Principles of Retirement Tax-Planning – SWR Series Part 44

March 22, 2021

It’s tax season in the U.S. right now! Even though that deadline has just been pushed back to May 17, taxes are on everybody’s mind, so this is a good time to write about the topic in the context of the Safe Withdrawal Rate Series. Until now, I haven’t written all that much about taxes and the main reasons are:

  1. While I do have a combined 6 letters behind my name (Ph.D. & CFA), I’m missing the three letters “CPA” to write anything truly authoritative about the topic.
  2. My primary focus is on getting the Safe Withdrawal Rate right. It’s the first issue everyone should worry about. I did some case studies years ago for early retirees and some of them could actually raise their SWR to more than 5% if they do their accounting for future cash flows right. That’s 25% better than the naïve 4% Rule. If you start with a tax plan that’s already somewhat OK and close to optimal, I doubt that you can squeeze out another 25% in after-tax withdrawals through a truly “optimal” tax plan. Hence my approach: get your SWR right and factor in the tax optimization plan afterward to make sure you squeeze maybe another percent or two in the after-tax numbers!   (And likewise, if you have a 60-year horizon and not much in the way of supplemental cash flows and you’re looking at a 3.25%, maybe a 3.5% withdrawal rate, you’re not going to “tax-hack” yourself to a 4% withdrawal rate either!)
  3. Taxes are very personal and it’s difficult to give any generalized advice. As much as I would like to create a spreadsheet like the Google Sheet to simulate safe withdrawal rates (See Part 28 for the details) where you plug in your numbers and the sheet spits out a detailed plan, it’s not so trivial. Very likely, the tax analysis would have to be more custom-tailored!  And just to be sure, my Google SWR simulation sheet isn’t trivial either! 🙂

But of course, even if you first do your SWR analysis in before-tax terms, you will want to know how much of a haircut you need to apply to calculate your after-tax retirement budget. Some retirees can indeed make over $110,000 a year and don’t owe any federal tax as I showed in my post in 2019 (“How much can we earn in retirement without paying federal income taxes?“). And in the same post, I showed that to get to a 5% average tax you’ll likely need a $150k annual retirement budget. So, it’s a fair assumption that most of us in the FIRE community will likely get away paying less than 5% of our retirement budget in federal taxes. Add another 0-5% or so for most state tax formulas, and you will likely stay below 10% effective/average tax rate.

But I get the message: because we can’t completely ignore taxes, I wrote today’s post to talk about the general ideas and principles in retirement tax planning. In at least one additional future post (maybe two, maybe three) I will also do a few case studies to see the general principles in action. At that point, I will also include the Excel Sheet I use to perform the tax planning analysis because a lot of readers asked for that tool when I published the Case Studies 3+ years ago! And as I warned before: it’s not as simple as just putting your parameters and Excel automatically spits out your plan. It involves a bit more human input and analysis, stay tuned!

But before we even get to the messy parts, let’s take a look at some general principles…

Principle 1: Try not to compound a tax drag

People often ask me if they should consume or reinvest the dividends in retirement. My recommendation: if you already paid taxes on the income that year, you might as well put it toward the retirement budget. Why would I want to reinvest the cash flow and liquidate more assets and incur even more taxes? Notice that retirement is much easier than saving for retirement in this aspect. You see, for the longest time while working I had to pay taxes on my dividend income in the taxable accounts. And with taxes, I mean Federal plus State (California, arghhh!) as well as 3.8% Obamacare taxes! Only to reinvest those dividends and pay taxes again on those dividends. All else equal, it’s always optimal to defer income for as long as possible and pay taxes only once in the end. Unless you expect a tremendously high tax in the end. Let’s look at the following example: 

  • A 10-year horizon
  • A 10% expected return  (all capital gains, no dividends for simplicity)
  • A 20% tax on gains
  • A $100 initial value

If you were to realize the capital gains every year and pay the 20% tax you’re left with 8% after-tax every year and $215.89 after ten years.

If you defer the capital gains taxes all the way until the end you have $259.37 before tax after 10 years. $100 of which is the tax basis and $159.37 capital gains. After paying capital gains taxes (20% of $159.37 = $31.87) you’re left with $227.50. That’s an annualized after-tax return of 8.57%, 0.57 percentage points higher than if you had realized the gains every year. Not a bad “alpha” purely from better tax planning!

And the tax-alpha goes up the longer you defer the gains! In the chart below I plot the IRR comparing the 8% return when you realize the gains every year, the 10% pre-tax return, and in the middle the after-tax return when you realize the capital gains after x years for x between 1 and 40 years. The longer you defer the gains, the higher the IRR because you spread the one-time tax impact over a longer and longer number of years!

SWR-Part44-Chart02
IRR for different investment horizons (x-axis) in the example above. Notice how the IRR advantage of deferring capital gains grows! You spread the one-time tax over a longer and longer horizon!

Of course, if taxes go up in year 10, the results may change (but refer to Principle 3 below when facing tax changes over time). But the rise in taxes would have to be substantial to overcome compounding the tax drag. In any case, the “don’t compound a tax drag” principle has many different applications in tax planning:

Application 1: Active vs. passive investing

The tax compounding effect is one of the reasons why stock-picking and market-timing don’t belong in a taxable account. In the numerical example above, an active stock investor realizing all gains every year would have to generate a pre-tax return of 8.57%/(1-0.2)=10.71% just to match the buy-and-hold investor’s after-tax return (potentially even more if the gains were short-term and taxed at a higher rate!). 0.71% annualized alpha is not that easy. If you ever want to do any stock picking, market-timing, dividend strategies, etc., try to do those in a tax-deferred account. And some will yell at me for even bringing up such a sacrilegious issue but keep in mind that while I’m mostly a passive investor many of my readers may not be card-carrying Bogleheads.

Application 2: Pre-retirement stock/bond asset location

The question of whether bonds belong in your taxable account or tax-deferred account is as old as the IRS. Or as old as the tax-deferred account, to be precise. I wrote a long 5,000-word post about the topic (SWR Series Part 35) drilling into the mechanics and the tradeoffs you face. Bonds pay interest and the income is (usually) ordinary income, taxed at a higher rate than capital gains and dividends. Besides, there was also a time when bonds still yielded 5%+, so they had a worse compounding issue than stocks with a 2% dividend yield, adding to the pressure to keep bonds in the tax-advantaged account. But that drag is now much lower in light of the lower bond yields, so for some investors, it may be optimal to keep bonds in the taxable account. White Coat Investor has written multiple posts about this issue all referenced in my SWR Part 35, including this one showcasing an example where bonds in the taxable account indeed give you the better expected after-tax outcome. In my analysis in Part 35 of this series, I showed that, quite amazingly, some of the math that drives the pros/cons of bonds in taxable vs. tax-advantaged account is very reminiscent of one of the oldest economic concepts: “Comparative Advantage“, going back to David Ricardo in the early 1800s to formalize how economists think about the gains from (international) trade.

Application 3: High-dividend yield vs. low-dividend-yield stocks

Aside from the stock vs. bond asset location, there is also the separate issue of where you want to hold what stock type. So, within your stock allocation, you’d be better off keeping the lower-dividend-yield stocks in the taxable account and the higher dividend stocks in the tax-advantaged account to minimize the compounding effect of the taxes. I once wrote a post quantifying the inefficiency of broad equity index funds and the benefit of splitting your equity holdings and investing the half with the lowest yield in a taxable account and the upper half in the tax-deferred account (Here’s an idea for a new ETF).

Application 4: But in retirement, it could be OK again to have high-dividend stocks in a taxable account!

Of course, when you are already retired and you withdraw your income every year to live on, the compounding of the tax drag is no longer a concern. You pay the tax on the income and you consume that income and never reinvest it. No need to sweat that tax drag compounding anymore! So, if you want to do a high-dividend strategy in retirement, go ahead. Just don’t come to me crying if you do worse than the the broad index!

Application 5: Keep RMDs low enough to never exceed your retirement budget

The Required Minimum Distributions (RMDs) starting at age 72 are taxable as ordinary income. If the total RMDs exceed your entire retirement budget it’s not the end of the world; you can simply invest the surplus in a taxable account again, but that will lead to the same problem again: You get taxed once on the RMD, and then part of that RMD keeps growing in a taxable account and gets whacked again by the tax-man.

Well, of course, if you are 72 this year and you have to withdraw $200,000 due to RMDs and your budget is only $100,000 each year you will have no choice. But most retirees will benefit from planning before they even reach age 72. It may make sense to avoid the RMD issue or at least alleviate it before you get there. Use the time before claiming Social Security, when you likely have relatively little ordinary income to perform Roth conversions and/or tap the 401k and IRA already to fund your living expenses to avoid the over-accumulation in the tax-deferred accounts. (see some guidance in Principle 3 below)

Principle 2: It’s likely optimal to first liquidate shares with a high cost basis

Before we even get into the question of what account types to liquidate first (taxable vs. tax-deferred vs. tax-free) there is one question that people often raise: if you have a taxable account, what tax lots should you sell first? Notice that this has nothing to do with stock picking. Even if you own only one single mutual fund (like Fidelity FZROX or Vanguard VTSAX) you still need to determine which tax lots should go first!

Here’s my answer: If you have losses (short and/or long-term), liquidate all(!) of those lots. If that’s more than you need for your retirement budget, you still liquidate them all and reinvest the residual in a similar but sufficiently different asset (=tax loss harvesting), i.e., you sell an S&P 500 index fund at a loss and you buy a U.S. Total Market Index Fund. Or vice versa. This avoids the IRS wash-sale rule. See my post “Be Your Own DIY Zero-Cost Robo-Adviser!” for more details.

Considering that you’re in retirement and you had a long history of accumulating assets, we can probably discard the possibility of sizable short-term gains. So within the remaining tax lots, now all with long-term gains, we’ll likely optimize our taxes when we liquidate tax lots with a higher cost basis first, assuming we face a constant tax rate on capital gains over time (not necessarily true, I know, but see principles 3&4 below). To prove this point, let’s look at the following simple numerical example:

A retiree has two equity lots, each worth $100,000. To make the math as easy as possible, let’s assume that the first lot has a cost basis of $100,000 (i.e., zero gains) and the second has a basis of $0 (assume that it’s close enough to $0 that it’s OK to round down, e.g., you bought $50 worth of AMZN in 1997, now worth $100,000). You also expect an 8% return over the next year and face a 15% capital gains tax. You have an after-tax $100,000 cash flow need this year and like to maximize the expected after-tax cash flow next year. How much of a difference would the order of liquidation make?

  • Option 1: If we sell Tax Lot 1 first we get $100,000 and pay no taxes. Tax Lot 2 will be worth $108,000 after a year, which is $91,800 after paying the 15% capital gains taxes.
  • Option 2: We sell Tax Lot 2 first and receive $85,000 after tax. We liquidate another $15,000 from Lot 1 to make it to $100,000 after-tax. Our $85,000 lot grows to $91,800 in year 2. But unfortunately, we still owe 15% taxes on the $6,800 in gains. That’s a $1,020 tax bill. So we are left with only $90,780.

So, it would have been wiser to let the lot with the larger capital gains run even longer and liquidate the high-cost-basis lot first. It may not sound like much but if you can increase your year 2 after-tax income by 1.12% that’s nothing to sneeze at. And remember this is not from stock picking, not from market-timing, it’s pure tax arbitrage.

I should also state that the results are qualitatively the same if I assume less extreme tax lots, say Lot 1 with a $70,000 basis and Lot 2 with a $30,000 basis. The math will get a bit messier but the advantage is still on selling Lot 1 first, though at a slightly smaller tax arbitrage percentage. If you drill down into the math, it has some of the same flavors as the “avoid the tax drag compounding” in Principle 1! Try to let capital gains run as long as possible! And the advantage of holding on to the highly-appreciated shares is even larger when you factor in the possibility of the step-up basis, see Principle 4 below!

The situation gets a bit ambiguous when you have both short-term and long-term gains. On the one hand, if one of the lots has a short-term gain much smaller than even the smallest gain in all of the long-term gain lots, it might be optimal to liquidate the short-term gain lot first, even if that means you need to pay ordinary income taxes on the gains. On the other hand, if the difference in gains is small it might be better to wait until the short-term gains turn into long-term gains. It’s hard to make a generalized recommendation, though. But as I said in the beginning: retirees will probably not have a lot of short-term gains, especially once you’re several years into retirement.

Caveat: It might be a good time to also get rid of the high-fee mutual funds with built-in gains once you reach a lower tax bracket in retirement. They may not have the highest basis, but if the fees are high enough, it might be time to get rid of the “stinkers!” See this post for more details: Stuck With a High-Expense-Ratio Fund? Here’s a Google Sheet to Weigh the Pros and Cons of Dumping that “Stinker” in Your Portfolio!

Principle 3: “Smooth” your marginal tax rates across time

In the U.S., as in most countries, we face a progressive tax system, which means that not only will taxes increase with income, but they (normally) increase at an increasing rate. Thus, the marginal tax rates also increase with income. Below is a chart that demonstrates this artifact. The blue line plots the federal income taxes as a function of the AGI (Adjusted Gross Income). There are some special rules for long-term capital gains, so I plot this chart assuming that all your income is ordinary income. Notice how the blue line has straight/linear sections (actually “affine” is mathematically more accurate) and kink points where you jump into the next tax bracket. So the blue line forms a (weakly) convex function, so it keeps going up straight and occasionally makes slight “left turns”.

SWR-Part44-Chart03
As a function of the AGI, not only do your taxes increase, but they form a (weakly) concave function with an increasing slope.

One implication from this tax function convexity is that variations in your income can potentially raise the average tax burden. Take the following example. A married couple filing jointly with a $100,000 annual (ordinary) income. At the $100,000 annual baseline, you’re looking at a tax burden of $8,590 per year. Small fluctuations don’t hurt you. For example, the +/-$1,000 variation still leaves you in the 12% federal tax bracket, so the tax burden is +/-$120. But if the fluctuations get larger, the high-income scenario pushes you into a higher tax bracket and you lose more on the upside (e.g. +$1,585 in taxes when making $10,000 more) than you gain from the lower taxes when your income is lower (e.g. -$1,200 in taxes when you make $10,000 less). This effect from the curvature of the tax function gets worse when the fluctuations get larger.

SWR-Part44-Table01
Fluctuations around a baseline income can hurt you!

And for the math geeks: Yes, I know, I haven’t invented anything new and revolutionary here. It’s all a result of Jensen’s Inequality, appropriately named after the famous FIRE blogger Carl Jensen. Uhm, no, just kidding, that was a different Jensen.

In any case, here are a few applications of this method:

Application 1: Roth 401k vs. Regular 401k

This is relevant mainly for younger folks still working. But it’s a nice application of this principle. Let’s look at the pros and cons of channeling money into the (regular) 401k vs. the Roth 401k. If the (expected) marginal tax rate is lower in retirement than while working, it’s advantageous to invest in the regular 401k. See the diagram of the payouts below. The 401k vs. Roth 401k edge is determined entirely by relative tax rates if we assume the portfolio is invested in the same asset! 

SWR-Part44-Diagram01
The pros/cons of the 401k vs. the Roth 401k. In this example, the 401k yields a higher after-tax value in retirement because the marginal tax rate is lower in retirement.

But that doesn’t have to be true for every single dollar you contribute. We always have to think at the margin and if your increased 401k contributions eventually push you into a lower tax bracket today and/or into a higher tax bracket while in retirement then the advantage might flip and you ought to reoptimize: you might stop contributing to the 401k and continue with the Roth 401k! 

Side note: As a commenter, Martin Silfen pointed out below: There one slight complication in the Traditional vs. Roth 401k tradeoff. The Roth 401k offers a slight advantage because if you are bound to max out all of your tax-advantaged then the Roth 401k is able to accommodate more money (pre-tax equivalent) than the 401k. So if you have a lot extra savings left over and all that money has to be invested tax-inefficiently in a taxable account it would make the Roth 401k slightly more attractive. Sometimes this can make a difference, especially if the above comparison is very close. I built a comparison tool where you can compute this effect for your particular situation.

Application 2: Capital Gains Harvesting (CGH)

On your federal return, a married couple filing jointly can generate $80,800 in long-term gains at a 0% tax rate (2021 values, according to the Tax Foundation). And those $80,800, the top of the 0% tax bracket, is in addition to the standard deduction ($25,100 in 2021). Capital gains harvesting means that you might sell appreciated assets above your cash flow needs to fill up unused space in that 0% tax bracket. This will raise your cost basis and hopefully lower your tax burden in future years where you might again overshoot the 0% bracket and get hit with the 15% rate (or even 20% or worse yet, 20% + 3.8% ACA taxes when you realize capital gains way into the six-figures).

And the idea behind CGH is exactly this tax smoothing approach. It’s inefficient to have 0% marginal rates on capital gains today and 15%+ later. It’s better to max out the 0% today and push your capital gains all the way to the beginning of the 15% rate if you expect a 15% rate (or higher) in the future. Smooth your marginal tax rate! You could potentially even justify CGH beyond the 0% bracket and harvest gains into the 15% bracket if you project landing in the 20% bracket or even the 23.8% bracket later.

Further reading:

Application 3: Roth Conversions and Preparing for RMDs

As mentioned above: We want to cushion the effect of Required Minimum Distributions (RMDs) later in retirement. The potentially large boost in ordinary income might put us into a higher tax bracket starting at age 72. So, let’s take a look at an example retiree facing this issue, see the chart below. Before claiming Social Security, this retiree gets away with paying zero income taxes by simply liquidating capital gains and staying in the 0% bracket for gains. Once Social Security kicks in we do end up in the 12% federal bracket. But leaving the IRA/401k accounts untouched for so long we are now getting hit with the 22% federal bracket once RMDs commence. Well, that seems really inefficient. We would have done better filling up some of the lower tax brackets in the early years. Certainly the 10% and likely the 12% brackets:

SWR-Part44-Diagram02
Try to smooth the marginal tax rates across different phases of retirement!

And the math and the mechanics are the same again as in Application 1: As long as the conversions/withdrawals are done at a smaller marginal rate than the 22% in the future we gain from the transactions. Once we leave the future 22% bracket and land in the 12% we would be indifferent if we reach the 12% bracket today. Well, I would forecast tax increases later in retirement and certainly still max out the 12% bracket. If we’re still in the 22% future tax bracket then we might even do some additional small conversions into the 22% bracket today to hedge against the possibility of rising tax rates in the future!

But I also like to point out an example where the Roth Conversions clearly went too far. If we get impatient and push the conversions too hard now and catapult our marginal tax rates into the 22% or even 24% bracket early on, only to find we have converted the entire(!) IRA/401k leaving us in the 12% bracket in the future, then that’s a losing proposition. You’d only go overboard like that if you believe that taxes on the middle class (federal brackets 1+2) jump to 24% in the future, but I’m not that risk-averse. It’s possible but not very likely.

SWR-Part44-Diagram03
But excessive Roth conversions into the 22% or even 24% brackets are a bad idea, too, if the reduced or even zero-RMDs put you into a much lower tax bracket later in retirement!

Application 4: Withdrawals from Roth vs. Traditional IRA

Before the 2017 federal tax reform, distributions of an inherited Roth IRAs could be spread over an extended period. But with the tax reform, most non-spouse beneficiaries of IRAs must liquidate those accounts within 10 years, making an inherited Roth IRA slightly less valuable. This applies to both IRAs and Roth IRAs. Your beneficiaries will be taxed on the (traditional) IRA liquation. Sure, the Roth IRA liquation will be tax-free, but the beneficiary loses the tax shield for potentially hundreds of thousands of dollars in the Roth and will be forced to reinvest that cash in a taxable account if it’s not used for their immediate living expenses. And of course, there are some exceptions to the 10-year Rule but most inter-generational transfers are subject to that rule.   [an earlier version of my post stated that before the 2017 tax reform, the inherited Roth could have been bequeathed indefinitely for as many generations as you like, but I corrected this misstatement. Thanks to reader Martin Silfen for pointing this out! You see: I’m not a CPA! 🙂 ]

So, the old recommendation to hold on to that Roth for as long as possible not as valid now. It might be advantageous for retirees to dig into the Roth during the last few years of their lifespan if liquidating too much of their Traditional IRA would push the marginal tax rate higher than what your heirs are expected to pay. Specifically, you want to play some of those tax smoothing schemes with intergenerational(!) marginal tax rates: if your heirs have much higher marginal tax rates than you, then leave the Roth to the kids. But if it’s the other way around, absolutely, dig into your Roth and leave the traditional IRA to the kids! Smooth your taxes, even across generations!

Caveats: There are probably many different caveats to this approach, but the obvious ones are all related to the fact that Jensen’s Inequality will not apply if the tax function isn’t convex. And there are at least several different quirks in the U.S. tax code and the ACA health care subsidies that create non-convexities:

  1. If your ordinary income pushes more of your previously untaxed capital gains into the 15% bracket, you will face a 27% (=12%+15%) marginal tax rate not just a 12% marginal tax on ordinary income. Thus, the marginal tax rate on ordinary income can go from 12% to 27% and then back down to 22% once your ordinary income goes into the third federal tax bracket, creating a non-convexity. I wrote about this quirk in 2016. A similar issue comes about again when the capital gains tax goes from 15% to 20% and then to 23.8%, and you might have an additional 5%/3.8% back-door marginal tax on ordinary income. Michael Kitces has more on this: Navigating The Capital Gains Bump Zone: When Ordinary Income Crowds Out Favorable Capital Gains Rates
  2. The “Tax Torpedo”: Not all of your Social Security income will be taxable on your federal return. The share that is subject to taxation will depend on your other income. And if you generate more income you will crowd out some of the deductions in the Social Security taxation equation, creating a jump in the marginal taxes and then a reduction in marginal taxes once the phase-out is complete. Another non-convexity. I wrote about this issue in 2019: Taxation of Social Security: The Tax Torpedo & Roth Conversion Tightrope
  3. The ACA subsidy cliff: If your income is even $1 above the maximum income amount you completely lose the subsidy. To account for this non-convexity it might be worthwhile to plan your taxable income accordingly and push it below the ACA cliff for several years but then “go to town” one year and make up for the lost income. The efficiency loss from the convexity of the U.S. tax code might be smaller than the gain from ACA subsidies!   (as readers pointed out: the cliff is not an issue in 2021/2022 and might even go away completely. Good news because this eliminates one of the non-convexities and it will make the case for tax-smoothing stronger!)

Principle 4: Plan for the step-up basis

The step-up basis means that if you inherit appreciated assets, you can readjust the cost basis to the market value at the time of the inheritance. You don’t need to pay taxes on the capital gains accumulated during the time the deceased held the assets. In effect, the government forgives you those capital gains!

Planning for the step-up basis comes with a bit of a caveat because there is some political uncertainty about whether this tax hack for the rich will survive the massive deficits we’re piling up these days. But under the assumption that a lot of the folks writing the laws like to use this tax hack in their own estate planning, maybe it’s not so far-fetched to assume it will persist?! Here are some applications:

Application 1: The step-up basis is even better for rental real estate!

The step-up basis works not just for stocks. The same principle applies to real estate, whether owner-occupied or investment property. But in the latter, there is an additional sweetener: The initial owner will likely “depreciate” the asset (for tax purposes) and use the depreciation allowance as a “business expense” to offset the rental income on their tax return. If that owner were to sell the asset then the accumulated depreciation will be “recaptured”, i.e., added to the capital gains, and it’s thereby taxable. Not so if the owner dies. The heirs will inherit the asset and also reset their basis. It’s as if all of the depreciation allowances to the original owner are forgiven! I think that this tax hack is almost too frivolous to stay in place over the next decades. But as long as it’s in place it would be a wise decision for current retirees who like to hand over the maximum (after-tax) inheritance to their heirs to hold on to their rental properties, especially if they have significantly appreciated and/or they have been subject to significant depreciation over the years! 

Application 2: What tax lots to sell in a taxable account

In Principle 2, I showed that even with constant marginal capital gains taxes, you want to sell the high-basis (low capital gains) tax lots first. If you can bequeath your highly appreciated assets to your heirs and their capital gains are reset back to zero it’s as if they face a 0% capital gains tax. So, if Principle 2 wasn’t enough of a rationale to hold on to the low-cost-basis shares, the step-up basis certainly makes it a no-brainer!

Application 3: Sequence of withdrawals: Tax-advantaged vs. Taxable accounts

For retirees planning to leave a sizable bequest, it might be worthwhile to hold on to the taxable accounts as well as the highly appreciated real estate assets and live off the retirement accounts during the last golden years in retirement. Especially if your kids face high tax burdens! This is often the case because most bequests move from the parents to kids when the latter are in their prime earning years and facing high marginal tax rates! Getting valuable assets with a step-up basis help a lot in that situation!

Conclusion

So much for today! We’re getting close to 5,000 words! I wanted to set the stage for doing some more specific retirement tax optimization post(s) in the future. There is no one-size-fits-all solution to the tax-optimization. It’s best to stay flexible and do the optimization on a case-by-case basis with all of the principles above in the back of my mind. Stay tuned for some case studies in the next few weeks! And an Excel Sheet to help with that, as promised! 🙂

Thanks for stopping by today! Please leave your comments and suggestions below! Also, make sure you check out the other parts of the series, see here for a guide to the different parts so far!

Title picture credit: Pixabay.com

66 thoughts on “Principles of Retirement Tax-Planning – SWR Series Part 44

  1. Great write up! There’s also the tactic of using margin loans as a form or tax arb to smooth the tax burden over time (Principle 3).

    By using margin, capital remains invested allowing for potential continued capital growth and dividends.

    Margin interest may be tax deductible, increasing Roth IRA conversion space

    Borrowing on margin does not increase MAGI which allows MAGI-dependent benefits such as ACA subsidies to remain non-impacted and the ACA “cliff” to potentially be avoided.

      1. My margin loan compounds daily with no expectation to ever pay it back as long as the assets cover it.

        Margin loans are often rolled forward just like the public debt is rolled forward (i.e. one can assume that there is no end date or rather that the margin loan will be rolled until the heirs step up the cost basis of all other assets, and then they can decide to lever up or down).

        It would be cool to have an analysis of margin loan as another tool for retirement planning, I made some back of the envelope analysis myself, here are some of my thoughts:
        * There exists a “safe margin rate”, which withstands all the events (1929, 2008,…), i.e. the portfolio is not over-leveraged after such a drop in stocks. I found that to be 27% (own 127 of assets, while borrowing $27 for each $100 equity) for a 60/40 stock/bonds. 27% is not that much when talking to other people who actually use margin, but I came from the “margin bad” camp myself originally.
        * Dividends currently exceed margin rates at IB, such that the margin would be automatically paid off after a couple years if the portfolio was untouched.
        * However combined with withdrawals, the stocks have to grow to keep the margin below the safe margin rate at all times.

        1. ERN – I would love to see an analysis of the use of margin loans. Nearly all of my savings are in a traditional IRA (rolled over from 401(k) from when I was younger), so I have little option but to pull it out at income tax rates at retirement. I will certainly leverage the Roth ladder for the years that I can, but if you happen to have a higher cost of living (spend level), then you rapidly walk out of the $0 tax brackets. Are margin loans useful here? Other suggestions?

          I have found your entire web site and the spreadsheets IMMENSELY helpful in establishing both my retirement date and post retirement spend plan. Thank you for the extremely clear discussions of these topics. My children will benefit greatly not only from my inheritance benefit but also in their futures as they will also leverage these resources. Many thanks for generations of my kin to come!

          1. If the step-up basis stays intact, then there is certainly a case to be made for the loan. But not sure if I could endorse a margin loan for early retirees. There is too much risk that a deep dive (-56% as in 2007-2009) could ruin that margin approach. But for older retirees with only a 10-year horizon who don’t want to dig into their highly appreciated assets? Why not!

        2. OK, have to think about this more. What could make this work is that normally, the danger to retirement is a large drop early in retirement. But at that time, you don’t have much in margin loans. The constriant becomes an issue later in retirement when you’ve lived on several years worth of margin loans.
          It’s worth a detailed look for sure. It’s on my to-do list! Which is becoming longer and longer! 🙂

    1. I think this is what the ultra rich do. Start Amazon, own billions in Amazon stock. Live off of margin loans forever. When you die your estate pays off the loans and billions of capital gains taxes are forgiven!

      If you’re not planning on leaving a big estate (you plan to use up your assets during retirement), it’s likely not more tax-efficient since you’ll have to sell eventually to pay off the loan. Plus there’s more sequence of returns risk.

      1. But you’d have to rely on the concentrated position to never go to zero, like Worldcom, Enron, etc. And even if the stock doesn’t drop to zero, if it drops below the margin loan, you’re toast. 🙂
        But, yes, I like the general idea of tapping loans backed by the portfolio. In moderation!

  2. It is a good write up. The numbers may be a bit off if the Trump tax cut isn’t extended. I don’t trust the current Congress to do anything about it. So I see a return to the old tax rates in a few years.

    1. Well, the principles are not off. It just means that you need to account for those expected tax hikes. 😉
      The Trump tax cuts for higher earners ($200k) will likely go away soon. The question is, will they also hit the middle class and take away all tax cuts? Hard to imagine but possible.

  3. Excellent analysis!
    I have two points I’d like to add:
    1. To your point about the 2017 tax law having reduced the post-death RMD period for Roth IRAs: Roth IRAs were never allowed to defer RMDs forever—only as long as the original contributor or their spouse/beneficiary was alive. After the survivor died, the Roth had to be distributed over the life expectancy of the beneficiary, in small amounts every year—perhaps 80 plus years for a young beneficiary, but not for thousands of years.
    2. To your point about the pre-retirement choice between a traditional and a Roth 401(k) contribution: I agree with your analysis for those who can only afford a limited amount of savings in a year, e.g., $10,000. But for those whose appetite for retirement savings exceeds the 401(k) elective deferral maximum, contributing that amount to a Roth 401(k) is a lot like being allowed to increase your elective deferral by the amount of extra taxes you’re paying.

    1. Both excellent points, thank you!
      I corrected the error in #1.
      I was aware of the issue on #2. I built a tool to quantify this “more bang for the buck” effect in the Roth 401k and it normally doesn’t push the needle unless the two marginal tax rates are very close. But thanks for the reminder to add a plug for my classic 2016 post. 🙂

  4. Wow, great writeup! I’ll need to read this one a few times, but certainly lots of options for tax arb. between 27% (adding generic state rate) and 12% (assume a move to a no tax state).

    Love my tax deduction now (i.e. 401k), but really want to have more in taxable for retirement. I need the taxable account to sell puts, use 0% Div/CG rate, hold munis, and use margin loan/box spread financing.

    The best concept is focus on leveling tax rate over time, both personally and across generations.

    1. Thanks! It’s always best to have a mix of accounts taxable, tax-deferred, tax-free. I certainly enjoy having the taxable accounts now to withdraw pre-59.5. And the average tax burden is not that bad, thanks to the std. deduction and 10/12% brackets!

  5. Always appreciate your carefully researched and analyzed posts. One thing that is nearly always missing in posts such as these (and please forgive me if you included it and I missed it), is the use of a good old brokerage account for early spending in retirement. We planned, invested, acquired real estate, and retired early, and accomplished it on a pretty modest salary compared to many folks. One tool which has paid huge dividends (pardon the pun!) is our brokerage account.

    Several years prior to retiring, with little time left to leverage the compounding effect of retirement investing accounts, we focused on building a traditional brokerage account containing the best tax-advantaged investments as you have mentioned in your article. Why on earth would we do this?? Well, when ACA came out, it appeared to me that my retirement would be postponed due to very expensive health care, UNTIL I realized that not all $$ are created equal. Once retired, various small streams of income trickled in and then were augmented by SAVINGS taken from the brokerage account. All Roths, IRA’s, etc, have been allowed to grow (we’ve even managed to squeeze in some Roth conversions, as well). Since savings is not income, we handily remain below the ACA cliff, enjoy extremely low cost health insurance and pay very little in taxes. With our net worth, it is totally insane for us to get subsidized insurance, but you know what? I did not write the rules nor was I consulted prior to, nor during their creation…I simply follow the rules as presented. Lord willing that I make it to 65, I intend to open the floodgates and take advantage of 33 years of investing and planning.

    Keep up the good work with your posts.

    1. Thanks! I agree 100%. While I haven’t mentioned the need for a plain brokerage account explicitly, it is an implication of the tax-smoothing technique. You most definitely want to be able to fill in that 0% bracket. Also withdrawing some of the tax basis (tax-free always) will help with tax planning (as well as ACA cliff planning).

      Also: as some have pointed out: the ACA cliff is paused for 2021 and 2022.

  6. “If you ever want to do any stock picking, market-timing, dividend strategies, etc., try to do those in a tax-deferred account. ” – thanks for this advise. I am trying to divest myself of most of my individual stocks left over from my former financial advisor, but I also wanted to have a small portfolio of individual stocks that I believe in. However, based on what I have seen from the individual stocks, it is REALLY hard to sell them because they all have gains and tax management then becomes more critical. So I do think this is really good advise and I am working on harvesting some losses today and then will be shifting some of these positions to tax deferred accounts over time.

  7. There is a tradeoff between tax-deferred and taxable accounts with the Foreign Tax Credit. If you hold foreign assets in retirement accounts (Roth or Traditional) you lose the foreign tax credit.

    I use taxable accounts to hold only foreign equity, but your point on Roth 401k allowing to “over”contribute makes me wonder whether Roth 401k is worth it. (Assuming I have to shift some international equity into the 401k due to the decreased after tax income).

    1. Good point. As someone who’s dropped the ball on foreign stocks and invests mostly in US equities, that wasn’t on my radar screen.
      It might justify another section on “other tax principles”

      But also caution: A lot of foreign stocks have much higher dividend yields which cause havoc due to the compounding tax drag effect.
      Once in retirement, though, I agree: foreign stocks should be in the taxable account. But it’s hard to turn on a dime!

      https://www.morningstar.com/articles/914550/should-you-keep-foreign-stocks-out-of-your-ira

  8. Thx ERN for this post and its very thorough detail on various paths and graph visual aids to illustrate different options. As someone considering retiring with a spouse in a few years at the mid 40s age range, and 20 years away from SS age, there is a lot to plan with what we do now, where we contribute, and what we hold vs. sell.

  9. Thanks ERN, great article! One question: for someone with high savings on an early retirement path, is it always better to put all money possible into tax advantaged accounts? For example, if you can contribute the full $58k to 401k (using the mega backdoor), plus $6k to Roth IRA (using the backdoor IRA), plus HSA, should you always do it? Or can you run the risk of having too much money in tax advantaged accounts at some point, even if you use a Roth conversion ladder?

    1. I doubt it. I certainly like to use the 0% capital gains bracket.
      But that depends on the tax situation. If you’re in a low-tax state while working and the front-loading of taxes doesn’t hurt you much, it’s good to have a lot of Roth money.
      But don’t go overboard and do too much Roth conversions because you still want to have the std. deduction and the 10% bracket filled in retirement. 🙂

  10. There’s also the concern around having investments that weren’t optimal (high fee or weaker performance) but you aren’t selling them because of a massive tax hit! That’s why capital gains taxes that don’t account for inflation can be super annoying =) Sometimes it’s a case of penny wise, pound foolish regarding taxes if you miss the bigger picture.

    I agree on your opening paragraph on the 60 years and no supplemental cash flows, tax arb isn’t going to move you from 3% to 4%. So rather get it right up front on the taxes, or just get a supplemental cash flow for that extra 1%, might be easier.

  11. Wow…I’ve never stumbled upon a quality/detailed Early Retirement site like this on my own, so thanks to whichever redditor posted a link to this. I know how I’m spending my upcoming weekend(s)!

  12. Three points to note:
    – The ACA cliff is eliminated in 2021 and 2022 and could be eliminated for longer as it is unpopular.

    – At older ages, you run into IRMAA which is a functional tax. Go from the top step of category 1 to category 2 and it’s a 3.2% surcharge, then 3.9%, 3.9%, and 0.3% (for the $163k to $500k step for singles; $337k to $750k for couples). $163k/$337k corresponds roughly to the break point between 24% and 32% tax brackets, although that’s on a taxable income basis and not a MAGI basis. Going from $87k to $163k comes out to about a 3.7% additional tax.

    I plan on retiring before 65 and have already thought about strategically converting Traditional 457 to Roth during the years I’m not working, probably to the 24/32% tax bracket break point. Depending on how the math works out, I may not get Medicare immediately but wait until the last possible month before a late penalty is charged, which would be roughly 15 months after my 65th birthday (I would have retiree health care from a government pension plan). I would receive a decent amount in my pension but would strategically try to avoid IRMAA.

    Certainly during the pre-65 years I would aim to convert 100% of my part time and gig work earnings into a Roth IRA. If I worked part time after 65, I would try to manage my deductible retirement contributions and expenses to try to mind the breakpoints in IRMAA should my income be above $87k. I also continue to buy savings bonds and would manage the withdrawal of interest to have my income come near the breakpoints without going over.

    – Also, the Earned Income Tax Credit investment income limit of $10,000 means a lot more folks can qualify for EITC. I generally would not try to aim for EITC for taxpayers without children as the amount of gross income you can have is way too low, such that you would be leaving 0% taxed income (standard deduction) on the table; but for a family with children depending on one’s asset mix it might be worth trying to aim for. You could work part time and contribute the investment gains earned that year to a traditional IRA so that your earned income matches your AGI. The EITC acts as a functional 16% (one child) – 21% (two or more children) “tax” on income above $20k (single)/$26k (married). Thus, you might wait to do your Roth conversions once your child(ren) are out of college, and can no longer be considered tax dependents. Likely if you were interested in maximizing financial aid, you would do so anyway to lower apparent income.

    1. Wow, thanks for sharing.
      Very interesting and very important.
      It looks like we would have to add the 3.7% marginal to the lower tax brackets to account for some of the phasing out of the discounts.
      So many things to consider! 🙂

      EITC is not mentioned very often in the FIRE circles. have to read up on that topic, to understand more! 🙂

      1. Go Curry Cracker and the Frugal Professor have discussed it, based on the old investment income limitation.
        I think it’s a great benefit for those who can work part time in a high paid per hour job, that want to spend more time with their kids. You do have to manage the withdrawals and may need to accelerate them in the period between kids graduating college and taking RMDs.

  13. Great post as usual. For the parts I manage to understand which might get to 40% lol !
    If only we could invest a lot in the tax deferred accounts but that’s very restrict to about 20k in 401k and 6k in Roth IRA for me (can’t add money to trad IRA because apparently I make too much) so the majority of my money goes to brokerage accounts where I hold bonds, dividend stocks (yeah don’t kill me) and 65% in the ITOT ETF so I can’t really take advantage more than I’m already taking I guess

    1. I like ethe ITOT. ETFs are very tax efficient for the taxable account!
      And yes, high earners will end up with a large chunk in the taxable account. To be honest, it suits me because I now have a portfolio in taxable that alone can support my FIRE life. I don’t have to stress out about Roth conversion, 10% penalty, 72(t) conversions, etc. Could be a blessing in disguise to have the limits on the 401k/IRA contributions! 🙂

  14. Hi Big Ern, was wondering if you can comment on this March 15 study suggesting that 2% is the proper SWR?

    https://www.advisorperspectives.com/articles/2021/03/15/the-false-promise-of-u-s-historical-returns-1#:~:text=Relying%20on%20only%20historical%20U.S.,%2Dthan%2Daverage%20equity%20returns

    “If we use historical periods that resemble today’s low-yield environment to estimate the range of potential withdrawal rates (less than 3%, which is the first row and is well above where rates are today), we see that even targeting a 50% success rate results in an initial withdrawal rate of 3.4%. If you’re targeting a 90% success rate, the SWR is closer to 2.2%. While a 2.2% SWR may seem implausibly low, it is what global investors would have experienced historically in a low-yield environment.”

    1. They make some good points and some nonsensical points. Using Wade Pfau’s “international SWRs” is a bit of a Litmus test for making me roll my eyes. If you believe that the US will be ravished by a war comarpable to WW2 in Europe/Japan, then go ahead, everybody lower your SWR. But I work under the assumption that we harvest the peace dividend in the U.S. a little bit longer and the Canadians don’t invade us until after I’m dead,
      But I do agree with their general idea: asset valuations matter. But we don’t need to go all the way down to 2.2. I stick with my 3.25-3.5% for early retirees, 3.75-4% for traditional.

    2. Also: I have no idea where the numbers in that table come from: Only 2.20% SWR to target a 90% success rate? WHat are they talking about? The absolut worst 30-year SWR was well above 3%, and that’s for a 100% success rate. Very odd. I would like to see their underlying data and the code to create that table!

  15. Big ERN,

    Thanks for all your work as I am a diligent reader.

    I am confused by a sentence in your Principle 3 Application 4 section. Can you please clarify the below statement?

    “… but the beneficiary loses the tax shield for potentially hundreds of thousands of dollars in the Roth and will be forced to reinvest that cash in a taxable account if it’s not used for their immediate living expenses. ”

    My understanding is for non-spousal IRAs, no matter whether traditional or Roth, the beneficiary has to take the distributions within 10 years of the owner’s death. With a traditional IRA, the beneficiary has to pay taxes on the entire distribution. With a Roth, there are no taxes but both grow tax free for 10 years. What tax shield are you referring to?

    1. Tax shield referred to the old rule whereby the beneficiary had their entire life to liquidate the Roth. That was much more useful if really young beneficiaries inherited a Roth.
      But that is no longer possible.

  16. Can you comment on order of taxable lots to sell when you are harvesting gains in the zero percent bracket (highest vs. lowest basis shares)?

    1. Highest basis will result in more shares sold.
      Lowest basis will result in fewer shares sold.

      May take is to sell the higher to have more total dollars that are reset to zero basis, so available for withdrawal.

      Then leave the lowest ones for either donations (consider a DAF) or hold until death for reset of gains.

    2. I’d tax-gain-harvest the highest basis lots first because those are the ones you sell first down the road. This will also allow you to harvest the maximum # of share for a given $ amount of space in your 0% bracket.
      Leave the low-basis longer, in case you can still utilize the step-up-basis!

      1. Thanks for the reply. I’ve been struggling to understand which gains harvesting approach is best ever since I retired early a few years ago. So far, I’ve been doing the exact opposite, thinking that I would “save” more money from future taxes by selling low-basis shares to provide living expenses or to reset them to a higher basis. However, I can see how harvesting the maximum number of shares makes more sense.

        1. Again: do the gain harvesting only if you stay in the 0% federal bracket and you have a low/zero state tax. That’s why a lot of people haven’t heard about it. It doesn’t apply to them while working. But in retirement, take a second look! 🙂

  17. Howdy ERN – my first ever comment, hopefully to include stray, related thoughts worth considering that might benefit others …

    After tax contributions to HSAs aren’t bound by earned income requirements like IRAs have. That plus the fact said contributions directly improve your MAGI (above and beyond the standard deduction) make it strongly compelling to max out annual HSA contributions using after tax dollars. A nice way for a FIRE to build up another tax advantaged account in lieu of having any earned income post retirement, plus pad a bit more headroom into the 0% tax bracket to exploit. Of course, you do need to be on a qualifying High Deductible Health Plan to contribute to an HSA.

    Which then leads to the Rule of 55 for 401Ks, something I started leveraging just last year to get the jump on one of the themes of your article, namely avoiding having RMDs bump us into a higher tax bracket come age 72. Rule of 55 also is disallowed for IRAs, so it may be a factor worth considering prior to opting to roll over any 401K into an IRA. Given that, you get 4 and a half extra years to tap your 401K without additional penalties applying. Great way to get started drawing down a significantly appreciated 401K ahead of any IRAs in the quest to level out marginal tax rates.

    And might I say there is something immensely satisfying about pulling proceeds early from a 401K, plowing them into an HSA, not paying a penalty, and reaping a larger tax deduction. Talk about a great backdoor.

    Up to now the ACA subsidy cliff alone has deterred me from converting a highly appreciated Traditional IRA into a Roth IRA. Like others who commented, we are benefiting from the ACA rules of play, for better or worse. It did not make fiscal sense to plunge over the cliff plus I was prioritizing 401K drawdowns as first order of business pertaining to marginal tax management. If, however, that cliff is indeed suspended at least for 2021-2, it might present a golden opportunity to perform the IRA conversion, “suffer” the income, and take the tax hit now. Something to look deeper into. Other ACA clients in a similar situation may want to do the same.

    Love all your stuff, ERN. You really stoke the fire in FIRE.

    1. Thanks! All very valid points! We are very much on the same page! 🙂
      My friend Fritz (Retirement Manifesto) did the “rule of 55” to tap 401k money early! Very good point!
      I also kept my HSA money untouched. Not enough money really in the big scheme but nice to have. Essentially a Roth only better due to tax-deductibility at the front.

      About the ACA cliff. Sure you avoid the cliff, but people shouldn’t go crazy and convert all the way into the 22% or 24% bracket and then have nothing left. Moderation is key!

  18. Another wonderful article. Thanks for all you do Big Ern. I would just like to remind everyone of uncertainty in life that can materially alter the future. The loss of a spouse – pushing the survivor into the single tax bracket could make it extremely difficult to access large pre-tax money at a reasonable rate, loss of both husband and wife would make pre-tax money very unappealing when providing for a young child via a trust (trust tax rates – ouch), the IRS may eliminate the Roth conversion option (which I hear is not unlikely), divorce and all the complications that come with that, etc. I agree with your assessment that it is unlikely tax rates will increase materially for lower/mid earners so I do not believe that is a real risk. I know several widowed individuals that have a huge tax liability (and one is not that old). The more I think about this, the more I like Roth accounts if the math is somewhat close. Just my two cents.

    1. All very valid points. When one spouse passes, it will wreak havoc due to brackets/deductions shrinking by 50%, but expenses shrinking by much less than 50%! It’s something to keep in the plan and this will push me to Roth-convert if the math is even close to even. 🙂

  19. Just out: Vanguard Roadmap to Financial Security. Excellent Resource with key Question Lists to set up each of our financial plans (Link opens summary which contains another link to the PDF)
    https://institutional.vanguard.com/VGApp/iip/site/institutional/researchcommentary/article/InvComRoadmapToFinancialSecurity?iigbundle=InvComRoadmapToFinancialSecurity
    34 pages, 1 hour to read for first time and then use in an ongoing basis.
    Audience: pre-retirement & retired across all countries (so not US-centric, though it is all very applicable to US).
    Goes very well as a companion piece with ERN’s general tax principle’s SWR series #44
    Do you know of any other resource of this type that you would recommend?

      1. I thoroughly agree with you, this Vanguard article does not supply us with quantitative tools to use. So, this article is not a direct substitute for a simulation tool like you have supplied in SWR series #28.
        Since Vanguard authors were writing it for multi-country audience, they kept it to a qualitative framework level covering goals, risks, resources, and broad guidelines for developing a plan . (I suspect that they are working to expand their advice platform internationally and want to develop a framework that can be used across countries.) Once they have this qualitative framework, then they can specialize it to a quantitative advice offering by country based on each country’s specific benefits, legislation, and tax rules. They have done this for the US in a more quantitative way in the first PDF link of this 2020 article : https://advisors.vanguard.com/insights/article/spendingguidelinestohelpeaseretireesmarketworries
        (This US-centric PDF is quite useful and more quantitative, but its dynamic withdrawal plan is not as well tuned as your CAPE-based rules given in your SWR #18.)
        Since I grew up in the US, but have spent 40 years outside the US, I am always looking for approaches that can be applied to other countries. And I know that you have a good number of readers from other countries that are also interested in doing this. So I think that the Vanguard overall qualitative framework in https://institutional.vanguard.com/VGApp/iip/site/institutional/researchcommentary/article/InvComRoadmapToFinancialSecurity?iigbundle=InvComRoadmapToFinancialSecurity
        plus, your SWR simulation spreadsheet in SWR #28 give a potential retiree from outside the US, a particularly good qualitative framework of what areas they need to consider, and then your quantitative tool to use into which they can incorporate their specific county’s benefits, legislation and tax rules.
        Following this approach, I have been able to do this for persons in Mexico, and for US-Mexican dual nationals residing in Mexico or in US. So, this should also be possible for your European, Australian, etc. readers.

  20. Karsten, truly this is one of your best articles yet. Priceless info, and I’ve bookmarked it for multiple re-reads in the coming years.

  21. I had a calculator just like that is stats class (except bigger, since it was a long time ago)! Liked your chart on IRR for different investment horizons.

  22. Another awesome SWR series article! Since there’s no ACA subsidy cap this year and 2022, what are your thoughts on doing more Roth conversions to lower the tax deferred bucket? I was initially planning to stay at the 400% FPL but now considering maxing out the 12% bucket. I’m estimating I can do an additional $12k on top of the 400% FPL limit at 12% tax rate. If the subsidy cliff comes back in 2023 then I will stay under the FPL limits.

  23. Good Morning ERN – Excellent article as always!

    With estimated quarterly state and federal taxes in mind, what is the best strategy for timing Roth ladder scenarios within a given year?

    i.e. is it generally better to ladder ~ 80% on January 1 – so it has more time to grow? or is the impact of reducing your total portfolio by paying those estimated taxes greater than the gain, meaning you should ladder throughout the year or at year end?

    Thanks!

    1. Considering that the market goes up on average, you should be able to convert more if you do the conversions at the beginning of the year. True
      It might not work out the best in any ONE year, but over time, that seems to be the way to.

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