The Tax Planning For Retirement
The Tax Planning Window is defined as the period of time after you stop earning income and before you are required to start social security and required minimum distributions. This is the optimal time to do tax planning for retirement.
For the tax savvy individual, The Tax Planning Window is a glorious time! There is no other window in time where you have such control of how and when you recognize income. During your tax planning window, you can decide exactly how much you are going to pay in taxes!
Do not ignore your tax planning for retirement, because the goal is: pay the least in taxes over your lifetime. A dollar less you pay in taxes is a dollar more you can enjoy in retirement, or leave as a legacy.
A Window is a good analogy because it opens and closes.
Open Window For Retirement Tax Planning
The window opens when you have access to your 10 and 12% tax brackets (or sometimes 22 or 24%) due to the fact you don’t have earned income filling them up!
Even better, below the $12,400 or $24,800 standard deduction for single or joint fillers, respectively, you can access income tax-free!
Use this Tax Planning Window wisely, because it closes when you are forced to take income again.
Close Window for Retirement Tax Planning
There are several ways your tax planning window closes.
First, when you take social security, you will pay taxes on up to 50 or even 85% of social security depending on your “provisional income.” Half them money you get from social security counts for provisional income, so most high earners should just assume they will have to include 85% of their social security as fully taxable. Taxation of social security is complicated.
Second, you will be forced to take required minimum distributions (RMDs) from you pre-tax accounts. Currently, thanks to the SECURE Act, you are forced to take ever increasing RMDs at 72. At 70, however, you will still claim social security as there are no more delayed income credits beyond that age.
Finally, other sources of income can be recognized as ordinary. Pensions and annuities are common sources of partially (say annuities from your brokerage account) and fully taxable income (pensions, and annuities from tax-deferred accounts).
But wait, there’s more! Of course, there are more sources of income that can fill up your brackets!
Alimony (prior to 2018-after that it stops being a tax deduction), business income (Schedule C), Schedule E income, Schedule F income, Form 4797… even Capital Gains!
Capital Gains Stack on Top of Ordinary Income, but can negatively affect your Tax Planning Window.
I know this is a lot to take in, but the Tax Planning Window is very important! Let me tell you why.
Why the Tax Planning Window is so Important
Control. Yes, you can control how much you pay in taxes.
For a traditional retiree who retires at 65, you have less than 5 years to access your low tax brackets.
For Financial Independence, the glory of being FI is prolonged access to your Tax Planning Window. This leads to a whole host of other issues (like what income is most tax-advantaged to live on) that is the bread and butter of FIRE.
Beyond control- flexibility. You get to decide when to do partial Roth conversions.
Partial Roth Conversions and the Tax Planning Window
Some people get confused and think there is an income limitation on Roth conversions. There is not. There are limitations on contributions, but not conversions.
If you have money in your pre-tax account, you can (usually) just press a button and convert that money to Roth money, paying taxes now.
You use your standard deduction, and the 10 and 12% tax brackets to do Roth conversions. This means paying much less now on taxes then you will in the future once RMDs force the un-taxed income out.
Having at least some money in Roth accounts is important for good tax diversification and to control your income in the future.
Let’s look at an example of partial Roth conversions and visualize the Tax Planning Window.
The Tax Planning Window Visualized
Note in figure one that income stops at retirement (age 60). The brackets are demonstrated by the colored lines, and there is no income in the example until social security starts at full retirement age (currently 66 or 67 years of age). At age 72, RMDs begin and the tax planning window closes.
There is a clear window in time when you can access your 10 and 12% tax brackets. You need to fill these up!
Some folks only use their brokerage account during this time and allow their tax-deferred accounts to grow. This is usually a bad idea, as you will increase the taxes you pay latter via RMDs. Again, the goal is to pay the least amount of taxes over your lifetime. Use the standard deduction, and the 10 and 12% tax brackets to pay some tax now so you pay less taxes in the future and overall.
Note the taxes paid above quickly go above the 22 and 24% tax brackets due to just social security and RMDs on the pre-tax accounts.
Partial Roth conversions can shift this money into tax-free Roth accounts during the tax planning window.
An Example of Partial Roth Conversions and Tax Planning in Retirement
Note in figure 2, there is now a dark blue shape filling the 10 and 12% tax brackets during the tax planning window. These are the partial Roth conversions!
Also, note in the future, this decreases RMDs and keeps them out of the 24% tax bracket in the future (which actually is the 28% bracket once TCJA expires after 2025).
You might think that this isn’t a big deal, going down two percent from 24 to 22. But you would be wrong! And don’t forget, 22 becomes 25 and 24 becomes 28 when Tax Cut and Jobs Act expires in 2026 (or sooner if Biden is elected).
Remember, during your tax planning window you are paying taxes at very low effective rates. When you are forced to take RMDs, all of the money comes out “on-top” of everything else, at your highest marginal tax bracket. Keep your effective tax rate low over your whole life by decreasing the amount of income included at your highest marginal tax brackets.
Tax Bracket Arbitrage
The long and the short of it; this is tax bracket arbitrage. Use your lower tax brackets effectively to keep out of your higher brackets later in life. This is especially important for those folks who are high income and use tax-deferred accounts during their working years to lower taxes.
A lot of annuity and Life Insurances salesman talk about the evils of tax-deferred accounts, but they are short sighted. If you have to pay taxes at some time, you might as well pay now they say. Well, that is only part of the story.
Remember to use tax bracket arbitrage and pay taxes when you have less income rather than more income. What is the total of taxes now and in the future?
Tax Planning for Retirement and the Tax Planning Window
What does this control offer you? What is the advantage of never taxable money?
Once you have Roth money, you can pull the money out without any implications to your taxes.
Decreased RMDs from your always taxable accounts are huge. In addition, there are no RMDs from Roth accounts! Efficient tax planning for your Heirs is a major consideration with partial Roth conversions.
With Roth money, you also have the ability to control your provisional income if you want to pay less in taxes from your Social Security.
What about health care? Controlling your income can get your premium ACA tax credits for Obama Care plans. And when you get to Medicare age, IRMAA is a huge deal. Medicare plan B and D are subject to large surcharges if you make too much money.
In the end, it is all about control. Who knows what the future will hold, especially in regards to tax rates set by Congress?
Understand your Tax Planning Window. Tax Planning for Retirement is your best chance to keep the money you earned rather than paying through the nose in taxes.