Tax Smart Retirement Strategies

The January 2013 tax hikes make tax planning more important than ever. Two strategies we’ve identified are of particular interest to retirees trying to make their savings last as long as possible.

The higher tax rates and lower deductions already passed by Congress, along with new “means testing” of entitlement programs which is likely to come, make it more important than ever to smooth out income sources. Spikes in annual income result in onerous tax rates and, more than likely, will result in reduced benefits from Social Security and Medicare during the high income years.

Retirees need to think about smoothing earnings to the degree that is possible. Having money in an Individual Retirement Account (IRA) is good because gains aren’t reported until money is distributed from the IRA. Outside of the IRA, gains tend to be more “lumpy.” However, all money taken as a distribution from a traditional IRA is taxable at ordinary income rates, so retirees who are taking $60K to $80K in traditional IRA distributions are pushing themselves up into a pretty high tax rate. It would be better, if possible, to spread money between a Roth IRA (which is “after tax” money, so distributions aren’t taxable) and a traditional IRA. A retired person taking out $30K to $40K from each may be in a much better tax situation than if it all comes out of a traditional IRA.

So make Roth conversions during low income years, and take advantage of that funding source as a non-taxable source of cash during the normal years.

Similarly, pre-funding charitable giving could also help smooth taxable income. During big income years, if cash flows allow, a person could put several years’ taxable donations in a Charitable Giving account and get a large deduction to offset the large amount of income. Then, in later years, rather than giving a portion of taxable income, less (taxable) income can be recognized while still meeting charitable giving obligations through the charitable giving account. For tithers, rather than having to earn $111K in order to maintain a $100K spending lifestyle, and paying high marginal tax rates on the extra $11K, the year’s tithe could be paid from the pre-funded tax-deductible charitable giving account.

A community foundation is a great place to establish a charitable endowment fund as a legacy planning strategy, however the Western Colorado Community Foundation (WCCF) is best suited to provide a long term philanthropy strategy. To create a bucket to build up giving for 1 to 5-year stretches, it will likely become necessary to use the charitable giving organizations set up by Schwab or Fidelity Investments to help donor giving strategies.

A charitable giving account could also be useful as part of a college financial planning program as well, although it is really only useful for people who maintain some control of their reportable income. For salaried workers, there’s not much that can be done. On the other hand, salaried employees tend to have much smoother income streams than entrepreneurs, who often enjoy very lean years that will hopefully be offset by the occasional windfall.

Finally, entrepreneurs selling a business can also structure a business sale to smooth reported income. Rather than taking a large lump sum, it may make sense to retain real estate assets that can be leased to create a smooth long-term revenue stream, or the entrepreneur may want to set in place a consulting contract that stretches out several years in order to reduce the size of a lump sum payment income spike that would push them up into the high tax bracket, or consider an installment sale instead of a large up front payment.

Most importantly, don’t succumb to the temptation to over-emphasize tax planning, however. It is an important consideration, but certainly not the most important thing to consider. After all, planning for retirement isn’t about the money. It’s about your life!

Douglas B. May is President of May-Investments, LLC and author of Investment Heresies.