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Targeting Taxes

Adam M. Grossman

RETIREMENT CAN—ironically—take work. It requires us to restructure how we think about both our time and our finances. That rethinking extends to tax planning, which tends to move to center stage once we quit the workforce. Already retired or approaching retirement? There are several tax strategies worth considering.

But before we review specific strategies, it’s worth pondering a more fundamental change wrought by retirement. During our working years, the usual goal is to minimize our tax bill each year. But in retirement, the objective is different: It’s to minimize our total lifetime tax bill.

Let’s say you have two accounts, a traditional IRA and a Roth IRA. Withdrawals from the traditional IRA will be taxable, while Roth withdrawals will be tax-free. If you simply wanted to minimize your tax bill in a given year, you could draw all of your living expenses from your Roth. But if you did that every year, eventually your Roth would be depleted, and then you’d have to turn to your traditional IRA for all future withdrawals.

Result? Because withdrawals in later years would lean so heavily on your traditional IRA, that could force you into higher income-tax brackets, causing your retirement’s aggregate tax bill to be higher than if you’d more evenly weighted withdrawals over the years. Because of this dynamic, a priority for retirees is to pick a target tax bracket—one that, they believe, will more or less remain the same throughout retirement. How should you go about choosing a bracket? I see it as a three-step process.

First, you’ll want to estimate your potential maximum tax rate in retirement. That will most likely be in your mid- or late 70s, after you’ve started both Social Security and required minimum distributions (RMDs). Next, you’ll want to estimate your minimum tax rate. That’s typically in the years immediately after retirement, before those other income sources kick in.

Finally, to choose an ideal target for the entirety of your retirement, you’ll want to pick a rate somewhere between the estimated minimum and maximum. Got that? Now, let’s turn to specific strategies.

Roth contributions. The first strategy is one you can implement even before you retire. Suppose you normally contribute to a tax-deductible 401(k) or 403(b). That usually makes sense during your working years, when your tax rate is at a high point. But for some people, this playbook has a wrinkle.

If your plan is to move gradually into retirement, perhaps working a reduced schedule for some time, your tax rate might also drop. If it drops enough, it may make sense to shift your retirement contributions to your employer’s Roth 401(k) or Roth 403(b). Yes, you’ll forgo the immediate tax deduction. But if your tax rate is lower, the benefit you’ll be giving up will be smaller, and it’ll allow you to build up valuable Roth money.

Medicare surcharges. Once you’ve entered retirement and you’re on Medicare, you may be frustrated by the income-related surcharges added to your premiums. Because these surcharges are calculated on a two-year lagged basis, they can be quite high in your first years of retirement. Fortunately, the government has an appeals process. Look for Form SSA-44. You’ll notice that it offers eight possible reasons to request an adjustment, one of which is “work stoppage”—in other words, retirement.

Roth conversions. In your first full year of retirement, you might consider a Roth conversion. In the past, I’ve described the mechanics and the many benefits of conversions. The goal: Undertake Roth conversions to smooth out each year’s income, so you remain in your target tax bracket.

Portfolio structure. The objective of Roth conversions is to reduce future RMDs. That, in turn, can help keep a lid on your future tax rate. Portfolio structure can also help to limit future RMDs. To do this, you’ll want to house your fastest-growing assets—typically stocks—in your Roth IRA, thereby taking advantage of the tax-free growth. Meanwhile, you’ll want to locate your slowest-growing assets—typically bonds—in your traditional, tax-deferred accounts. The result: Your tax-deferred account will grow much more slowly, thus limiting future RMDs.

Roth IRAs are most attractive for holding stocks, but you can also house stocks in your taxable account. Yes, this means you’ll incur capital gains taxes when you sell your stocks down the road. But capital gains rates are often lower than the ordinary income rates that apply to withdrawals from traditional retirement accounts. Moreover, at death, appreciated assets benefit from a step-up in cost basis, thus nixing the embedded capital gains tax bill.

Charitable giving. Suppose you’re further along in retirement and contending with RMDs that exceed your annual expenses, causing your tax rate to creep up. After age 70½, you could turn to a strategy known as qualified charitable distributions (QCDs). Consider a retiree whose RMD is $100,000 but who only needs $80,000 for expenses. This is where QCDs can be a godsend. If this retiree were to give $20,000 directly from his traditional IRA to a charity, it would count toward his RMD but wouldn’t add to his taxable income.

Monitoring the mix. If you’re still many years from retirement, are there any steps you can take now? Two strategies are worth considering. First, keep an eye on your mix of retirement accounts. Sometimes, high-income taxpayers become too enthusiastic over tax-deferral strategies, such as employing cash balance plans that end up deferring six-figure sums each year.

While these plans can make sense, they can also have an unintended consequence. If the tax-deferred balances grow too large, the resulting RMDs can push a retiree into a very high tax bracket later in life. This is unusual, but I’ve seen it happen, so it’s worth doing some projections to see where your retirement balances might end up once you’re in your 70s. You could then adjust your contributions, if need be.

Direct indexing. Another suggestion for those in their working years: In the past, I’ve discussed the concept of direct indexing. Instead of owning an S&P 500 index fund, for example, a direct indexing service would purchase all 500 stocks individually. While this might sound unwieldy—and the cost is certainly higher—it can deliver a benefit over time. When you reach retirement and want to take withdrawals, you’ll have much more control over the gains you realize each year. You’d also have the option of donating the most highly appreciated stocks to charity.

Because direct indexing has pros and cons, you shouldn’t view this as an all-or-nothing decision. You might establish a separate account with just a portion of your assets dedicated to the strategy.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.

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