, it is important to consider who might inherit your assets, the type of assets they might be inheriting, and how those assets might be taxed for income and estate tax purposes. In the example above, if we assumed that one son had a high income and the second son had a much lower income, a sensible estate plan might be to leave the house to the son with the high income and the $1M fully taxable IRA to the son with the lower income. Implementing such a planning technique would help the family save a substantial amount of income taxes on the transfer of the mother’s wealth.
Implementing Your Tax Plan
While your strategic tax plan will identify the specific tax strategies you plan to use in the future, a strategic tax plan cannot account for how the tax code might change, whether your investments will generate future gains or losses, or what your exact income level might be in a future year.
Therefore, implementing your tax plan involves not only the execution of the strategies outlined in your strategic plan, but also an ongoing focus on adjusting and optimizing these strategies as new information or more precise estimates become available.
An illustration: In her strategic tax plan, a 62-year-old retiree identified a potential opportunity to take elective IRA distributions at favorable tax rates in the early years of her retirement.
While this is a sensible plan, the reality is that she won’t know exactly how much to distribute in each future year until that year arrives. However, as each year unfolds, she will have greater clarity on her exact income level and the tax rates that would apply that year. She would also be able to verify whether any recent tax code changes have made the planned strategy more or less effective. With this information in hand, she can then determine whether a distribution makes sense each year and, if so, she can calculate the precise size of any IRA distribution to maximize her tax savings.
In conclusion: Tax Planning is a major opportunity to preserve your wealth by reducing your taxes over time. However, the tax code is complex and professional knowledge is often necessary to successfully navigate it. The tax code is also in a constant state of change which can result in an ongoing need to adjust your tax planning strategies over time.
It is for these reasons that many tax-focused retirees ultimately decide to work with a tax advisor who can help them navigate these ongoing complexities. However, for those who do hire a quality tax advisor, the potential tax savings is not only meaningful but quite achievable as well.