There are some unique tax planning considerations for people in the phase between retirement from full-time work and age 70. In this blogpost I discuss some of those strategies.
In working with my financial planning clients I have discovered over time that many end up in a phase where their income (and thus their tax rate) is lower than when they were working full time and lower than what it will be after age 70, when they will be collecting Social Security and taking required minimum distributions from their IRAs and 401(k)s. In addition, income during these years can impact health insurance costs whether through subsidized healthcare via the affordable care act (pre age 65) or because of the Medicare income surcharge (post 65). As a result, significant tax planning opportunities arise, typically for those in their sixties, that can mean substantial tax savings if planned for correctly.
Let’s start with the potential to pay tax at lower rates pre 70 ½. The IRS requires that distributions be taken from traditional IRAs and 401(k)s once you turn 70 ½. Age 70 is the latest that you can delay drawing Social Security. The combination of these two factors often leads retirees to end up in a higher tax bracket after age 70 ½ than the tax bracket they are in during their sixties. The strategy that can be employed to take advantage of this tax rate differential is a Roth conversion. With a Roth conversion you simply move money from a traditional IRA to a Roth IRA and pay income tax on the amount transferred. Let’s say, for example, someone is in the 12% tax bracket at age 67 but will be in the 22% tax bracket post 70 1/2. They do a $20,000 Roth conversion. The tax they will pay will be $2,400. Had they left the $20,000 in the traditional IRA, that amount would later have been withdrawn as part of their required minimum distribution and the tax on that portion of the withdrawal would have been $4,400. The Roth conversion thus saved them $2,000 in tax.
The key is understanding what your current tax bracket is and what it will be post 70 ½. As part of our annual planning process we do a 20-year tax forecast with all our clients so we understand what these rates look like and develop a strategy for each year that maximizes tax efficiency. Often, we’ll do a Roth conversion in late December that will “fill up” the lower tax bracket.
The other opportunity that presents itself is that generally when someone is in the 12% income tax bracket the tax rate on capital gains and qualified dividends is 0%. Thus, there is the opportunity to sell holdings in a taxable brokerage account and pay zero tax on the resulting capital gain.
What also must be considered is the impact of income on health care costs. People who retire before age 65 will generally look to the Affordable Care Act exchange for health insurance during this gap period. What many don’t realize is that government subsidies for health insurance on the exchange are based solely on income. Assets do not factor into the equation at all. As a result, with proper planning many people, even those with significant investment assets, can qualify for heavily subsidized health care.
Here is an example. A couple both age 63 have $1.5 million in investment assets ($1.2 million sitting in IRAs, $200,000 in a taxable brokerage account, and $100,000 in savings). Their annual dividend and interest income are $10,000. Their cash flow need for the year is $90,000. They will thus need to withdraw $80,000 from some combination of the IRAs, brokerage account, and savings account to supplement the $10,000 in dividends and interest. The income threshold for obtaining a subsidy on the exchange is $65,000 so they will want to keep their adjusted gross income (AGI) under that level. Here is a potential strategy:
- Sell $50,000 of investments in taxable brokerage generating a capital gain of $20,000.
- Withdraw $31,200 from IRA and withhold $1,200 tax.
Their AGI will be $61,200 ($10,000 dividend/interest, $20,000 capital gain, and $31,200 income from IRA distribution). The premium subsidy for a couple age 63 with $61,200 income is $1,164. The lowest cost plan in New Jersey would cost $1,365 per month, but with the premium subsidy would cost $201 per month. This is likely to be much lower than COBRA or any other alternative coverage.
Their cash flow would be $90,000 ($10,000 dividend/interest, $50,000 from the sale of investments, and $30,000 from IRA distribution). Their total Federal tax would be around $1,200, assuming half of the dividends/interest were qualified. The reason is that the tax on the $20,000 capital gain and $5,000 qualified dividends is 0%. Their only taxable income would be the $31,200 IRA distribution plus $5,000 non-qualified dividends/interest, which would then be reduced by the $24,000 standard deduction.
The reason to pull some of the cash needed from the IRA (and not all from the taxable accounts) is to ensure that they have funds available to do the same thing in the future. In this case the tax rate on the IRA withdrawal will be close to 10%, which is far lower than what they will pay on their required minimum distributions down the road.
Careful income planning is critical here. If a couple does not plan properly and their AGI comes in over the $65,000 threshold, they would have to pay back the entire $13,968 premium subsidy that was provided to them.
The other income consideration related to health insurance is the Medicare Income Related Monthly Adjustment Amount (IRMAA). The standard Medicare Part B premium that nearly everyone pays is $135 per month. But Medicare beneficiaries with higher incomes are hit with a surcharge for both Part B (doctors, etc.) and Part D (prescription drugs). For a single person the surcharges start when AGI is over $85,000. For couples the surcharges start at $170,000 of AGI. There are several thresholds with ever-increasing surcharges. The maximum combined Part B and Part D surcharge is $402.40 per month for those with incomes over $500,000 (single) or $750,000 (married). Understanding the impact of these surcharges is another factor to consider.
To make matters even more complex, residents of New Jersey, where I am based, have another factor to consider. New Jersey recently passed a law providing a retirement income exclusion for those with New Jersey gross incomes under $100,000. In 2019 the exclusion is $80,000 for married couples and $60,000 for single filers; those exclusions will increase to $100,000 and $75,000 in 2020. The $100,000 threshold is a cliff. If your New Jersey gross income is $100,001, you lose the entire exclusion. The good news is that Social Security is not counted as part of New Jersey gross income. The key here, of course, is to keep your NJ gross income under $100,000. For example, someone might decide to draw the last $20,000 of cash flow needed for a given year from a Roth IRA (or from a home equity line if there is no Roth IRA) instead of from a traditional IRA if that $20,000 would put them over the NJ threshold.
What can be tricky when doing this type of tax planning is that some of these strategies run counter to each other. For example, maximizing a Roth conversion to pay tax at a lower rate might put you over the threshold for a Medicare surcharge. You then need to understand what is worth more, the tax savings or the Medicare surcharge.
I have come to realize in my years as a financial planner that this type of tax planning is where advisors can really add a ton of value, but it is not an area that most tend to focus on. If you do feel you could use some assistance in this area, please feel free to reach out to us.