By David O’Neill, JD, CWM®

In Part I of Turning Savings into Income During Retirement, we discussed the asset location strategy for income during retirement. To recap, this is the practice of holding assets with different tax treatments in different types of accounts. This can help your retirement savings grow faster and last longer once you begin taking distributions in retirement.

We’ve heard it’s better to get the bad news first, so here it goes -- taxes are complicated; and a large IRA balance going into retirement can lead to paying large tax bills. But the good news is, with some advance tax planning, it’s easy to increase your retirement income by avoiding the “tax explosion.”

Conventional Wisdom Can Cost You

When it comes to spending down your savings in retirement, the rule of thumb is to spend your taxable and tax-free savings first, allowing your pre-tax savings to continue to compound tax-free. Conventional wisdom here would allow your pre-tax savings to grow to its maximum amount before tapping into it later in retirement.

Unfortunately, this rule of thumb can lead to a much higher tax bill once you begin to take required minimum distributions (RMDs) from your IRA. The problem with this is that as your IRA account balance grows, so do your RMDs, which could push you into higher and higher tax brackets. Moreover, taxes are set to increase once the Tax Cuts and Jobs Act (TCJA) expires December 31st, 2025 – leading to an even larger tax bill.

Let's apply this to real life: A 65-year-old couple has a combined pre-tax IRA balance of $3,000,000. Their estimated rate of return is 7% on their IRA, and we’ve calculated RMDs under the Secure Act which requires the first RMD to be taken at age 72. This example includes Virginia state taxes but does not include any other taxable income, such as social security or pensions, which can vary greatly from person to person. Any additional income would be taxed at the couple’s highest marginal rate. Take a look at the chart below showing estimated taxes on RMDs. What do you see?

The first thing you may notice is just how large the pre-tax RMDs (blue line) increase over time. When the couple is 75 years old, their estimated RMD will be more than $210,000 and at 80, their estimated RMD is almost $300,000 a year. They may neither need nor want $300,000 a year in taxable income. Furthermore, as the RMDs grow, this couple is pushed into even higher tax brackets. Our retirees start out in the 28% bracket (plus Virginia’s 5.75%) but end up in the top 39.6% bracket sometime in their 80s.

What you may not have noticed is how estimated taxes compare to their after-tax RMD income. While this couple is in their 80s, the taxes they pay will be more than half of their after-tax RMD.  And it’s not just rising tax brackets that are the problem – ever-increasing RMDs subject you to increased taxation of Social Security, Medicare premium surcharges and higher capital gains tax rates. In this example we’ve not calculated in the Net Investment Income Tax, but let’s not forget that it will add 3.8% once you reach $250,000 in modified adjusted gross income (MAGI) if you’re filing jointly.

The Winning Tax Strategy

The big problem here is a large pre-tax account balance later in retirement. Once you see the problem, we hope the answer is obvious. To avoid this “tax explosion,” you’ll want to tax-efficiently reduce the size of your pre-tax IRA before your RMDs really begin to balloon. You can do this by spending down your pre-tax IRA, converting your pre-tax IRA into a tax-free Roth IRA, or participating in a Qualified Charitable Distribution (QCD) strategy. Some of these tactics have age-based limitations, so please check with your financial professional.

• The first tactic for reducing your pre-tax IRA account is spending it down to fill your lower tax brackets. Seems obvious, we know, but you’ll still have to pay the taxes on these distributions. Be mindful of this when electing your distribution amounts and how it will affect your tax payments and potential bracket increase.

• The second tactic for reducing the amount in your IRA is converting a portion or all of your IRA to a tax-free Roth IRA with a Roth IRA conversion. The downside is you’ll want to pay the taxes on the conversion with tax-free or after-tax savings. You won’t want to pay the Roth IRA conversion taxes with pre-tax IRA money because you’ll be paying taxes to pay taxes.

• Finally, there are QCDs. These are completely tax-free withdrawals from your IRA directly to a charity (or charities) of your choosing. Any QCD amount up to $100,000 per spouse is excluded from your taxable income which means it doesn’t count toward the taxability of Social Security or your Medicare premium calculation.

Putting it All Together

So, what do these strategies look like in practice? First, you’ll need a pretty good idea of your annual spending needs. Using your spending needs as a guide, split your withdrawals between after-tax, pre-tax and tax-free accounts using a tax-efficient strategy based on your unique situation. Spending from your pre-tax account allows you to take advantage of the lower tax brackets while avoiding a ballooning balance in later years. After you have funded your annual living expenses by withdrawing from your taxable, pre-tax and tax-free accounts, you can fill the remaining lower tax bracket with Roth IRA conversions.

Roth IRA conversions have two advantages: they move money out of your pre-tax account, slowing the growth of the RMD bubble and they provide a source of tax-free money that provides tax planning flexibility in the future.

Finally, Michael Kitces at Kitces.com has produced an excellent illustration of how a blended spend-down strategy can increase your account balance (and income in retirement). The figure below shows the spend-down outcome for a retiree with $1,500,000 in two accounts: $750,000 in a taxable account (e.g., brokerage) and $750,000 in a pre-tax IRA. The illustration assumes an 8% return in the pre-tax IRA and 7% return in the taxable account. This retiree plans to withdraw $80,000/year from their portfolio, and they are choosing among four options:

• Spend down the pre-tax IRA first, and then the taxable account once the pre-tax is exhausted.

• Spend the taxable account first, and then the pre-tax IRA.

• Split strategy - spending the pre-tax and taxable accounts in equal amounts.

• Split strategy with Roth IRA conversion to fill the lower tax brackets.

You can see with basic tax planning, filling the lower brackets with Roth IRA conversion early in retirement increases the account balances later in retirement.

In the end, you can dramatically increase your retirement income by doing a little tax planning every year. Of course, exactly how much more retirement income and how long your savings last in retirement depend on your personal situation.

If you’d like to continue the conversation, please reach out to schedule a time to speak with us.