Why Do We Care About Taxes?
We care because we want to pay less of them to stretch or optimize our limited resources over our lifetimes. In retirement, there are so many things we do not have control over, we must take advantage of those things that we do have some control over. We cannot control tax policy, but we can take advantage of our situations within that policy. You can look to implement several strategies to minimize the amount of taxes you pay over your lifetime.
The Tax System in the United States
In the United States, we employ what is known as a "progressive tax system." A progressive tax system is one where the more income one makes, the higher the effective tax rate will be. This is achieved through employing a system of "marginal tax rates." The marginal tax rate is the tax rate someone must pay on each additional dollar of income earned. Let's look at an example of how marginal tax rates apply to someone. Let's say we have a person who earned $50,000 last year, and this person's marginal tax rates are 10%, 20%, and 30% applied at these income levels. The first $20,000 of the $50,000 earned would be taxed at 10% resulting in $2,000 of taxes owed, the next $20,000 of the $50,000 earned would be taxed at 20% resulting in $4,000 of tax owed, and the last $10,000 of the $50,000 earned would be taxed at 30% resulting in $3,000 of taxes owed. So altogether, this person who made $50,000 last year has to pay $9,000 in taxes, resulting in an effective tax rate of 18%. This person's marginal tax rate though is 30%. 30% would be the tax rate on his last dollar of earnings.
This is how the United States' system of marginal tax works. Now this example may make taxes look straightforward, but there are actually many complicating factors.
Two Categories of Income
For beginners, there are two different categories of income that receive different tax treatment:
- Individual Income: Individual income is realized, or is taxable, when it is earned or taken. This income category includes:
- Employment income
- Interest earned on savings accounts, CDs, or bonds held outside of a qualified retirement account
- Short-term capital gains, which are gains on the sale of a capital asset held for 365 days or less
- Qualified retirement account distributions – Your retirement accounts, whether they be a 401(k), Traditional IRA, or 403(b), were all funded using pre-tax dollars. It is this pre-tax growth along with employer matching provisions that are the primary advantages of these accounts. Pre-tax dollars are allowed to grow and compound in these qualified retirement accounts. Still, the flip side is that you have to recognize the withdrawals from these accounts as individual income and pay income taxes based on the amount withdrawn.
- Possibly a Portion of Social Security– To the dismay of many, up to 85% of your Social Security benefit will be included in individual income and taxed if you are married and have a taxable income above $44,000.
- Capital Gains Income: Capital gain income is realized, or taxable, when an asset is sold. Or, in the case of qualified dividends, earned. Capital Gain income includes:
- Long-term gain from the sale of a capital asset held for more than 365 days
- Qualified dividends, or dividends paid by stocks, mutual funds, or ETFs. Most dividend income is considered qualified.
Two Sets of Marginal Taxes
We have to account for income under these two categories properly because the IRS applies a different marginal tax rate table to each. The two marginal tax rate tables I am showing here are for married couples filing jointly. There are different sets of tax tables, depending on how you have to file. So, there are a couple of things I want to point out here. First, notice how big the jumps are in the individual income marginal tax rates above $40k and $163k. Second, notice there is a 0% tax rate on the first $80,000 of capital gains. Third, notice how much lower capital gains tax rates are than individual income tax rates. These observations are important because managing your tax situation has to do with undertaking strategies to maneuver within and around these points.
Interactions Between Income Types
Now it's time to add another complicating factor. These two different categories of income interact with one another. Both categories of income still count toward your total income for the purpose of applying marginal tax rates. Let's go ahead and take a look at two example couples to illustrate. In both of these examples, the couple earns $140,000 in total income, but the makeup of that income is different. Starting with Social Security, we can see both couples collect the same benefit of $40,000. Where the difference lies is in the category of the other $100,000 of income. Couple #1 derives their $100,000 of income from Capital Gain sources, whereas Couple #2 derives their $100,000 of income from Individual Income sources.
Both couples will end up with taxable income over $44,000, so let's go ahead and start by recognizing 85% of each couple's Social Security benefits, which is the $34k you see here. Now, both couples will be able to take their standard deduction of $12,400 each and an additional $1,300 each for being over 65. So let's go ahead and apply this total deduction of $27,400 for each couple. This leaves us with the same $6,600 of taxable income leftover from Social Security under both examples.
Next, let's apply the $100,000 of capital gain income for couple #1. Referring to the 2020 Capital Gains schedule, we see the first marginal tax rate bucket is up to $80,000. Remember, we still have $6,600 of taxable income leftover from our first step, so it only takes another 73,400 to fill up the first $80,000 marginal bracket. The remaining $26,600 of capital gain income would get taxed at the next marginal rate of 15%. What should the $6,600 of social security benefit get taxed at? It is categorized as individual income and is taxed at the marginal rate between $100,000 and $106,600 of income. You can see it falls in the 24% marginal rate bucket. Altogether, couple #1 would pay $5,574 in tax leading to an effective tax rate of 4.0%.
Now let's move on to couple #2 and apply their $100,000 of individual income. Since the leftover taxable social security benefit is in the same income category, we will tack that on to the end to make the example a little cleaner. So let's start by attacking the $100,000 of individual income first. The first $9,875 of taxable income is taxed at 10%, the next $30,250 is taxed at 12%, the next $45,400 is taxed at 22% and the last $14,475 of the $100,000 of individual income is taxed 24%. The leftover $6,600 from social security will also in the 24% bracket. Altogether, couple #2 would pay $19,644 in tax leading to an effective tax rate of 14%.
As you can see, all income is not equal when it comes to taxes. Couple #2 in the example is paying ~$15,000 more in taxes on the same income. This brings us to our first strategy.
Managing Your Taxable Income
Managing your taxable income is about strategically realizing (or not realizing) categories of income in an attempt to optimize your situation in any given year. Managing taxable income is complicated, uniquely personal, and there are no hard and fast rules to follow. Strategies will vary from person to person and even year-to-year for the same person. The trick is to build a habit of projecting taxes and looking for tax opportunities before the end of each year to make it work. Most financial advisors have software that helps them to model and do this.
If you recall, Individual income is recognized when you make distributions from your tax-exempt retirement accounts. So to the extent you can control the timing of those distributions, the better. Generally speaking, the longer you can postpone taking withdrawals, the better. It delays taxes and allows for longer tax-deferred growth. But there are times when it may make sense to take a distribution and recognize some amount of income sooner. For instance, say you're early in retirement, you have a few years until RMD's kick in, and you're living off savings, and your only income is $20,000 annually from social security. Further, let's say this person projects to be in the 24% marginal bracket in a few years when RMDs kick in and savings run out. This is a perfect opportunity for this person to recognize income now, filling the 10%, 12%, and maybe even 22% bracket level of taxable income by converting some qualified retirement funds into a Roth IRA. This could be a tremendous win-win strategy. This person can pull forward the realization of income to fill the lower tax brackets while at the same time placing funds in another tax-advantaged vehicle that is free of taxes when withdrawn.
This strategy gives this person added flexibility down the road that allows for a tax-smart coordinated approach to withdrawals. Say a person needs to generate $50k of taxable income per year to fund their retirement. Now that this person has a Roth account, they can fund $40k from their traditional IRA and recognize $40k of individual income that will fill the 10% and 12% marginal tax rate buckets, but then they could fund the remaining $10k from the Roth tax-free. If that other $10k had to come from the traditional IRA, it would have been taxed at the 22% marginal rate. This strategy just saved this person $2,200 of tax per year. Further, this strategy also lowers the amount remaining in the traditional retirement account, so when RMD's do kick in, the amount you will be required to take will be lower, meaning fewer dollars having to be taxed at the highest marginal rate. Having various account types – pre-tax retirement accounts, Roth accounts, and after-tax savings gives a person more flexibility to fund expenses more optimally.
Tax-Gain and Tax-Loss Harvesting
This type of thinking applies to capital gains also and brings us to our second strategy. Strategically timing capital gain realization can be equally as beneficial. Suppose a person has investments in an after-tax brokerage account and happens to be below $80,000 in taxable income. In that case, it might be beneficial to recognize some capital gains to fill up the 0% bracket. To do this, you would sell the capital asset, thereby triggering the realization of the gain, and then buy an alternative asset that represents the same exposure in your portfolio with the proceeds. This is known as Tax-Gain Harvesting.
Opposite of Tax-Gain Harvesting is Tax-Loss Harvesting. Here, assets are sold purposely at a loss to lock in a capital loss. The proceeds are then reinvested into an alternative asset to maintain appropriate asset class exposure in your portfolio. Capital losses are valuable because they can offset capital gains. Additionally, capital losses can carry forward until they are used, and up to $3,000 of capital losses can be deducted from income each year.
One last note, try to avoid taking short-term capital gains if possible. Remember that gains on assets held outside of retirement accounts for 365 days or less get classified as individual income and taxed at the higher individual income rates.
Again, managing your taxable income can be complicated, and it requires a strategy. Still, it is taking advantage of opportunities like these that lie at the heart of managing taxes in retirement. Projecting your income, understanding your brackets, and having a strategy is the key to effectively managing your taxable income.
Another strategy that is thankfully a little more straightforward is Asset Selection. Asset Selection is understanding the effect certain assets have in taxable accounts. ETFs and mutual funds are different. Mutual funds pass-through gains incurred within the fund, whereas ETFs do not, making mutual funds less ideal for taxable accounts. If you hold bonds in a taxable account, you may benefit from holding municipal bonds instead, depending on your marginal individual income tax rate. Municipal bonds pay rates of interest below that of taxable bonds, but their interest is not taxable. To make a comparison, you have to figure out what is known as your "taxable-equivalent yield." If you were at the 32% marginal rate, would you be better off with a taxable bond paying 4% or a tax-free bond paying 3%? With some simple math, we can see this person would be better served by holding the tax-free municipal bond because the taxable-equivalent yield is 4.41%. The taxable-equivalent yield is what allows you to compare municipal bonds to taxable bonds on an apples-to-apples basis.
Also straightforward is the strategy of Asset Location. The idea behind Asset Location is that it is advantageous to hold certain types of assets in certain types of accounts. You can view all of your assets and accounts as one aggregate portfolio. You do not have to create a balanced portfolio in every account. When viewed in this aggregate way, you can take advantage of the fact that capital growth assets, like stocks, are best held in taxable accounts. Why? Because stocks will grow fastest, and when they get taxed, it will be at the lower capital gains rates. Holding stocks in a Roth account is even better where there is no tax ever on the growth. Holding bonds in a Roth account would be a waste of that account type's advantage. Income-producing assets, like bonds and REITs, are best held in retirement accounts, so their income distribution can grow tax-deferred rather than become immediately taxable as they would if held in a taxable account.
Value of Tax Management Strategies
How meaningful are all of these strategies? Is it really worth the time and effort? The answer is probably yes, but it does depend. Each person's situation is different, and a tax strategy needs to be customized. Whether you chose to do it yourself or with a professional's help, there is clearly at least some value from managing your tax situation.
There are two well-known industry studies that have been done by Vanguard and Morningstar that attempted to quantify the strategies discussed today, and others. In their Advisor's Alpha study, Vanguard found that up to 1.10% of value can be created from an optimal withdrawal strategy, and another up to 0.75% of value can be created through the deployment of an effective asset location strategy. Morningstar's Gamma study is much more conservative at a little over a half percent of value for both, though many practitioners see some fault with their level of conservatism. Regardless, I think it's fair to say there is some real value in adopting some of these strategies whether you do it yourself or with a financial advisor's help.
We stand by ready to help if you need assistance in assessing your tax management strategies. If we can ever be of service, please feel free to reach out.
ABOUT THRIVE RETIREMENT SPECIALISTS
Thrive Retirement Specialists is a retirement planning specialist dedicated to delivering a more thoughtful and strategic approach to retirement planning for those nearing or in retirement. We are a fee-only Registered Investment Advisor (RIA) offering a single, flat-fee service entitled ThriveRetireTM that goes far beyond what has traditionally been known as retirement planning. ThriveRetire™ is an engaging ongoing 8-step retirement planning process and investment management service that seeks to identify all risks, assets, tools, and tactics to develop an optimal retirement plan designed to support your ideal retirement lifestyle and goals to the fullest extent possible. With every interaction, we seek to inform and serve, so our clients can safely trust their ThriveRetire™ plan and process, leaving each client with the confidence and peace of mind to live a vibrant and full life through retirement.
ABOUT ANTHONY WATSON, CFA, CFP®
Prior to founding Thrive Retirement Specialists, Tony spent eight years serving as the Chief Investment Officer of a firm where he provided advice and investment management services to over 600 individuals representing at the time over $1.5 billion of investments. Before this, Tony served as Vice President at J.P. Morgan Private Bank, where he advised high- and ultra-high net worth individuals on all matters of wealth, including investments, portfolio construction, portfolio management, and retirement planning.
Tony lives in Dearborn, Michigan, with his wife Dawn and daughters Emma and Anna.
- BBA in Finance, Walsh College
- MBA, University of Michigan, Ross School of Business
- Chartered Financial Analyst (CFA)
- Certified Financial Planner (CFP®)