As predictable as the changing leaves and the shorter daylight, year-end tax planning is a best practice for just about every taxpayer in the late Autumn. This year, year-end planning is certainly more complex given day-to-day and even hour-to-hour shifting of the tax landscape as politicians debate upcoming (or even retroactive) changes to the tax code. Political wrangling aside, we still believe November and December are a great time for most people to project income, withholdings, and liabilities and use these final weeks of the year to optimize or reduce tax liabilities with these basic tasks:
- Max out employer retirement plans (if available)
- Max out health savings accounts (if available)
- Contribute to deductible or non-deductible IRAs (if eligible)
- Harvest capital gains and losses to minimize capital gain income in taxable accounts
- Ensure Required Minimum Distributions are distributed before December 31st
- Consider bunching charitable deductions into one year to exceed the standard deduction
- Estimate and make payments for federal and state “safe harbor” to avoid penalties and interest
What is The Golden Window of Tax Planning Strategies for Retirees?
Beyond the year-to-year tactics, another critical once-in-a-lifetime window of opportunity can and should be optimized by those recent or soon-to-be retirees. This is a “Golden Window” for strategic tax planning that spans decades instead of just one year at a time. The potential tax savings from exploiting this window can be substantial given the potential for a multi-decade retirement. The Golden Window is a period of several years when retirees can, with careful planning and knowledge of the tax code, utilize the lower income tax brackets in the near term, in exchange for not enduring much higher tax liabilities in retirement. This Golden Window is most often characterized by the following circumstances:
- Recent retiree with very little wage income
- RMDs are not required yet (not yet 72 years old)
- Social Security income is usually not claimed yet
- Ample after-tax assets to fund living expenses
- Cash available for slightly higher federal and state taxes
How Does it Work?
The graphic above depicts this window of time prior to income ramping up in retirement due to the combination of Social Security (sometime between age 62 and 70, depending on the claiming strategy) and required minimum distributions age, currently 72.
At its core, exploiting the Golden Window is voluntarily incurring some level of income at the lower tax brackets using several tax-smart strategies. These include one or a combination of the following strategies:
- Strategic Roth conversions taken at a level calculated to incur the lower rates
- Intentional but careful incurring of capital gains income at what are currently more attractive income rates of 0% or 15%
- Using a donor-advised fund to “bunch” charitable contributions in a single year to offset other income incurred
Using the table above as an example, a taxpayer would actually increase their effective tax rate above the roughly 4% in years 2021 – 2025 in exchange for lowering their tax rates below the 20%+ they are projected to incur in years 2031 and beyond. The goal is to have a net reduction in tax dollars over the course of the retirement. Typically, we recommend targeting high single-digit tax rates in the Golden Window for a much bigger payoff (and larger reduction in rates) in later years of retirement when RMDs, Social Security, and other income can really add up. Of course, the longer the retirement, the better the pay off as the lower tax rates can be the gift that keeps on giving through a long stretch.
What are the Advantages?
The main advantage is paying lower federal and state taxes over several decades by using the lower rate brackets to their full extent so that future income isn’t climbing to the higher rate brackets. The strategy assumes tax rates are biased higher and will always be progressive, which means the higher one’s income, the higher tax rate they will pay.
Strategically converting to Roth IRAs adds another benefit, because heirs owe no federal or state tax on the growth nor on the distributions from inherited Roth accounts. While tax law can always change, so far there is no proposed legislation that would change this key advantage for efficiently passing assets to heirs for most clients.
What are the Risks?
Despite these advantages, we urge taxpayers to proceed with caution. We highly recommend working with a CPA or an enrolled agent to ensure proper tax compliance and calculation of potential tax liability. There are many moving pieces to an income tax return. Examples include:
- Medicare premiums can increase in later years if too much income is incurred. This is the dreaded Income-Related Monthly Adjustment Amount (IRMAA) which can add significantly to monthly premiums. IRMAA kicks in at $88,000 of income for a single filer or $176,000 for joint filers.
- Capital gains tax can be incurred if other income is too high. This can increase tax on capital gains from 0% to 15% or even 23.8%, causing an unpleasant surprise when filing taxes.
- Higher income levels can increase the tax on Social Security income (up to 85% of Social Security can be taxed depending on other income).
Tactical tax planning is a healthy financial practice, especially when it’s done with the guidance of an informed wealth advisor and a quality tax professional. A longer, multi-decade approach can potentially create a more sustainable and less-taxing retirement income stream, leaving more after-tax dollars for clients and their heirs.