Managing Taxes in Retirement: Income Thresholds versus Incremental Average Tax Rates

This is the first in a series of articles that will explore tax-efficient retirement distribution strategies. The conventional retirement strategy is to spend taxable assets first, then tax-deferred (IRA) assets, and then tax-exempt (Roth IRA) assets. There is wide consensus that more tax-efficient distribution strategies are possible, including the strategic use of Roth conversions, and this series provides a deeper dive into these aspects.

I will simulate different strategies to determine which provides the greatest tax efficiency in terms of supporting the most after-tax spending and legacy for retirees. I will focus on how to source retirement spending needs as well as deciding whether to generate additional taxable income through Roth conversions. Though this article will use a fixed return assumption for the investment portfolio, I will shift into investigating these assumptions with volatile market returns in future articles.

These articles build on research popularized by William Reichenstein, which aims to understand how to strategize the withdrawal order sequencing between taxable accounts, tax-deferred accounts, and tax-exempt accounts to obtain the most after-tax spending potential for wealth in the face of our progressive tax system and with these important nonlinearities in the tax code:

  • The Social Security “tax torpedo” applies when an increase in taxable income uniquely causes a greater percentage of the Social Security benefit to become taxable.
  • Preferential income sources (qualified dividends, long-term capital gains) stack on top of ordinary income and have their own tax schedule. An increase in ordinary taxable income can also uniquely push preferential income into higher tax brackets.
  • An increase in taxable income above certain thresholds triggers increases to Medicare premiums two years later.
  • The net investment income tax and Medicare surtaxes apply when certain types of income exceed the relevant thresholds.

Numerous resources are available that explain the specifics of these tax non-linearities. For those first seeking further background on this, I suggest reading Chapter 10 of my book, Retirement Planning Guidebook.

The answer for creating tax-efficiency beyond the conventional approach generally involves spending from a blend of taxable and tax-deferred assets to meet expenses and to potentially make Roth conversions to generate more taxable income beyond what is needed to cover current spending, while taxable assets remain. Once taxable assets are depleted, the retiree then shifts to spending a blend of tax-deferred and tax-exempt assets to control the amount taxable income and taxes, which might also include Roth conversions, in a manner that allows for the greatest after-tax spending and legacy potential for investment assets. Harvesting capital gains could be a part of this process, but I do not specifically consider it for this case study.