As folks who wanted to retire early a big emphasis of our plan was reducing expenses so our money would last longer. While we prepared to retire we crunched our budget every which way to Sunday. We found ways to cut our spending on food, housing, gifts, insurance, and travel. We played the travel rewards and credit card games. We joined all the points programs for airlines, hotels, grocery stores, restaurants, and gas stations. Once we got our spending and budgeting strategies all figured out the next thing for us to focus on was taxes. Taxes may not be the most exciting topic, but for money nerds like us learning how to manage your current and future taxes is fun stuff!
We did our best to learn about the IRS codes that applied to us while we were still working but we didn’t have enough time or energy available back then. Once we retired we set a goal to gain a comprehensive understanding of our tax scenario so we would be able to manage our tax spending. One of the things we love about this book, The Retirement Planning Guidebook by Wade Pfau, is that it’s helping us learn even more about taxes and how they apply to retirees.
We are not certified financial professionals, nothing we discuss is professional advice. This post contains affiliate links. For more information please read our Disclaimer.
In Chapter 10: Tax Planning for Efficient Retirement Distributions, Pfau describes how tax-efficient distributions and utilizing leftover tax bracket capacity can reduce one’s overall lifetime expenses and extend the life of one’s portfolio. That’s exactly what we wanted to learn more about, but we all know the IRS doesn’t make it easy. With a bit more help from this amazing retirement guide we’ve been able to evolve our tax strategy. We went from focusing on paying ZERO taxes in early retirement to the idea of Front Loading our taxes, paying more taxes now to reduce our lifetime tax obligation. It’s been a huge mind shift to say the least.
Before we dive in here’s a reminder that this is the second post in our three part book review series about The Retirement Planning Guidebook. In the first post in this series, Part 1, RISA Profiles and the Funded Ratio, I covered Retirement Income Style Awareness (RISA) Profiles from Chapter 1 and the Funded Ratio from Chapter 3. And in the third and final post in this series I’ll cover Building a Later in Life No-Go Budget. So stay tuned!
A Personal Observation
What Ali and I discovered during our first few years in retirement, regardless of whether we were living as nomads in other countries or living in a home of our own in the US, is that focusing on the game of going as cheap as possible and paying the lowest possible taxes in early retirement can make you lose sight of your long term tax obligations. In other words, if you only pay attention to your current year’s taxes you might end up paying much higher taxes in the future. By the time you reach age 65 if you’re living in the US you’ll have to start paying for Medicare, and then by the time you reach age 72 you’ll have to start taking RMDs from your IRA, which can cause your income and taxes and spending all to jump up. It makes sense to pay attention to more than your current taxes, it also makes sense to start strategizing about your long term tax obligations now.
Strategizing about taxes sounds pretty boring, but it can also be an interesting puzzle. It helps to start thinking about your income and taxes in a stack like a game of Tetris. That’s what charts like this one below from our personal spreadsheet always remind me of.
Some Tax Bracket Basics
One of the first things Pfau explains in Chapter 10 is that there are several different kinds of income and at least two different sets of tax brackets.
The first taxable income category the IRS considers is Ordinary Income. Generally this is income earned from work such as salary from a job or side hustle. Ordinary Income also includes rental income, interest, short term capital gains, IRA distributions, pensions, annuities, and some Social Security. Ordinary Income is taxed using marginal, progressive tax rates. The IRS raised the top limit amounts for federal income tax brackets for 2023, but the tax brackets will stay the same at 10%, 12%, 22%, 24%, 32%, 35% and 37% for Ordinary Income. At the end of 2025 the current tax brackets are set to sunset, but we can’t predict for sure how they might change.
The second taxable income category the IRS scrutinizes is Capital Gains. This type of income includes gains and qualified dividends from long term passive investments like stocks and personal real estate. This income is taxed at much more preferable rates starting at 0% and topping out at 15%.
There are other thresholds that can trigger other taxes, or increases in Medicare premiums, or higher Social Security taxes. But for now we’re going to stick with these two income types to build on our understanding of their tax brackets. Here we go!
In this post we’re including a couple whose tax status is Married Filing Jointly (MFJ) with an all-in annual budget of $80k, and our example couple has to determine which accounts and what kind of income categories to tap to cover their budget. That’s right, you do have some control over which accounts you tap and when. For now to keep things simple they’re going to claim $40k in Ordinary Income and $40k in Capital Gains to cover their $80k budget.
After taking the standard deduction of $25,500 that leaves $14,100 of Ordinary Income to be taxed at 10%, and $40k of Capital Gains to be taxed at 0%. That leaves them with an IRS tax bill of $1,410 on a total taxable income of $80k. That’s a real tax rate of only 1.76%. But how can that be? It’s the magic of strategically turning on and off different kinds of income from different kinds of accounts in order to come up with the most advantageous tax strategy, all while being mindful of your lifetime tax obligation.
The graphic below from one of our personal spreadsheets illustrates how the IRS stacks income into their corresponding tax brackets. Ordinary Income is accumulated first then Capital Gains is stacked on top of that. For this example note the line for the top of the 12% Ordinary Income and the top of the 0% Capital Gains tax brackets, which represents the $83,350 limit for Capital Gains and $83,550 for Ordinary Income. The limit for these two kinds of incomes is basically the same! It’s like building a mixed drink, the more Ordinary Income or Tequila you put in your drink the more pain or taxes you might feel the next day. But if you use more Capital Gains or club soda, as long as your drink doesn’t overflow your glass or those 12%/0% tax brackets, you won’t have to pay big taxes the next day.
In the graphic below, the column on the left starts with Ordinary Income shown in blue, then Capital Gains income in red is layered on top. In the column on the right the standard deduction of $25,500 for MFJ has been applied so the income stack is shifted down and any income stacked below $0 becomes tax free.
[Note: If the income amounts in the graphic above were much larger the total income number would climb into the next bracket and then we’d include more lines for other tax brackets and discuss those other brackets, increased premiums and hidden taxes here as well.]
Considerations For Tax Efficient Income
To achieve tax efficiency during retirement, Pfau suggests the strategic use of account types and income timing to create an optimal flow of funds to cover your current and future expenses. That might sound like an impossible puzzle but it’s a manageable puzzle if you know when you’ll start accessing your various accounts, such as pensions and IRAs, and which tax brackets your income will fall into.
Pfau looks at three basic building blocks for a tax efficient strategy:
- Efficient asset allocation through account types
- Tax diversification of income or distributions
- Tax bracket management
You can think of this as a game like Tetris or a recipe for a cake. Or pretend you’re Oz the Great and Powerful behind that curtain, pulling levers and pushing buttons to create your tax strategy. Pfau wants us to learn that we have much more control than we realize when it comes to taxes.
1. Asset Allocation Based on Account Types Reduces Tax Drag
Back in our Allocations Strategies Series we talked a lot about asset allocation and asset location. Keeping your investments in accounts that help you manage income and growth with the least amount of tax drag will allow your portfolio to grow faster before and during retirement.
The following table suggests where different asset classes might best be held given their growth and income potential.
- Taxable accounts: Taxes on interest, dividends, and capital gains realized in a given year will be due when you next file taxes. Depending on the income type it can either be taxed at ordinary or capital gains rates.
- Tax deferred accounts: No taxes are due on any income or growth until funds are withdrawn after you are 59.5 years old. Taxed at ordinary income rates.
- Tax free accounts: No taxes are due on any income or growth. No taxes or penalties are due on withdrawals after 59.5 years old.
2. Diversification Leads to More Tax Efficient Distributions
Working with all three account types (taxable, tax deferred, tax free) provides the most tax diversification to help our market investments see us through our retirement years. As you take withdrawals pay attention to the tax implications of whether our accounts were funded with post-tax or pre-tax dollars.
The table below gives a quick rundown of account categories, how they were funded, whether distributions will be taxed, and the types of income each will generate.
And just to make sure we don’t try to keep retirement funds in our tax deferred accounts forever, the IRS requires account holders of tax deferred IRAs to take required minimum distributions (RMDs) starting at age 72 in order to comply with their lifetime tax obligations. RMD withdrawals are included in your ordinary taxable income, and the size of your RMDs is calculated by dividing the value of your IRA by your life expectancy as determined by the IRS (that’s a whole other post, probably heavily focused on Roth conversions!).
Building a more tax efficient withdrawal strategy starts with understanding any access restrictions for each of your accounts. Depending on your current and lifetime income goals estimating your future account balances and their tax requirements can be a bit tricky.
In this example shown below, this person has a brokerage account that can be accessed at any age. Their employer sponsored retirement plan and their Roth will both be accessible without penalty when they reach age 59.5. They also have a pension they can take at age 65, and they’ve decided to wait until age 70 to take Social Security. Remember, this is an example, not a suggestion regarding income timing. Everyone should make their own choices based on their personal circumstances. You can quickly start to build a picture of when accounts and different kinds of income become accessible, which will help you grasp when your income types might change and how that will affect your taxes.
3. Utilizing Leftover Tax Bracket Capacity
For this example we have a couple with an annual budget of $80k. To meet their budget they’ll be drawing $40k in Ordinary Income and $40k in Capital Gains from their accounts. After taking the standard MFJ deduction they noticed they had extra room in those tax brackets before they hit the top. Pfau calls this the Sweet Spot in tax bracket capacity.
Filling the Sweet Spot
Understanding which kinds of income your accounts will generate and how they stack together after your standard deduction is taken will help you make strategic tax choices. Especially if you want to modulate your income streams to maximize preferable tax brackets. Though it also helps to remember that you don’t need to optimize everything all the time, and sometimes drifting up to higher tax brackets is prudent for long term planning. Choosing to fill up unused tax bracket capacity will always depend on your short and long term goals.
All that being said, that extra sweet spot space could be the perfect opportunity to make a strategic decision to pay more taxes now and also lower your lifetime tax obligation. For instance, you could choose to make a Roth conversion now, which would increase your Ordinary Income now, which isn’t a bad thing since you would most certainly pay more in taxes on that same distribution in the future after additional growth in a tax-deferred account. This is one of many options for Front Loading Taxes.
If you fill up that sweet spot by making a $20k IRA to Roth conversion within the 12% Ordinary Income tax bracket, you’ll be moving that future growth into a tax-free account, reducing future tax implications and thereby avoiding paying taxes in the future at an unknown tax rate. This type of strategy makes a lot of sense to folks who assume the tax brackets will be higher as the years go by due to inflation as well as inevitable changes in tax codes.
This could also be a perfect time to do some Capital Gains harvesting. Simply put, you could sell a highly appreciated holding in a taxable account and within that sweet spot you pay 0% Capital Gains tax. Then you can turn around and buy more shares of the same holding to increase your cost basis for other money moves down the road.
[Note: If you’ve heard of the Wash-Sale Rule you might be thinking about that in light of this discussion, so remember if you want to sell a fund at a loss and buy the same fund again within 30 days after the sale, you won’t be able to take a loss for that fund on your current year tax return.]
The chart below shows both the Ordinary Income and Capital Gains tax brackets on either side of the example income stack. For simplicity’s sake the Ordinary Income stack shows four tax rates and the Capital Gains stack shows two tax rates. Keeping your total taxable income below the 0% Capital Gains income limit of $83,350, which also keeps you below the 12% Ordinary Income limit of $83,550, means paying lower Ordinary Income taxes and possibly no Capital Gains taxes at all.
In the following graphic note the black box around the sweet spot in the income stack, which is basically unutilized 12% tax bracket space in the amount of $29,250. You can add more Ordinary Income in that sweet spot from another Roth conversion, or tap more Capital Gains from a taxable brokerage account at a 0% rate, or a little of each.
There’s one more thing to be aware of with this tax efficient strategy of filling up the sweet spot, which is the connection with the ACA marketplace. For our MFJ example keep in mind that the 400% Federal Poverty Level (FPL) for a family of two is $69,680 for this year in 2022. If your primary goal is maximizing your ACA subsidies in order to keep your health insurance premiums as low as possible, you might want to drop your personal sweet spot limit down to $69,680 instead of $83,350. Choosing the 400% FPL as your income limit instead of the limits for the 0% Capital Gains/12% Ordinary Income tax brackets would help you take advantage of enhanced premium credits offered by the Inflation Reduction Act of 2022 for another 3 years.
Tax-Free Ideas to Fund Expenses
It can be tough when we first start figuring out how to fund our expenses in retirement, that’s the withdrawal strategy puzzle that needs to be wrangled and tamed. To start with we know we’re taxed on Ordinary Income and Capital gains, but don’t forget all the tax free ways to meet your budget. It’s important to remember we can fund some of our expenses from things like cash, original cost basis, tax free gifts, or Roth withdrawals.
I hesitate to mention Roth withdrawals at this point as many of us are in the middle of making Roth conversions to push some of our IRA balances into tax free accounts. Sadly, we can’t take Roth withdrawals until our last conversion has been in the hopper for 5 years. Unless we’ve carefully tracked all Roth dollars and can be 100% sure we aren’t pulling earnings that have been in the account less than 5 years. And regardless we must be over 59.5 years old to withdraw funds from a Roth penalty free. All that being said, at some point Roth withdrawals might be a great way to fund your retirement while keeping your tax bill in check.
If you do want to make a Roth conversion in your early retirement years how do you make it happen and also have funds to live off of without pushing your income over the 12%/0% tax brackets or the ACA income thresholds?
Using the same example $80k budget mentioned above this couple also wants to make a $40k Roth conversion this year. This $40k conversion will be taxed at Ordinary Income rates. And since this is a Roth conversion and the funds will not be used to cover any expenses, for tax purposes that $40k will be added to the $80k they need for their regular annual expenses for things such as food, utilities, taxes, and insurance. That’s potentially $120k of taxable income which will push them over the ACA thresholds and increase their premiums. What to do?
First, they made their Roth conversion with an in kind transfer from their Schwab Rollover IRA account to their Schwab Roth account. Making an in kind transfer meant they were transferring shares between accounts held at the same institution so they knew both accounts could hold that type of asset. This simplified conversion was done with no selling, no checks generated for deposit, and no new buying. Regardless, they generated $40k that the IRS will track at Ordinary Income rates. And just so we’ve said it, we don’t care where you invest, as long as it’s low cost and meets all your needs. We could have used Fidelity or Vanguard in this example since all three brokerages are great.
Second, this couple sold a long term holding in their taxable brokerage account which was their oldest lot of a US Broad Market ETF. That sale realized $40k in Capital Gains, which would be taxed at 0%. The original Cost Basis of $20k from when the ETF was purchased was also realized, and the Cost Basis is tax-free. Selling that one long term holding produced $60k of the $80k needed for regular expenses!
Last, they pulled $20k from a money market account to make up for what they were missing after the sale of the equity mentioned above. So they made the $40k Roth conversion and collected another $80k in spendable funds for a total of $120k in money moves. They owed 0% tax on the Capital Gains and only 10% tax on the taxable portion of the Roth conversion (which was $14,100 after the MFJ standard deduction).
However, since they had a total of $80k in taxable income before the standard deduction they went over the 400% FPL of $69,680, and that means their ACA health insurance premiums would be a bit higher than they would like. If staying below the 400% FPL was their top priority they could have made a smaller Roth conversion, reduced their budget, sold a smaller equity holding, or used more cash to get their total taxable income below $69k, all in an effort to reduce their premiums.
Front Loading in Action – A Fictitious Story
Now It’s time we give our example couple some names! Fictitious Sue and Joan file taxes as MFJ and they have a plan of retiring together in 10 years. They currently each have one 401k and they’ll convert those to IRAs as soon as they retire as they don’t anticipate needing or wanting to access those accounts during early retirement. Sue and Joan also have a healthy joint brokerage account and they each have one modest Roth account.
Sue and Joan have started building a written personal finance plan that includes reducing their cost of living after retirement by either moving to a more affordable area or living a nomad lifestyle as traveling renters for a few years. They’ve set their post-retirement budget at $102k per year because they currently live on $96k per year, they plan to work for another 10 years, inflation will continue to raise prices over time, and they will immediately reduce their living expenses by leaving their high cost of living location once they retire. Sue and Joan will review their plan and their numbers annually to make sure the math works as time goes on.
Sue and Joan have been following a bunch of FIRE bloggers that have helped them conceptualize how their numbers will come together. The information they’ve found online so far has motivated them to organize their accounts based on the types of income Sue and Joan will withdraw in combination with their MFJ standard deduction. At this point they’re planning to pay zero federal taxes for their first few years in retirement because that’s what all the cool FIRE kids were talking about. After that they plan to settle into the 12% tax bracket, or the equivalent at that point in time. Since they’re currently in the 24% tax bracket because of the size of their salaries you can imagine how thrilled they are to have a strategy of starting their retirement at a lower tax rate.
Strategy 1: Understanding Your Lifetime Taxes
From 2032 to 2046 Sue and Joan will cover their living expenses 100% from their brokerage account. They’ll live off the dividends from that account and sell securities up to the current year’s budget every year. Each year they’ll plan to increase their withdrawals by 2.30% to accommodate inflation.
Sue and Joan have estimated their portfolio will grow over time by a nominal 6%. But what might their lifetime tax obligation be? They could pay 0% in taxes for those first 10 years of retirement by living off of Cost Basis, Capital Gains, and tax free qualified dividends from their brokerage account. They’ll keep their taxable income below the top of the 0% Capital Gains tax bracket. But when we estimate their lifetime tax obligation they’re looking at a total tax bill of $1.2M. Wow that’s a lot! Even with moderate spending and 6% nominal growth Sue and Joan would have a whale of a 50 year tax bill.
Why so high? That’s partly because 40% of Sue and Joan’s total portfolio is in their IRA accounts. When they turn 72 years old they’ll have to start taking big RMDs based on their large IRA balances. Then along with the Social Security they’ll be receiving and the dividends their accounts automatically throw off they’ll find the compulsory income generated by their portfolio will be much higher than their budget and much more than they really need.
The chart below shows Sue and Joan’s retirement income in action. One of them will take a small pension at 65 and they’ll each start taking their respective Social Security benefits at 70 (5 years apart). Their RMDs will start at 72 (again 5 years apart), and their combined RMDs and dividends will jump over their budget line almost up to the income-related monthly adjustment amount (IRMAA) threshold. Their RMDs will eventually push their Ordinary Income into the 22% tax bracket and their Capital gains will be taxed at 15%. This combination could create a potential hidden tax through increased medicare premiums because of the potential for strong growth in their IRAs, and remember we’re only estimating 6% nominal growth here. Ouch!
Not to be a downer, but it gets worse when one of them dies and the survivor is forced to deal with what’s commonly referred to as the widow’s penalty (gotta love those old fashioned terms!). When one of them dies the remaining spouse will file taxes as Single, which means the survivor spouse will be pushed into a higher tax bracket since their portfolio will continue to throw off the same income and dividends. In this scenario the surviving spouse will land in the 24% Ordinary Income tax bracket and the 15% Capital Gains bracket.
In the chart below we can see the taxes Sue and Joan are paying now while they’re still working. Sue and Joan estimated their lifetime tax obligation so they can make thoughtful decisions about taxes during retirement with the big picture of their lifetime tax obligation in mind. This chart shows their tax rate jump a bit in 2026 when the current rates are set to expire. Then a gap with zero federal tax due as they cover their expenses with tax free long term Capital Gains for 10 years. But starting in 2047, when the older spouse starts taking Social Security their tax obligation comes back to life and continues to grow over time. Sue and Joan’s total lifetime tax obligation is estimated to reach $1,219,257.
And now to editorialize just a bit… the scenario above is commonly recommended to folks as they retire. “Spend from your brokerage account first, leave your IRA to grow tax free, and we’ll see what your taxes look like down the road because we can’t estimate them now as we know they will change.” We had a financial professional say something like this to us in the year we retired and for us that was an unacceptable answer. For folks with big IRAs, you WILL pay more in taxes in the future if you don’t make some adjustments now. And of course it is possible to estimate future taxes. Know that many CPAs want you to think they’re amazing if they can help you save on taxes today and remember that you might have much more taxes to pay in the future if you’re only thinking about today.
Strategy 2: Chipping Away at Your Lifetime Tax Obligation
Depending on who you talk to, common advice often says to spend down a brokerage account first and hold off on accessing tax deferred accounts to let those tax sheltered dollars grow tax free. Yippie right? That’s what we had been reading and so that was our first plan as well. But is that advice really worth following? The only way to know is to test your numbers.
Since the balances of Sue and Joan’s 401k’s (which will become IRAs when they retire) represent about 40% of their portfolio today it’s important for them to consider how those accounts will grow over time and when they should tap into them. Sue and Joan do want to manage their lifetime tax obligation so they’re looking for ways to control their IRA balances over time, thus managing their eventual RMDs and finally their taxes.
Ideas for Managing IRA Balances and Taxes:
- Start IRA withdrawals when you turn 59.5 years old
- Taking withdrawals after age 59.5 will start to lower your IRA balance which will moderate your future RMDs.
- Pay ordinary income tax on those withdrawals.
- Annual Roth conversions
- Convert money from your IRA and directly deposit it into your Roth.
- Use money outside of the conversion to pay the tax due, to maximize the amount you convert to the Roth. As an example, if you convert $10k from your IRA to your Roth and use $1k of those funds to pay the ordinary income tax that would result in a $9k deposit to your Roth. If you instead use $1k from your brokerage account to pay the taxes that would result in a $10k Roth deposit.
- Allocation management
- Pick a slower growing asset to hold in your IRA to slow growth while maintaining your total portfolio allocation goal. From the table describing efficient fund placement above, pick either an efficient or neutral asset type that will save taxes while held in this account and moderate account growth.
- Make Qualified Charitable Distributions from your IRA
- You can make a QCD up to $100k per year directly from your IRA to a qualified charity after you turn 70.5 years old.
- Those QCDs would be tax free withdrawals from your IRA.
With the above suggestions in mind, Sue could tap into her IRA when she’s 59.5 years old in 2035 and withdraw funds to cover 30% of their living expenses. Since that 30% would almost be the same amount as their MFJ standard deduction they would still pay zero Ordinary Income tax from 2032 to 2046. And they would pay 0% on Capital Gains. They would also have the option for Capital Gain Harvesting in that sweet spot of extra space in the 0% Capital Gains bracket.
But what do those withdrawals totaling around $32k from one of their IRAs every year over 10 or 11 years do to their future RMDs? The RMDs shown as light green bars in the chart below have dropped much closer to the budget line compared to the original version of this graphic shown earlier in this post.
And what about total lifetime taxes? As shown in the chart below, this strategy drops their total tax bill down around 20% from the original estimate of $1,219,257 to $972,916 over their 48 year retirement.
More Roth Conversion Thoughts
Many of us have or are investing heavily in 401k’s to help fund our retirement years. Doing so gives us a tax deduction now as well as a tax deferred account to let our investments grow in. But after you’re 59.5 years old and start taking withdrawals, and after you’re 72 and start taking RMDs, those funds will be taxed at Ordinary Income rates. Unless you’re sticking only to brokerage accounts or Roth accounts for your portfolio you’ll be paying tax at Ordinary Income rates and no withdrawals will be tax free.
One of the ways to generate future tax free income is Roth conversions. This money strategy is a common topic in many of our posts because we’re always looking for ways to make them fit in our personal finance strategy. Roth conversions are appealing to lots of people like us who invested heavily in a 401k but did not (unfortunately) also invest heavily in a Roth account while employed. Ali is convinced that Roth conversions are about as close as we can get to a time machine that would allow her to go back and invest more in her Roth during her career.
Roth conversions are not needed in every portfolio. So consider them with a grain of salt and test them on your portfolio to find your lifetime tax obligations before you jump on the Roth conversion bandwagon.
Strategy 3: Taking Control of Your Income and Lifetime Taxes
Next let’s have Sue and Joan continue annual IRA withdrawals to cover 30% of their expenses. In this example they’ll also make a Roth conversion that will stack up with other Ordinary Income and Capital Gains. Once their standard deduction is taken all of their taxable income will drop below the 12% Ordinary Income bracket and the Capital Gains will still be in the 0% bracket.
As you can see in the chart below, the individual years look very different now compared to the original version of this chart. At the start of their retirement Sue and Joan will make varying amounts of Roth conversions over 14 years, keeping their taxes within the 12% Ordinary Income and 0% Capital Gains brackets respectively. The light green RMD bars in the chart below are much smaller because of larger discretionary IRA withdrawals or Roth conversions over time which manages their IRA account balances.
As shown in the chart below, Sue and Joan are making Roth conversions designed to push their total taxable income up to the top of the red dotted line that represents the top of the 12% Ordinary Income tax bracket with the standard deduction. Getting all sources of income to stop at the budget line is exactly what we want to see, though any tax-free Cost Basis can be above these limits because those funds are needed for living expenses. Roth distributions make taxes for the surviving spouse much more manageable, but this strategy has one disadvantage since Sue and Joan’s taxable income is over the ACA threshold in their first 10 years of retirement and that will result in higher ACA premiums. If this strategy doesn’t erode your spending too much in order to reduce your lifetime taxes then feel free to put on your big girl pants and go for it!
They could also use additional income sources based on how much money they need and how their taxes change year to year. Once their IRA balances have been converted over to their Roth’s Sue and Joan can take tax free withdrawals from their Roth accounts, assuming those conversions have cooked for a minimum of 5 years to avoid penalties. That option will be good for the survivor as her tax obligation would be almost zero after her standard deduction, 0% Capital Gains, and the rest of her annual expense needs covered with Roth dollars. Another benefit of depending on a Roth account for your income is keeping your taxable income well below income-related monthly adjustment amount (IRMAA) levels, avoiding higher medicare premiums.
Ok now, how did we do with reducing Sue and Joan’s lifetime tax obligation this time? According to the chart below, we did great! This exercise dropped that big lifetime tax number by almost 63% from the original amount of $1,219,257! Taking what they owe down to $449,025 over 48 years. That’s pretty awesome!
What becomes clear after running your numbers with all of these approaches outlined above is that lots of people living on median incomes can keep their taxes within the lower tax brackets during retirement by understanding relevant tax codes. And yes, we know the tax codes are going to change many times over the coming decades. Current tax rates will sunset in 2026, and at that point tax rates are likely to go back up to the percentages we had in 2017. Meaning, the likelihood that one could sustain the same size of Roth conversions every year is not assured for all kinds of reasons. The amount by which you can reduce your lifetime tax obligation through Roth conversions will vary based on the level of conversion each year, changes in tax codes, ACA Marketplace income restrictions, and the need to cover changing life goals over time.
So, What’s the Conclusion?
Don’t be afraid to dive into your taxes now and in the future. We started questioning our tax strategies after we attended a FIRE Chautauqua in Ecuador in 2019. At this amazing gathering we were challenged over a discussion about trying to pay zero taxes, and eventually Vicki Robin reminded us to stop being money rats and look at the big picture. You can estimate your lifetime tax obligation, then look at different strategies to help you make the best withdrawal moves to preserve as much of your portfolio as possible.
The reality is that retirement planning is an ongoing process so you’ll likely make different choices year by year based on your current and long term life goals. The Retirement Planning Guidebook was the one book where we found the tools and ideas we needed to dial our retirement strategy in more concretely, and we plan to keep referencing this book. Pfau’s take on Front Loading taxes was eye opening for us and we hope it will be for you too. If you want to tackle this book take your time since this isn’t a one-read-and-done kinda book.
And remember, don’t be a money rat!!