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Tax-Efficient Income Management in Retirement

by Christine Van Meter, M.B.A., E.A.

Many of our clients have planned very carefully and worked very hard to fund their retirement savings in order to enjoy a comfortable and worry-free retirement. They have dutifully invested in tax-deferred savings vehicles such as their 401(k) plans and traditional IRAs, SIMPLE and SEP IRA plans, tax-deferred annuities, and even savings bonds issued by the US Treasury.

But with retirement comes a series of new and at times counter-intuitive challenges in managing your income in a manner that funds the lifestyle you deserve, while at the same time avoiding paying unnecessarily high income taxes on the money you worked so hard to save over your working career. Every year at tax season we see too many people get distressed to find that they owe unexpected taxes as a result of money choices they (or in some cases their parents) made over the course of the year. At that point, it is too late to do anything except enrich Uncle Sam at your expense, which is why it is so important to plan ahead.

For most retirees, staying in the 15% tax bracket is a desirable goal that can often be achieved with a prudent investment strategy and proactive tax planning. The benefits of success can be astounding; for instance, in the 15% tax bracket, under current law, the long-term capital gains on securities or investment property that you sell are taxed at 0% (yes, you read that right: there is no tax on your capital gains)!

One of the major and confusing variables that complicate tax planning in retirement is your Social Security benefits. Starting in 1984, up to 50% of Social Security benefits could be added to gross income if the taxpayer's total income exceeded a set threshold, and this amount was then increased to 85% ten years later in 1994. Unfortunately, the thresholds that were established under that legislation were not indexed for inflation, so today a great many people of comparatively modest means exceed one or both of the thresholds.

This treatment of Social Security can cause some very unhappy surprises. For instance, let's say that you have set up your retirement income streams so that you do not pay tax on your Social Security, but then you draw $100,000 from an IRA to buy that motorhome that you so richly deserve. You expect to pay some income tax on the IRA distribution, but then at tax time you learn that the distribution caused 85% of your Social Security to be taxable, which pushes you into the 25% tax bracket, and suddenly you owe nearly double the amount of taxes that you expected!

More systemically, IRAs and 401(k)s are assets that can cause tax problems as well. Most of us assume that we should diligently avoid touching our IRAs and 401(k)s until we are required to begin required minimum distributions (RMDs) at age 70 and a half. But sometimes, to our dismay, we learn that our RMDs are so large that they thrust more of our Social Security into the taxable column and thus increase our marginal tax rates in an unhappy manner. Some retirees avoid this trap by beginning to take carefully apportioned distributions from their IRAs or 401(k)s once they reach age 59 and a half, and reinvest the funds in either a ROTH IRA or even a regular investment account. If done with careful planning, this can enable you to more precisely manage your taxable income over time, and avoid exposing yourself to higher tax brackets.

Savings bonds can also cause a very unhappy tax trap. All too often, we keep our savings bonds in the safe deposit box until we need the funds all at once, either for a major purchase, or perhaps to fund nursing home care. Suddenly decades worth of accrued interest becomes taxable in one year, and we wind up giving a sizeable chunk of our savings to Uncle Sam. Again, it may make sense to begin an orderly liquidation of savings bonds earlier than later, with an eye to keeping our tax rates manageable. And children, if you are forced to liquidate your parent's savings bonds in one year to fund nursing home care, try to cash in the bonds in the same year that you pay for the care, so at least the medical expense deduction might offset some of that income!

Even taxable investments can cause problems. Selling a security at a gain adds to your gross income and can potentially affect your tax rates. One of the advantages of working with an investment advisor who is sensitive to tax issues is that you can embark on a systematic program of tax-loss harvesting in order to offset gains in the future. While pretax returns are important, and indeed how performance of managers is measured against peers, a tax-aware best practice is to take advantage of inevitable market volatility in order to enhance your actual after-tax returns.

Of course, these are fairly advanced income management strategies that do not apply uniformly to all investors. Be sure to call Chris or Dave Van Meter at (315) 823-9200 to see if they may be right for you.

Van Meter and Van Meter, LLC.
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