The Retirement Tax Time Bomb
There’s a tax trap in retirement that could come back to bite you. Most people would prefer to pay less in tax in any given year. The problems arise when this year’s tax bill is looked at in isolation. When it comes to drawing income from a portfolio in retirement, tax considerations can have an enormous impact on how long your money can last and even the total amount you can spend. It may seem like a lower tax bill is always a win, but as with many decisions based only on the short-term there can be unintended consequences down the road.
It makes sense on the surface that you want to pay less taxes during retirement. However, under current tax law, many retirees have opportunities in early retirement to optimize their withdrawal strategy. For retirees with qualified assets (traditional 401k/ IRA) distributions must start by age 73 (75 if born 1960 or later[i]). These are tax deferred accounts, meaning what comes out counts as ordinary income. The imagined pain of a tax bill leads some retirees to delay tapping those accounts until forced. This could mean large taxable distributions being forced on you in your mid-70s and beyond which could lead to Medicare Surcharges.
If you have tax deferred retirement savings you need to know that your potential surcharges for Medicare will be based on your income starting at age 63[ii] (2 year lookback) and when your RMDs must begin. All of this should be considered along with both you and your spouse’s (if married) social security claiming strategy. Whether you're listening or not that clock starts ticking when you retire and failing to diffuse it before RMDs can blow up your nest egg
If you ask 100 people if they want to pay less taxes this year, you will probably get 100 yeses. Here’s the reality though, trying to pay less tax for as long as possible will create a ticking tax time bomb in your portfolio. Having accounts with different tax treatment gives you optionality that can help you stay flexible if things change. Your plans could change, but so could tax law. In retirement, as you start to draw down, you should be mindful of balancing current year’s liabilities with your future options.
My most recent blog was about opportunity cost, which ties into tax planning beautifully. Decisions always involve tradeoffs and tapping funds with lower tax costs today means leaving funds with higher tax costs for the future. Like a Jenga tower, the stability of what’s left depends upon which pieces you take out and when you pull them.
It’s not just the dollar amount of the tax bill either. All other things being equal, tax advantaged accounts benefit from time. Trying to take out the lowest tax cost funds first isn’t just creating a bigger future tax bill; you’re also giving up the potential future growth in that tax-advantaged account. When it comes to longer retirements or legacy planning these differences can compound.
A failure to look beyond the current year could lead to huge tax bills in the future. For example, a newly retired couple trying to pay as little tax as possible today might not think about the single tax bracket, one of them will likely be in as a widow or widower. A couple with successful adult children might be okay with paying a little bit more in current tax if that means a more tax efficient legacy. Refusing to tap your taxable retirement account until you have no choice could mean required distributions high enough to increase your Medicare premiums.
It’s not about how much you pay Uncle Sam, it’s about how much you and your family have to spend as you wish. If you only see your tax professional once a year in the middle of tax season, they might not be on top of all of this either but that isn’t necessarily their fault. Tax preparation doesn’t necessarily include any tax planning; in different stages of life this matters more than others. We don’t provide tax advice, but we coordinate with clients’ tax professionals to ensure tax planning is being considered.
