Enhancing Retirement with Tax-Bracket Management

The following is excerpted from Chapter 10 in Wade Pfau’s new book, Retirement Planning Guidebook: Navigating the Important Decisions for Retirement Success. It is available at Amazon, Barnes & Noble, Target, and other leading retailers.

Here is an example that quantifies how strategic tax planning and delayed Social Security claiming can increase portfolio longevity in retirement. I have created an example for a 60-year-old single individual who has just retired in 2021. She has $2 million of investment assets, divided between $400,000 in a taxable account, $1.3 million in a traditional IRA, and $300,000 in a Roth IRA. The cost basis for her taxable assets is also $400,000. Her goal is to spend $95,000 a year in retirement net of any federal income taxes and she lives in a state that does not tax income. For Social Security, her primary insurance amount is $30,000 if she claims at her full retirement age of 67. She will get $21,000 if she claims at 62 and $37,200 if she claims at 70.

This example does not incorporate asset location issues and long-term capital gains management, as I simplify investment returns to be 2 percent annually with no inflation. This implies that investments are held in bonds and provide 2 percent taxable interest payments annually without potential for capital gains or losses. While investment returns are simplified, the full tax code has been built into the example. Taxes for 2021 to 2025 are based on present law, and the 2017 tax code (with inflation adjustments through 2021) is used for 2026 and later.

Exhibit 10.16 summarizes the results for this example. It shows five different strategies for this individual. The first is to claim Social Security at age 62 and to follow the conventional wisdom for spending down assets: take any RMDs, then spend the taxable portfolio, then the tax-deferred portfolio, and then the tax-exempt portfolio. This strategy supports 28.99 years of retirement spending, and the details are provided in Exhibit 10.17. It is the baseline. When the portfolio covers a fraction of the year, that represents the percentage of the overall spending goal that can be funded in the year.

Next, to show the value of delaying Social Security, if this retiree claims Social Security at 70 and uses the same conventional wisdom spend-down strategy, portfolio longevity increases by 1.86 years to 30.85 years. The remaining strategies in the exhibit also use Social Security claiming at 70. The next strategy is to use tax bracket management at a pre-determined level of AGI without using Roth conversions. I test various AGI levels to manage and find that an AGI target of $60,000 provides the most benefit for this example, with portfolio longevity of 32.82 years (see Exhibit 10.20). If we follow the same strategy and include strategic Roth conversions as well, portfolio longevity increases to 33.54 years (see Exhibit 10.21). Coincidentally, an AGI target of $60,000 also creates the greatest portfolio longevity with Roth conversions. Finally, I provide an example of front-loading taxes to a higher level in the early retirement years and then targeting a lower AGI level for later in retirement. After several different permutations, I find that managing AGI to $111,000 until age 70, which is the threshold just before a second layer of IRMAA-related Medicare premium increases kick in for earnings starting at 63, and then switching to manage an AGI of $25,000 for age 70 and later (when Social Security starts) can increase portfolio longevity by more than another year to 34.62 years (see Exhibit 10.22). This is 5.63 years longer than following convention wisdom on spenddown strategies and claiming Social Security early. After raising the claiming age to 70, this more tax-efficient strategy still adds 3.77 years of portfolio longevity to the convention wisdom tax strategy. The topics described in this chapter can add significantly to the longevity of retirement distributions.

As a further note, this exhibit also shows the five corresponding strategies assuming that everything is the same except that the discussion is about a married couple instead of a single person. The point for including results for the couple is to demonstrate how much impact the differing tax brackets between singles and couples can have on retirement sustainability. For the different strategies, applying tax brackets for married filing jointly could extend portfolio longevity by more than 3.66 years. This does speak to the planning idea mentioned about how those who are married filing jointly may seek more balance by frontloading taxes in anticipation of an inevitable point when the surviving spouse will face the tax brackets for singles. We can also note that the strategy for managing the second IRMAA threshold for couples ($222,000) is too aggressive and results in worse outcomes. It forces too much taxes to be paid early on, such that tax capacity is wasted later in retirement.