Tax Alpha

No investment advisor can honestly tell you that they can make you an additional 10% return on your investments. However, I can honestly say that I can, in many instances, save you 10% of your investments through good tax planning. How, you ask? I’ve got a lot of strategies. Taken altogether, they form what we’re calling “Tax Alpha”.

It’s pretty complex, so let’s put some building blocks in place first.

  • Tax-deferred “qualified retirement money” (deductible IRAs, 401ks, etc.) is going to be taxed when you take it out.
  • Social security is untaxed if you live on social security and a small additional income. But if you have more than a minor amount of retirement income, social security becomes taxable. During that time when your social security is phasing in as taxable you’re paying at either a 27.75% tax rate (if you were otherwise in the 15% bracket) or a 46.25% tax rate (for those who thought they were in the 25% bracket.) These high rates are a combination of the tax on your retirement income plus the additional tax on your social security income. Additional retirement income can also cause dividends and long-term capital gains to go from 0% to 15% taxed: it’s a bitter reality that sneaks up on people taking IRA distributions!
  • If you make over $85k single or $170k married filing joint, there’s a surcharge on your Medicare premiums that works as a de facto extra tax. This is called the IRMAA threshold and it sounds like a good idea (“tax the rich”) until you realize that higher Medicare premiums hit people who are merely taking distributions from their retirement plans for large purchases (like buying the RV they were saving up for, or paying for a nursing home).
  • Required Minimum Distributions (RMDs, sometimes called MRDs) are the government’s way of saying “we’ll let you defer taxes so you can save more when you are young, but not forever.” When you turn 70 ½, you must start paying taxes on a required minimum amount each year. Required distributions typically start after you’re on social security and that’s when you discover you’re in the highest tax bracket of your life. (Not what you meant to do when you deferred the taxes, was it?!?)
  • If you are in a low tax bracket, your tax rate on long-term gains and qualified dividends is currently at 0%. That means sometimes we can sell a stock to harvest the accumulated gain at 0% federal income tax!
  • People talk about simplifying taxes as if it were all about changing the tax rates. It really isn’t! Taxes are complex because you have so many ways to earn income, and so many ways to take deductions and credits. The actual tax calculation is easy-peasy. It’s determining what your taxable income (after deductions and credits) is that is subject to much of our strategizing.

So, a tax-focused comprehensive planner (that’s me) accounts for tax ramifications when providing investment advice. We look at several things at the same time:

  • how much cash you need to fund your goals
  • what tax bracket are you likely to be in after age 71
  • how much room for additional income you have left in the same or lower tax brackets before age 71
  • all while paying attention to the IRMAA thresholds that increase Medicare premiums

I have a truly scary Excel spreadsheet to help solve these problems. I also use various tax planning tools. But without getting into numbers, here are some examples.

Fran and Alex are retirees in their 60s. They need $50k/year to fund their retirement goals. They decide to delay taking social security until age 70. They still need money to live on now, though. Let’s say they have $200k in after-tax money (plain old savings or investment accounts) and $900k in qualified retirement money (IRAs).

In this case I’d run some calculations to see what tax rate bracket they’ll be in when they’re 71, and I’d convert as much as possible of their Traditional IRA into Roth IRAs each year to pay lower taxes now rather than later. During the clever Roth conversion years, they live on the $200k after-tax money. The Roth conversions protect the IRA money from ever being taxed again, and reduces the size of their eventual required distributions after age 70 ½. The desired net effect avoids having their required minimum distributions being taxed in a 10% higher tax rate bracket.

Here’s another case: Sage is still working, still accumulating, still growing assets. All of Sage’s money is in workplace plans. When Sage retires, quite possibly not until age 70, there’s going to be a massive required distribution (RMD) hitting at the same time as social security payments start. The trick here is to consider some other strategies; QLACs, donor advised funds, and the Roth side of a 401k.

Dale is early-career but has an inheritance. In Dale’s case we’d pay attention to tax-loss harvesting of inherited taxable investments; have Dale contribute as much tax-deferred income as he can at high brackets; but use Roth contributions if Dale is in low tax brackets.

Everyone loves to save taxes. An investment advisor who is tax-focused and considers comprehensive financial planning goals will do a better job for you than the typical investment advisor. I am a member of the Alliance of Comprehensive Planners and that’s how we work.

Wendy Marsden, CFP®, CPA, MS

Greenfield, MA