The Multi-Legged Tax Stool

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Retirement is full of unknowns, which can make it a bit scary. Taxes represent one area that tends to be of particular concern to people. By using a multi-legged approach, it is possible to reduce some of the potential risk of the unknown and, as such, a significant source of retirement anxiety.

Following the Tax Cuts and Jobs Act in 2017, tax rates were as low as they have been for quite some time. If you had asked people in 2012 about rates in 2018, few would have predicted the level. Unfortunately, our era of relatively low rates may be short-lived based on comments from the current administration along with a sober look at the state of our economy – or rather the debt load of our nation.

While higher rates might be on the horizon, the challenge is that we don’t really know if that will actually be the case or what “higher rates” might look like. If we do have higher rates, will they take the form of higher income taxes, capital gains taxes, inheritance taxes, a value added tax or a combination of the above?

Quite a conundrum!

Fortunately, there is a way to mitigate some of the uncertainty – diversify the taxation of your income streams with a multi-legged approach.

There are fundamentally three different tax “legs”:

Leg 1
This leg consists primarily of traditional retirement accounts.  These accounts are characterized by tax-free savings and tax-free growth, making them appear attractive during high tax earning years.  However, distributions during retirement are fully taxed at ordinary income rates.

Leg 2
This leg consists primarily of traditional taxable accounts.  These accounts are funded with after-tax dollars.  Capital gains, dividends and interest are taxed over the life of the account.  Historically, taxation of long-term capital gains and dividends has been at rates that are considerably lower than ordinary income rates.

Leg 3
This leg consists of sources that can provide tax-free income.  Tax-free income can be derived from Roth IRAs, municipal bonds and life insurance, to name a few.  All are funded with after-tax dollars, but growth and distributions can be tax-free.  (Note: in some cases, it may be possible to fund life insurance with tax-advantaged funds, but that’s a topic for another discussion).

People tend to have the bulk of their savings in Legs 1 and 2.  That can provide some control over taxes since one can decide how much to take from Leg 1 and pay ordinary taxes and how much to take from Leg 2 to potentially pay lower taxes on capital gains and dividends.

However, by adding Leg 3, there can be much more flexibility since that income is tax-free.

Let’s look at a quick example so you can see the power.  We’ll start off assuming a married couple who takes $125,000 from their retirement accounts with no other income.

Leg 1 only
In this case, the full $125,000 would be taxed.  After accounting for deductions, the actual taxes due would be around $13,625.

Legs 1 and 2
In this case, we’ll assume the couple takes $62,500 from retirement plans and $62,500 from their traditional investment account.  We are also going to assume that 100% of the income from the investment account is taxable at long term capital gain/dividend rates (in reality, a portion of this may represent return of principal, which is not taxable).  In this case, ordinary income is lower, so the marginal tax rate may be lower.  Also, moving a portion to capital gains and/or dividends reduces the taxation even more.  As a result, the overall tax is reduced to about $7,120.  In other words, you would have just over $6,500 or 5.2% more to spend on yourself.

All 3 Legs
Now, let’s assume that we take equal amounts from retirement accounts, traditional investment accounts and tax-free income sources.  This results in a significant reduction to both ordinary income and capital gain income, potentially reducing the tax rates on both significantly and also reducing the overall income that will be taxed.  By doing this, taxes are decreased to about $1,700.  This gives you about $11,925, or 9.5% more to spend versus using Leg 1 only.

To summarize:

As you can see, the inclusion of tax-free income can make a significant difference. Keep in mind that this simply assumed taking equal amounts from each leg. The results can be even more significant if larger amounts can be taken from legs 2 or 3. Additionally, if we were to perform the same comparison using higher withdrawal amounts, the results would be even more dramatic.

For those of you over 70, it is likely too late to add Leg 3. However, if you aren’t there yet, doing a Roth conversion or exploring tax-free insurance options may be prudent, particularly given concerns about our debt loads and possible tax rates going forward.

Give us a call and let us know how we can help.

Have a great month!

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