July 27, 2018

One of the things that tends to change pretty drastically for those transitioning from working into retirement (besides going from living a life with meaning to one in which your enjoyment is derived solely from how close your guesses are in the Showcase Showdown on today’s ‘The Price is Right’ – joking), especially if they have accumulated savings in multiple vehicles (IRA, Roth IRA, taxable accounts, etc.) is that that person (couple) now has some ability to dictate their type and level of income. One result of this is that tax rates and multiple tax breaks can be altered from being just above or below specific income thresholds. So as great as it is that you nailed the price of the boat/tent/grill/vintage gumball machine showcase – and it was a rerun, but who’s counting – it may behoove you to spend some time with your financial advisor and accountant to help get your tax ducks in an intelligently designed row. Heck, you might end up with enough tax savings to buy several years’ worth of that Flex Tape you’ve been eyeing.

So let’s go through an example of how this might work and how NOT to do it. Let’s say that a couple has retired and decided to start taking Social Security (whether or not you do those things simultaneously is a topic all its own). You’ve decided that you want a NET income of $75,000 and your combined Social Security payments will provide you with $40,000 – for simplicity, we won’t account for Medicare premiums in this example. If your only form of savings is a Traditional IRA, you will need to make up that gap with withdrawals, all of which we will assume to be taxable. In your working years, you always made a point of keeping your tax withholding high because you enjoyed getting a refund at tax time – so why not aim for the same thing now?

Ahh, here’s the rub. As I said above, one of the discrepancies between now and your working years, especially if you were a salaried employee, is that in the past, you didn’t choose your income level – if you made $50,000, you could withhold $5000 for taxes or $25,000 and it wouldn't change how much tax you actually owe, it just changes your net pay. In retirement, however, if the only way that you take income above Social Security is an IRA distribution and if you decide to make that gross withdrawal amount unnecessarily large to accommodate the increased tax withholding, you can actually cost yourself money. Say you decide to take out $50,000 and withhold 30% in federal income tax ‘so you don’t have to pay in at the end of the year.’ In this instance, none of your income will be taxed above the current 12% marginal rate and your effective rate will be even lower than that, so you obviously overpaid, but what’s worse, you’re taxed on your GROSS distribution. This means that the additional dollars that you pulled out just to pay the taxes are also taxed.

Take person A in this scenario who withdraws $39,772.73 and withholds 12% in federal taxes to get to $35,000 NET, which was our stated goal. If that entire amount was taxed in the 12% bracket, they would have pretty much hit the nail on the head and taken care of their entire tax bill – paying $4,772.73 in taxes (and in this instance, 49% of their Social Security would be taxable). Now take person B who withdraws $50,000 and withholds 30%, also leaving them with $35,000 NET. This person obviously overpaid, but they’ll get it back, so what’s the harm? The harm is that the additional $10,227.27 they took out to pay taxes was also taxed at 12%, meaning that they’ll pay an additional $1,227.27 in taxes over person A, 70% of their Social Security will become taxable (another $1,000+ tax hit over person A) and their refund will not make them whole in comparison to person A. This says nothing of the litany of other tax breaks and deductions that can be impacted by not being carelful with distributions. This is why it’s vitally important to plan for and understand tax consequences in retirement so you can make efficient decisions given your particular situation.

If you add Roth IRAs and/or taxable accounts to the above scenario, a bevy of other potential planning opportunities exist – from timely harvesting of tax losses (of which you can count $3,000 against ordinary income in any given year) to Roth IRA distributions that could possibly decrease both your federal tax liability (in comparison to Traditional IRA distributions) and the amount of your Social Security subject to taxation. This issue has the potential to be even more poignant in 2018 because of the changes to the tax code. These are not insignificant details when it comes to crafting a retirement income and distribution strategy, so treat them with greater care than the Flex Tape guy does his fleet of aluminum boats.

The above example is simply one of a lack of thoughtful planning when withholding, but what about those in higher income brackets where Required Minimum Distributions (RMDs), along with pensions and Social Security, become large enough to affect not just marginal tax rates, but Medicare premiums, as well? First of all – what income levels would trigger increased Medicare premiums (referred to as Income Related Monthly Adjustment Amounts – or IRMAA)? For married couples, these charges start at $170,000 of Modified Adjusted Gross Income (this would result in $1284 in additional Medicare Part B premiums for a couple – and that’s triggered whether you’re $1 or $1000 above the threshold) and top out at $320,000 MAGI for couples (which would increase annual Medicare Part B premiums by over $7000 per couple).

In these situations, whether or not opportunities exist depend on a couple’s mix of assets and their charitable intent. For couples with large Traditional IRA balances, and subsequently, large RMDs that put income near or above levels that would trigger IRMAA, planning both well in advance and once RMDs begin can help. In advance, couples may wish to take advantage of Roth Conversions – paying taxes to convert a Traditional IRA or 401(k) to a Roth IRA so that future income will not be taxed and no RMD rule applies. As Michael Kitces says, however, going out of your way to make large conversions and paying huge sums of tax to avoid a small Medicare Premium increase isn’t necessarily a sound decision, so make sure you understand how what you’re doing impacts the big picture.[1] Once RMDs have actually begun – starting at age 70.5 – there are multiple options to attempt to control income around the threshold levels – one being Qualified Charitable Distributions (these can be simpler and cleaner than charitable contributions as an itemized deduction), which we discussed here, and another being managing gains and losses and types of income in non-retirement accounts, a topic we delved into here. One more option for those whose income needs push them up to levels near IRMAA cutoffs is to pay quarterly estimated tax payments with taxable money they have available to them (whether that be savings or non-retirement accounts) rather than increasing the gross distribution from IRAs and withholding for taxes if that would send them above threshold levels. Of course, these aren’t the only ways to decrease MAGI, but they’re some of the simpler and more common examples we see.

Regardless of your situation, whether you’re a low or middle or high income individual, whether you like black or gray or clear Flex Tape, chances are planning opportunities exist to help maximize your tax-efficiency and failing to do so could cost you money in retirement – who knows how many lifetimes of leaky buckets and boats without bottoms that could mean? While you can’t control the level of competency of your financial advisor or CPA, you can help them out by giving them as much information as possible, because complete information likely gives them the best chance to give you sound advice. Here’s to a retirement free of leaks, financial and otherwise.



LPL Financial does not offer tax or legal advice.

This information is provided for educational purposes only and is believed to be accurate. The hypothetical examples presented are for illustrative purposes only and are not intended to represent any specific product. The information is intended to be generic in nature and should not be applied or relied upon in any particular situation without the advice of your tax, legal and/or financial services professional. It should not be considered investment advice, nor does it constitute a recommendation to take a particular course of action. The concepts presented may not be suitable for every situation. Please consult with a financial professional regarding your personal situation prior to making any financial related decisions.  

Traditional IRA withdrawals are taxed as ordinary income and may be subject to a 10% federal tax penalty if withdrawn prior to age 59 1/2. Roth IRA earnings withdrawn prior to the end of the Roth IRA five-year aging period and prior to reaching age 59½ will be subject to a 10% early withdrawal penalty unless used to meet qualified expenses.  A distribution from a Roth IRA is tax-free and penalty-free provided that the five-year aging requirement has been satisfied and one of the following conditions is met: age 59½, death, disability, or qualified first-time home purchase.

Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.

The opinions of Michael Kitces do not necessarily reflect those of LPL Financial.