Smart Tax Planning Before and During Retirement

On this episode of The Long View, tax guru Jeff Levine discusses Secure 2.0, tax planning before and during retirement, and whether investors should bank on continued low tax rates.

Here are a few excerpts from Levine’s conversation with Morningstar’s Christine Benz and Jeff Ptak:

Smart Tax Moves for 2023 and Beyond

Benz: We want to spend some time talking about tax planning before and during retirement. We sometimes hear about the years just after someone’s retired, so maybe they retire at 65 or whatever and before those required minimum distributions begin at age 72 as a particularly opportune time to do some tax planning and to embark on some strategies to reduce future tax bills. Can you talk about that particular period in life? Or perhaps you would even start the clock even earlier before someone retires.

Levine: I think certainly the year that someone retires and if they are in between, let’s say, retirement and taking required minimum distributions and having Social Security, and so on, so-called gap years, you often hear it referred to like that. Those are opportune times for sure for individuals to take these sorts of distributions or to do some tax planning, I should say. But for some, it’s earlier.

At the heart of this, I would say, there are a few principles that people should live by when it comes to tax planning. The first principle that people should adopt is the winner of the tax-planning game is not the person who has the lowest tax bill in any one year, but he or she who pays the lowest lifetime tax bill. That is the key here. So sometimes having a lower lifetime tax bill means paying more taxes today. That’s OK if it’s in service of the higher principle, which is the lowest lifetime tax bill wins.

The other thing I would say, is that a low-income year is a terrible thing to waste. Sometimes I hear people say, “I had almost no tax bill this year.” And I look, and I say, “I’m so sorry.” If you’ve done a good job saving over the course of your lifetime and you have a $0 tax bill or a very low tax bill, you have wasted the opportunity to use lower tax brackets. And there’s a couple of ways you can do that. So, perhaps one of the most common ways and probably the one I imagine you were thinking of when you started this discussion, is Roth conversions. Certainly, Roth conversions are one of the most effective ways of utilizing those low-income years. You’re able to pay tax, add income at a time of your choosing, effectively wave the magic wand, create income and have it taxed, if it’s by your choice, at a time when you believe your tax rate today is lower than it would otherwise be in the future.

But that’s certainly by no means the only strategy that people can use. For instance, others might want to look at using the 0% long-term capital gains bracket. This is one of the very best strategies that you can use if you have money in a taxable account that has gone up in value and you find yourself in either the 10% or the 12% ordinary income tax bracket. Because at those brackets, the long-term capital gains tax rate is 0%. And the only thing better than not paying tax is paying tax at a 0% rate. And the reason is, once you’ve paid tax at a 0% rate, that money is considered to be aftertax. Even though you only paid $0 because you had a 0% rate, it’s all aftertax, which means it’s basis to you. It can be spent at any time tax- and penalty-free. And so, even those individuals who really, let’s say, like an investment that they’ve held for a long time that is appreciated in value, maybe that’s why they like it so much, well, they can sell some or all of that investment depending upon their income and how much gain they have and then almost immediately repurchase that investment with a higher basis amount, and that allows an individual to take advantage of that 0% capital gains rate, and you don’t have to worry about things like the wash sale rule. That’s what comes up all the time: “Don’t I have to wait 30 days? What if I like this investment? What if I think it’s going to go up?” You don’t have to wait 30 days because the wash sale rule only cares about what you rebuy when you sell something that had a loss. But here, we’re trying to sell something with a gain to take advantage of paying tax at the 0% rate on the gain that you have. So, those are two tried-and-true strategies about figuring out how to bring more income into your return now while you have those so-called gap years and not wasting them. Because once again, low-income years are a terrible thing to waste.

Ptak: One of the key questions that investors and their advisors often wrestle with is how to decide which accounts to pull for their withdrawals in retirement. We sometimes hear about how taxable assets should go first, followed by traditional tax-deferred, followed by Roth, and people like rules of thumb. But is that one too simplistic to be useful, in your opinion?

Levine: Yes, it is certainly better than the alternative. So, if you told me I’m spending my Roth dollars first and then I’m going to take my IRA, and then I’m going to take my taxable assets, well, that would be a problem. I’d be hard-pressed to think of a situation where I would think that would work well. So, it is certainly better. And as a rule of thumb, or as a guideline, a starting point, OK, starting with your taxable dollars and going tax-deferred and tax-free, that makes sense. But ultimately, it is often a combination of many things.

For instance, sometimes early on, like if we have those gap years we were just talking about, maybe you’re better off living off of your taxable assets and trying to use tax-loss harvesting and selecting the right lots and all that sort of stuff to create a very low-income situation. But where you still have income—when I say income, you have money coming in, mostly principal at that point, or hopefully, gain that’s been offset with losses. You can use that to keep your income for the year low but meet your spending needs and then use that low income that you’ve created to take money out of your traditional IRA—not to spend it but to convert it. And down the road, sometimes it’s a combination of things. You may take some out of your IRA and some out of a Roth IRA. At the end of the day, what we’re really trying to do is to keep the lifetime tax bill as low as possible.

And so, if that’s the case, if you find you have a particularly high need for income in one year—let’s say, the roof leaks and you need $30,000 unexpectedly, and that might push you into a much higher bracket. Well, while generally you want to leave the Roth dollars for last, if you see it’s going to force you to go into a much higher bracket, or it’s going to phase you out of some sort of credit, or it’s going to trigger some sort of surtax, well, that can be a situation where you want to buck the trend and take money from the Roth ahead of time even if it means taking some of that money from the Roth before you take all the money out of your traditional IRA. So, yes, it’s an OK starting point, but you want to be much more granular, and this is where, again, a good financial advisor or a good tax advisor can look at your situation, not just once, but each and every year, and sometimes multiple times throughout the year, and figure out how to get you the income you need or the dollars you need from your portfolio of assets at the lowest long-term cost.

Benz: I wanted to ask about required minimum distributions again, Jeff. As you know, many older adults love to hate their RMDs. They get them really mad. So, can you quickly outline these strategies that one could potentially employ with an eye toward reducing their RMDs, or perhaps reducing the taxes due on their RMDs?

Levine: I think one would simply be you don’t have retirement accounts or pretax retirement accounts. That’s the easiest way. You could do that through a number of different ways. A) you could just not use them; or B) you could have your money inside Roth IRAs, and Roth IRAs have no required minimum distributions during an individual’s lifetime. And so, that would eliminate that issue. Beyond that, some of the other things that individuals can do: Certainly, those who are charitably inclined and who are 70.5 or older, and the good news is, if you’re 72 and need to take RMDs, you are definitely 70.5 or older. If that’s the case, you can use what is known as the QCD, short for qualified charitable distribution, as a way to take money out of your IRA and give it directly to charity. And Jeff, Christine, this is even better than having money come out of your IRA and then writing a check to charity even if you’re able to deduct that amount as an itemized deduction, and there’s a few reasons for that.

First of all, not everybody gets to itemize as we talked about before. But even if you do itemize, the itemized deduction for charitable contributions is a below-the-line deduction. It’s an itemized deduction. It happens after AGI is calculated. And why that’s important is that even though the tax brackets apply to taxable income, which is after itemized deductions, other than the QBI deduction, that business income tax deduction for pass-throughs, that’s a 20% deduction for some—other than that, pretty much every single credit that goes away in the tax code, or a deduction that goes away in the tax code, or surtax that kicks in, or even things that aren’t even taxes, like Medicare Part B premiums, none of them look at taxable income. They care about AGI, and you can give $1 billion away to charity as an itemized deduction, but it doesn’t lower your AGI a single dollar. Using the qualified charitable distribution is a way to take money, again, from your IRA and give it directly to charity if 70.5 or older, and it never even gets added to your income in the first place. So, not only does it keep your taxable income amount low, but it keeps your AGI low too, so you don’t phase yourself out of those credits and deductions or trigger surtaxes, and so on.

I would also add one other thing there, and it’s this is that the qualified charitable distribution can be used to satisfy an individual’s RMD for up to $100,000 per year. It’s not limited to the RMD. So, if your RMD is $2,000, you can still do a QCD for five if you want to be especially generous. But if you had a larger account, you can take up to $100,000 out of that IRA each year and use it toward satisfying your IRA RMD. And by the way, that is another area where there are some proposed changes as part of Secure Act 2.0, potentially inflating that $100,000 amount each year, maybe even allowing individuals to take a one-time distribution that qualifies as a QCD and using it to fund a charitable trust that they have, or some other split interest, perhaps like a charitable gift annuity. So, there are some proposals there to keep an eye on as well.

And then, finally, I would say another way for those individuals who are still working in their 70s and beyond is to use what is known as the “still working exception.” This is not something that’s available for everyone. But if you’re still working for an employer and that employer offers a 401(k) plan, or a similar type of plan, 401(k), 403(b), and so on, that employer may allow you to delay taking required minimum distributions from that plan until you retire. So, if you’re still working at 73 and 74 and 75, you might not have to take required minimum distributions from that plan. And sometimes that plan will allow you to take all your other money that was maybe sitting in an IRA or an old 401(k) or an old 403(b) and move it into that plan, and now you don’t have to take RMDs on anything, which if you’re still working, might be exactly what you want because you don’t want to add all that retirement account income on top of your earnings from work. So, those are a few ways in which people who are struggling, if you will, and it’s a very first-class problem, we have to agree with that. But those who have required minimum distributions that they don’t want, those are some ways in which they might seek to address them.