Effective Marginal Tax Rate Management for Wealthier Couples

This 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.

Comparing the EMR method to conventional wisdom

We compare the EMR methodology using different target rates to the conventional wisdom strategy to quantify the positive impact these approaches have on the after-tax legacy value of assets at age 95. The EMR methodology will generally call for 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 deplete, the retiree then shifts to spending a blend of tax-deferred and tax-exempt assets to control the amount of 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. The objective is to generate additional taxable income when the effective marginal rate on that additional income can be kept below the targeted threshold.

To meet spending, the couple first takes any RMDs from the IRA, which begin at age 75. They also delay Social Security benefits to age 70. If Social Security benefits and RMDs from the IRA exceed the desired spending level and taxes due, then any surplus is added as new savings to the taxable account. More commonly, if RMDs and Social Security benefits are less than the desired spending and federal income taxes due, additional withdrawals are first taken from the taxable account until empty, then from the IRA account until the targeted tax rate is reached, then from the Roth IRA. If the spending need is met through withdrawals from the taxable account or a combination of the taxable account plus IRA withdrawal, but additional IRA funds can be withdrawn while staying under the EMR target, those funds are converted to the Roth IRA.

Taxes on these additional IRA distributions and conversions are paid through further distributions from the taxable account when possible, or otherwise from the tax-deferred account after the taxable account depletes. Distributions are taken at the start of each year.

Financial market returns

This analysis is based on simple financial return assumptions. We assume an overall portfolio return of 5.06%. This consists of a 2.5% inflation assumption and a 2.56% real return. Asset allocation is not directly relevant other than to manage the breakdown between interest income and qualified dividends to determine income distributions from the taxable portfolio. We assume a portfolio of 60% stocks and 40% bonds, with a dividend yield of 2.5% (matching inflation) and a bond yield of 5.06%. Dividends are assumed to be qualified. The remainder of returns for stocks reflect long-term capital gains.

Case study details

We consider a wealthy couple with $5.5 million of investment assets. Both individuals are age 62 and are assumed to be born on January 1. For simplification, the start date for this analysis is the start of 2024, as the 2024 tax numbers are now available. For their retirement finances, the priority is to build a financial plan that will cover their spending goals through age 95. When meeting spending goals, a secondary priority is to maximize the after-tax surplus of wealth for their beneficiaries at age 95.

Their financial details are provided in Exhibit 1. Retirement assets include $1.5 million in a taxable brokerage account (with a $1 million cost basis), $3.5 million in a tax-deferred IRA, and $500,000 in a tax-free Roth IRA. For simplification, this household has one wage earner whose Social Security primary insurance amount is $3,600 monthly. Both spouses will delay claiming until age 70, which provides a 24% benefit increase through the delay credits for the worker, but not the spouse, allowing for a combined $75,168 per year in 2024 dollars. Annual cost-of living adjustments are assumed to match the 2.5% inflation rate.

The projected core annual retirement expenses for the couple equal an inflation-adjusted $220,000 throughout retirement. They live in a state with no income tax. This couple rents their home in retirement to avoid the additional complications associated with managing home equity in the retirement plan.

They must pay federal income taxes – an additional expense that will be calculated beyond these spending goals. We calculate taxes on the portfolio distributions, including qualified dividends, interest, and long-term capital gains from the taxable account, the ordinary income generated from IRA distributions, the precise amount of taxes due on Social Security benefits, any Medicare premium surcharges if modified AGI exceeds the relevant thresholds, as well as any potential net investment income surtaxes due. These taxes are calculated based on the current tax law, including the shift to higher tax rates in 2026 that is part of the sunsetting provisions in current law. Tax brackets increase with inflation, though the thresholds for determining taxes on Social Security and the net investment income tax are not inflation adjusted. This couple uses the standard deduction instead of itemizing.

The legacy value of assets reflects the real (inflation-adjusted) after-tax value of investments remaining at age 95 in 2024 dollars, using the inflation rate as the discount rate. Taxable assets receive a step-up in basis at death, providing their full value for heirs. Tax-deferred assets maintain their embedded income tax liability after death. We assume that adult children will be beneficiaries, and the SECURE Act requires them to spend down the account within a 10-year window when they may still be in their peak earnings years and face higher tax rates. To reflect this, we assume that remaining tax-deferred assets will be taxed at a 25% rate to reduce their legacy value to heirs. Tax-free Roth assets also face the same distribution requirements, but they will not be taxable to heirs, so their full value passes as legacy.

If the entire spending goal cannot be met over the retirement-planning horizon, we calculate the spending shortfall relative to the goals as a negative legacy. Only Social Security remains to cover a portion of spending if investments deplete. But this case study was designed so that all strategies considered were able to meet the full lifetime-spending goal.

Results

The results proceed in two stages. First, we seek to determine the EMR target for the effective marginal tax rate strategy that provides the best outcome and confirm that this outcome provides an enhancement over the conventional wisdom. Then we provide a detailed comparison between the tax-efficient strategy and the conventional wisdom to better explain how tax planning can improve retirement outcomes.

Exhibit 2 shows the after-tax legacy value of assets for different strategies (all monetary values are defined as real 2024 dollars). We investigate different fixed EMR targets, including cases where the tax target approaches but does not include the tax rate, keeping spending out of that tax bracket when feasible, as well as when the target does include that tax rate to allow for movement through the tax bracket when feasible. The conventional strategy results in a poor outcome with less legacy than EMR targets, at least until the EMR target becomes overly aggressive. The conventional wisdom supports a legacy of $1.63 million after meeting spending goals. The EMR target supporting the best outcome is to manage a 28% EMR as the upper limit for desirable income generation. This supports $1.8 million of real legacy.

We also calculate the internal rate of return on after-tax spending and legacy supported by these strategies. We find that the conventional wisdom strategy supports a net 3.95% after-tax investment return. Taxes reduced returns by 1.11% from the pre-tax 5.06% return. For the best performing strategy, the net after-tax return is 4.06%, which is an improvement of 0.11% over the conventional wisdom. This can be interpreted as the additional tax alpha generating by a more efficient strategy compared to the conventional wisdom. Compared to our earlier mass-affluent case study for a couple with $1.5 million, we observe two differences here: A higher level of wealth leads to lower after-tax returns, which can be expected with a progressive tax system, and the tax alpha improvements are less for this couple (0.11% tax alpha instead of 0.41%). Fewer tax planning opportunities will exist in this case, as avoiding the Social Security tax torpedo is not possible and RMDs are not a binding constraint that forces greater IRA distributions than desired when the spending goal is larger. Nonetheless, we will see how tax planning adds value by avoiding unnecessary IRMAA surcharges and by taking full advantage of the standard deduction. After-tax real legacy has increased by almost $177,000 in today’s purchasing power, which is a worthwhile legacy improvement to seek.

The next set of exhibits compares characteristics of the conventional wisdom strategy and the tax-efficient strategy. First, exhibit 3 shows the dollar amount (in real 2024 dollars) of the Roth conversions made at each age. For the first two years, there is no 28% tax bracket, as the 24% bracket shifts to 32%. This allows the couple to create large Roth conversions for two years until income increases to the beginning of the 32% bracket without exceeding the 28% EMR in a substantive manner. This is the case even with the preferential income stacking and NIIT that is endured and with the IRMAA surcharges which begin to apply at age 63. Generating ordinary income through the start of the 32% bracket does push the couple through four IRMAA thresholds at age 63, leading to an addition $11,742 of IRMAA surcharges at age 65. But this will end up as the only IRMAA surcharge experienced in retirement for the tax-efficient strategy.

Exhibit 4 shows the tax map for age 62.

For ages 64 to 67, there are still taxable assets to support spending and taxes, allowing Roth conversions to continue at a lower level. The constraint at these ages becomes to avoid preferential income stacking (from 0% to 15%), as the income tax bracket shifts from 12% to 15% in 2026 with the restoration of the pre-2018 tax rates. The effective marginal tax rate with preferential income stacking is 30%. This is illustrated in exhibit 5 for the age 64 tax planning decision.

Once the taxable account depletes at age 68, the IRA distributions must be redeployed to first cover spending needs, and no further Roth conversions opportunities are possible with the 28% effective rate target. For the remainder of retirement, the couple generates IRA distributions up to the first IRMAA threshold to cover a portion of spending, with the remainder supported through Roth distributions and Social Security benefits (after age 70). Fortunately, with this tax planning, the couple has created a large enough Roth IRA so that it can support these remaining spending needs. Exhibit 6 illustrates this for the age 70 decision.

Also, exhibit 7 demonstrates how this continues to be the case after RMDs begin at age 75. The endpoint goal of reaching the first IRMAA threshold is the same. The RMD simply increases the required starting level for ordinary income. But the RMD is not binding, as the couple would still like to distribute more than the RMD to cover their spending need.

Next, we look at features of the tax-efficient strategy compared to the conventional wisdom. Exhibit 8 shows the adjusted gross income (ordinary plus preferential income) at each age with these two approaches. In this case study, with no above-the-line deductions, total income is equivalent to adjusted gross income (AGI). Compared to the conventional wisdom strategy, the tax-efficient strategy front-loads taxable income with Roth conversions in the years that taxable assets remain to meet spending needs. This lays the foundation for subsequent AGI to be less, as Roth distributions are blended to control AGI at the desired level of the first IRMAA threshold. With the conventional wisdom, once the taxable account fully depletes at age 69, IRA distributions are used to support all spending needs beyond what Social Security helps to support after age 70. This higher AGI for the conventional wisdom strategy is broaching the first IRMAA threshold for the remainder of retirement, leading to IRMAA surcharges to apply every year starting at age 72. The tax efficient strategy avoids this outcome by keeping AGI below the IRMAA threshold.

Exhibit 9 next shows the total taxes paid for each retirement year. This includes IRMAA surcharges, which are large for the tax-efficient strategy at age 65, and which become permanent for the conventional wisdom strategy starting at age 72. With the conventional wisdom, taxes are $0 while the taxable account remains because interest income is less than the standard deduction and preferential income remains within the 0% bracket. But taxes increase dramatically when spending is covered through the IRA. This is compared to the tax-efficient strategy, which frontloads taxes in the years before Social Security begins and is then able to reduce subsequent tax bills in a manner that we showed can increase after-tax legacy values.

Exhibit 10 illustrates the RMDs by age. With Roth conversions, the tax-efficient strategy keeps them lower. But, as we have noted in this case study, the RMDs are not binding in either case. With both the conventional wisdom, which sources all spending beyond Social Security to the IRA at RMD ages, and the tax-efficient strategy, which seeks IRA distributions up to the level of the first IRMAA threshold at RMD ages, the couple seeks IRA distributions larger than the RMDs. Because of the larger spending goal for this couple compared to the mass affluent case, non-binding RMDs are an important reason why the tax alpha is less in this case study, since forced taxation through RMDs is not serving as a binding constraint.

Next, though we like to include an exhibit showing the taxable percentage of Social Security benefits by age, it is not meaningful for this couple. Their wealth levels are high enough that 85% of Social Security will be consistently taxed in both the conventional wisdom and the tax-efficient strategy. This is another factor that reduces the potential tax alpha for this couple relative to the mass affluent case explored in our previous article.

Finally, exhibit 11 makes clear that the differences in legacy for the tax strategies are not found only at age 95. The tax-efficient strategy supports more after-tax legacy than the conventional-wisdom strategy from a much earlier point in the retirement horizon. This can be understood with a reminder about how after-tax legacy is calculated. Taxable and Roth IRA assets pass tax free, but we assume any remaining IRA assets are taxed at 25%. Since the tax-efficient strategy begins Roth conversions at age 62 and keeps the effective marginal tax rate on these conversions under 28%, but more precisely less than this with the availability of the 24% tax bracket, the tax-efficient strategy begins to quickly support a higher after-tax legacy.

The bottom line

This case study shows the potential value for tax planning in retirement to improve results for clients and create tax alpha through strategic effective marginal tax rate management. For wealthier couples, there may be fewer opportunities to benefit, especially when it is not possible to reduce taxation on Social Security, but the absolute level of dollars added to after-tax legacy can still be substantial.

Wade D. Pfau, PhD, CFA, RICP® is a co-founder of the Retirement Income Style Awareness tool, the founder of Retirement Researcher, and a co-host of the Retire with Style podcast. He also serves as a principal and the director of retirement research for McLean Asset Management. He also serves as a research fellow with the Alliance for Lifetime Income and Retirement Income Institute. He is a professor of practice at the American College of Financial Services and past director of the Retirement Income Certified Professional® (RICP®) designation program. Wade’s latest book is Retirement Planning Guidebook: Navigating the Important Decisions for Retirement Success.

Joe Elsasser, CFP® is the founder and president of Covisum, a financial planning software company focused on retirement income related decisions and is a founding partner of Adaptive Advice, a Registered Investment Advisor. He co-authored Social Security Essentials: Smart Ways to Help Boost Your Retirement Income and has been a frequent contributor to a variety of industry publications.

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