Effective Marginal Tax Rate Management for Wealthier Couples

Wade Pfau, Joe ElsasserThis article is part two in a series on tax-efficient retirement distributions. Much of the groundwork used here was laid out in part 1, and readers may refer to it for greater context. Whereas part 1 focused on mass-affluent taxpayers, in part 2, we analyze a case study for a wealthier couple with $5.5 million in investment assets and a larger retirement spending goal. This will bring to the forefront some tax situations that were not considered in part 1, such as vulnerability to Medicare premium surcharges and the net investment income tax (NIIT).

As we noted in part 1, research on tax-efficient retirement distribution strategies aims to sequence withdrawals from taxable, tax-deferred, and tax-exempt accounts to maximize after-tax spending. That can be either in terms of meeting an after-tax spending goal for as long as possible or preserving the greatest after-tax legacy after meeting spending needs over a specified timeframe.

We 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. We focus on how to source retirement spending needs as well as deciding whether to generate additional taxable income through Roth conversions. We incorporate important non-linearities in the tax code that extend beyond the progressive federal income tax brackets. Those include the Social Security “tax torpedo,” the stacking of preferential income sources (qualified dividends, long-term capital gains) on top of ordinary income, the presence of income thresholds that trigger increases to Medicare Part B and Part D premiums two years later (called income-related monthly adjustment amounts, or IRMAA), and the net investment income tax (NIIT). Again, more background on these matters is provided in part 1, and chapter 10 of Pfau’s Retirement Planning Guidebook is another helpful resource.

We analyze two tax planning strategies. The first is the conventional wisdom. The conventional retirement strategy is to spend taxable assets first, then tax-deferred (IRA) assets, and then tax-exempt (Roth IRA) assets. This serves only as the baseline, as there is wide consensus that more tax-efficient distribution strategies are possible, including the strategic use of Roth conversions. The answer for creating tax-efficiency beyond the conventional approach addressed here is the “effective marginal rate” (EMR) methodology. It uses “tax maps” within each year to track the effective marginal tax rate on each dollar of ordinary income, including the non-linearities above.