Finding Your Tax Equilibrium

Tax Deferral is not always the best policy.

Many of us have been told for a very long time to defer as much tax as we possibly can. This sounds good on paper. No one likes to pay taxes, right? In essence, tax deferral is a loan that the IRS gives you that comes due when you draw money from your tax-deferred savings. For most, this loan comes due during a financially vulnerable time – retirement.  Deferring as much income as possible, however, might not be the best strategy. The best strategy is to find an equilibrium between how much you pay in taxes now and how much you will pay during your retirement years.

An individual making the maximum contribution to a 401(k) beginning at age 30, who works until age 67, could have a tax-deferred balance of more than $10 million by the time their required minimum distribution (RMD) begins at age 75 if they achieve an average annual return rate of 8%. The RMD on a $10 million balance would be more than $400 thousand. That is enough to place them solidly in the 32% marginal tax bracket if they file a joint tax return, even higher if they are filing as single.

In the example outlined above, an individual earning $190 thousand a year would have paid taxes at the 22% marginal rate during their career only to have their tax rate climb to 32% later in life. Simply splitting the difference between pre-tax and after-tax contributions would result in $5M in tax deferred assets and $5M in after-tax Roth. This would result in an RMD of around $200 thousand, in-line with their tax rate from their working years.

While planning earlier in life is ideal, all is not lost for those for who have already accumulated large tax deferred assets. A golden period of low income exists between retirement and the age at which RMDs begin, during which individuals can right size their tax buckets. This can be accomplished by taking ‘non-required’ distributions from their tax deferred accounts in the form of a partial Roth conversion or simply a standard distribution to pay for living expenses. The same principle applies: take distributions while in a lower tax bracket before RMDs push you into a higher one.

If your RMD will push you into the next higher bracket, the best strategy is to maximize the tax bracket you are currently in. Based on current tax brackets, an individual with $100 thousand of taxable income per year would be in the 22% tax bracket. You could draw an additional $90 thousand from an IRA and still remain in the 22% bracket. The sooner you start the more you can reduce your tax-deferred balance before RMDs begin.

The same opportunity exists for capital gains in a taxable account. We are all familiar with “harvesting losses” to reduce capital gains tax. However, harvesting gains during years of low income can potentially be a winning strategy as well.

It’s impossible to get this perfectly right. Much like choosing a starting age to begin drawing Social Security benefits, we may only know the correct choice after the fact. Tax laws change, investment returns do not always turn out as we expect, and sometimes life events just get in the way. However, working with an investment advisor to find your tax equilibrium can help you avoid unintended tax consequences when they matter most.