Show Your Value with Retirement Transition Tax Planning

Kyle Moore, CFP® founded Quarry Hill Advisors with the goal of helping others align their money with their values and make a lifetime of smart decisions with their resources. Kyle discusses how he helps clients transition to retirement with a smart tax strategy.

Tax planning in the retirement transition

For most people facing an imminent retirement transition, the years between 60-70 years old are most critical. After age 70.5, all pensions must be taken, Social Security is locked in, and their Retirement Minimum Distributions must now be, well…distributed. It doesn’t take more than that to show a client that there are much fewer tax planning opportunities post age 70.5 than before.

Without careful planning, those income sources are stacked on top of one another, a client could end up stuck in a higher income tax bracket than necessary for the rest of their life. In the retirement years prior to that, we have the ability to pick and choose what shows up on their tax returns depending on those timing decisions and from which accounts we withdraw.

Most people are overwhelmed with coordinating these variables for themselves, and as advisors, we can help clients make decisions that will minimize their tax burdens over the course of their lives.

One strategy that often presents itself for retiring clients is partial Roth conversions. You can identify this opportunity when a retiring client has a sizable portion of their portfolio in both taxable and tax-deferred accounts. Before we get too far, the advisor and client must understand the interaction of capital gains and ordinary income taxes.

Capital gains and ordinary income tax

The long-term capital gains and dividends tax rate is lower than the ordinary income tax rate, but can realizing capital gains cause wages or IRA withdrawals to be taxed at a higher rate? That's an important question for whenever you are planning to take capital gains, whether you are coordinating retirement withdrawals or straddling between tax brackets.

The bad news is that capital gains will drive up your adjusted gross income (AGI). As your AGI increases, you begin to get phased out of personal exemptions, itemized deductions, certain tax credits, and you could become ineligible for Roth IRA or deductible IRA contributions, but that’s largely irrelevant for our retired clients.

The good news, however, is when you take capital gains, tax rates apply FIRST to your ordinary income. So long-term capital gains and dividends which are taxed at the lower rates WILL NOT push your ordinary income into a higher tax bracket.

Long-term capital gains at 0%

The long-term capital gains tax is 0% if realized in the 12% bracket. But what happens when some of those gains are in the 12% bracket and cross over into the 22% bracket? Fortunately, a little spillover into the 22% bracket will not make the entire gain taxable at the higher marginal rate.

Let's look at an example. If your ordinary income is $5,000 under the 22% tax bracket (put another way, $5,000 more room left in the 12% bracket) and you have a $10,000 long-term capital gain, you pay 0% tax on first $5,000 of the gain and 15% capital gains tax on second $5,000. The ordinary income remains in the 12% bracket.

Long-term capital gains and Roth conversions in retirement

Let's look at another, more extreme example. Let's say a married couple just retired and no longer earns income. Therefore, you want to convert IRA dollars to Roth to fill up lower tax brackets. But in order to do so, you'll need to realize capital gains to meet your living expenses. Let's say you require $200,000 to meet living expenses and taxes and must realize $150,000 of long-term capital gains.

If tax rates didn't apply to ordinary income first, the Roth conversion amount would stack on top of the $150,000 long-term capital gain. However, since tax rates DO apply to ordinary income first, you can likely also convert up to $100,000 of your IRA to Roth in the 10% and 12% brackets (after deductions)!

Make sure you have the right tools

Knowing the correct order of taxation for different types of income can open up a wide range of tax planning opportunities for those making the switch from earning a wage and saving to retiring and coordinating their income streams. You also need the right tools to synthesize your client’s information and determine the right strategy for them.

Using a software that is able to clearly demonstrate and personalize strategies like this is a great way to display the value of your expertise. RightCapital’s tax focus and ability to quickly coordinate all of these variables has been a tremendous way for me to enrich the lives of my clients and grow my practice.

Kyle Moore, CFP® has a bachelor’s degree from Northwestern University in Evanston, Illinois. While attending Northwestern, Kyle was a member of the Varsity Golf team and earned honors as an Academic All-American and Academic All-Big Ten selection.

Kyle is married to Madeline and they have two very (!) active children, Sophie Sue and Graham. They enjoy spending time exploring their neighborhood, serving in their church, and sneaking off to the golf links for a quick nine holes.