This post was written with the permission of the clients discussed below. For purposes of confidentiality, I have changed their names and changed or omitted ancillary details about their personal circumstances.
Summary/TL;DR
By pursuing a tax-efficient distribution strategy, I will help my clients, Bill and Mary, save an estimated $300,000+ in taxes over the rest of their lives. This will have been accomplished without them taking any sort of pay cut. Specifically, this has been accomplished by pursuing a tax-aware distribution strategy that avoids the dreaded “social security tax torpedo” and is properly integrated with the timing of other sources of taxable income they will receive in the future. Furthermore, their tax-savings will remain in their investment accounts to grow over time, increasing their estimated portfolio value by $1.3 million by the end of their lives.
Introduction
Tax planning is nothing more than understanding how different actions that one takes will manifest themselves on one’s tax return and taking proactive measures to plan out these actions. By far, the lowest-hanging tax-planning-fruit that most retirees have is their portfolio distribution strategy.
In this post, I will explain how I am helping my clients, Bill and Mary, save an estimated $300,000+ in taxes over the rest of their lives by making one simple change: modifying the order in which they are taking distributions from their retirement accounts.
Setting the Scene
Bill and Mary have most of their income needs met from Social Security and variable annuities. Specifically, Bill has a social security benefit of $37,769 annually and Mary has yet to file for social security. Bill also has a variable annuity in his IRA that is paying him $32,813 annually. All $32,813 is currently being taken as a taxable distribution. Besides their IRA, they have a non-qualified account with a few hundred thousand dollars that they take about $18,000 in annual distributions from to supplement their other income sources. When Mary claims social security in about five years, they will no longer need to supplement their income with portfolio distributions. Finally, Mary also has a variable annuity in her IRA that has a guaranteed income rider. This annuity has yet to be “turned on”.
Now, there’s nothing really wrong with the facts I’ve laid out. Bill and Mary’s situation isn’t outlandish and nothing “bad” would occur if they continued their current course. What they wouldn’t realize on their own, however, is that there is substantial opportunity within their seemingly innocent circumstances.
Creating a Strategy – Tax Planning In Practice
Because Bill and Mary are taking distributions from their non-qualified account, they aren’t adding significant amounts to their taxable income. This decreases what’s called their provisional income, which makes less of Bill’s social security benefit taxable. In fact, only about $19,000 (or 50%) of his $37,769 social security benefit was taxable in 2022, meaning social security was a significant source of tax-free income for him.
What I noticed, however, is that they were taking more from Bill’s IRA than was necessary. Remember, his annuity is paying them $32,813 annually. And since that annuity is in Bill’s IRA, all of those distributions are included in taxable income.
What I pointed out to Bill and Mary is that they could take Bill’s annuity distribution as a lump sum every year and roll it over to his IRA at Fidelity, investing it alongside the rest of his retirement portfolio. Then he would only take his Required Minimum Distribution (RMD) and effectively reduce his taxable income by the difference. We’ll then increase annual distributions from their non-qualified account to make up for the smaller distributions from Bill’s IRA. By decreasing his taxable income this much, the amount of social security he will have subject to taxation will also be $0. And after the standard deduction, Bill and Mary will have negative taxable income! This means they can make tax-free Roth conversions!
Yes – you read that correctly. Despite receiving more than $85,000 in income from various sources, Bill and Mary will have negative taxable income and can make what are essentially tax-free Roth conversions.
Analyzing Impacts
Here’s what this means for them. By modifying their portfolio distributions, they will pay essentially $0 in taxes until Mary starts social security in 2028. By that time, we’ll have been able to convert substantial amounts of Bill’s IRA to Roth (while paying nothing in taxes), decreasing his future RMD and, therefore, future taxable income. This will give us more flexibility to control taxable income in the coming years when Mary claims social security and the Tax Cuts and Jobs Act ends.
We also decided to delay Mary’s social security benefit until her full retirement age and “turn on” the guaranteed income rider on her variable annuity at her age 70. Both decisions not only improve their tax planning, but also provide maximum lifetime benefits from both income sources.
The impact of this can be seen visually below.
In grey, you’ll see their annual tax liability if they remain on their current course. In blue, we see their projected annual tax liability representing a decrease in taxes. And in red, we see a projected increase in taxes relative to their current course (in their case, from a hefty Roth conversion I’ve modeled). My software projects lifetime tax savings of over $300,000 from these simple changes. And I believe that this is a conservative estimate because there are things that I cannot model in the software that would further our cause.
Keep in mind that it is the wholistic approach of tax planning that produces these results. I was careful to integrate their distribution plan with the timing of Mary claiming social security and “turning on” her variable annuity. In other words, it is not only their distribution strategy that produces these substantial tax savings, but their distribution strategy within the broader context of additional variables.
The power of this planning can also be seen in another way: the amount of their income that will be considered “tax-free” in the future. See below how their non-taxable income changes over time if nothing is done. I’ve blocked out other parts of the table for confidentiality considerations:
Now, look how their non-taxable income is expected to change after our changes. The difference here is mostly from the amount of “tax-free” social security they will be receiving because of our distribution strategy:
And remember, I have not asked them to decrease their income in any way. The only thing we have changed is the order and magnitude of their distributions from their various investment accounts. By dialing in on this issue, being precise, and making the most of current tax legislation (in other words, tax planning), we’ll have worked together to save them hundreds of thousands in taxes.
Tax Savings Compound Within Their Portfolio
The impacts don’t stop at tax savings. Every dollar they are saving in taxes stays in their portfolio to grow over time, significantly increasing their portfolio value down the road. My financial planning software projects a portfolio value of over $1.3M more than it would be on their “current course” by the time we’ve projected Mary to pass-away at age 90. And this is just from changing their distribution strategy and integrating it with social security! Imagine what this represents to them – more dream vacations, peace of mind, security, and more memories with each other and their family.
Conclusion
Bill and Mary are perfect examples of how comprehensive financial planning can help almost everyone. Those who don’t believe they need it because their circumstances are “too simple” or they “don’t have a lot going on” are simply mistaken. Even if their circumstances are relatively “simple”, the tax code is not. And small improvements that compound over time will have a dramatic impact over the course of a 20–30-year retirement.
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