Retirement Tax Strategy Yields 15% Higher After-Tax Income
Executive Summary
Many individuals approaching retirement face uncertainty about the tax implications of their diverse income streams. Pacific Gate Capital addressed this challenge for a client by conducting a thorough analysis of their social security, pension, and investment income, projecting their tax liabilities, and developing a tax-efficient withdrawal strategy. This personalized approach, leveraging tools like RightCapital, is projected to increase the client's after-tax retirement income by a significant 15%, providing greater financial security and peace of mind in their retirement years.
The Challenge
John Smith, a 62-year-old engineer, was nearing retirement and felt overwhelmed by the complexities of managing his finances in a tax-efficient manner. He had accumulated a comfortable nest egg, consisting of a 401(k) valued at $800,000, a taxable brokerage account worth $300,000, and a defined benefit pension plan promising an annual payout of $40,000 starting at age 65. He also anticipated receiving Social Security benefits of approximately $30,000 per year (at full retirement age, which for him is 67).
John's primary concern was that he lacked a clear understanding of how each of these income sources would be taxed and how he could potentially minimize his overall tax burden during retirement. He was aware that withdrawals from his 401(k) would be taxed as ordinary income, but he wasn't sure about the tax implications of his pension and Social Security benefits. He also worried about potentially bumping himself into a higher tax bracket by taking large withdrawals from his retirement accounts.
Specifically, John was concerned that without a proactive tax strategy, he might be paying an effective tax rate of 25% on his retirement income. This would significantly reduce his disposable income and limit his ability to enjoy the retirement lifestyle he had envisioned. He estimated needing approximately $80,000 per year (pre-tax) to maintain his current standard of living. A 25% tax rate would leave him with only $60,000 after taxes, falling short of his financial goals. Furthermore, John was unsure of the optimal sequence of withdrawals from his various accounts to minimize taxes over his entire retirement horizon. He also had not considered Roth conversions as a viable option for tax optimization.
The Approach
Benjamin Chow, a financial advisor at Pacific Gate Capital, took a comprehensive approach to address John's concerns and develop a personalized retirement tax strategy. The process began with a detailed discovery session to gather information about John's financial situation, retirement goals, and risk tolerance. This included a thorough review of his investment portfolio, retirement account statements, and projected pension and Social Security benefits.
Next, Benjamin analyzed John's various income sources and projected his tax liabilities under different withdrawal scenarios. This involved considering the following factors:
- Taxation of Social Security Benefits: Social Security benefits are taxable based on a complex formula that considers the taxpayer's other income. Benjamin projected that up to 85% of John's Social Security benefits could be subject to federal income tax.
- Taxation of Pension Income: John's defined benefit pension would be taxed as ordinary income upon distribution.
- Taxation of 401(k) Withdrawals: Withdrawals from John's traditional 401(k) would also be taxed as ordinary income.
- Taxation of Taxable Brokerage Account: Capital gains and dividends generated within the brokerage account would be subject to capital gains tax rates.
Benjamin then developed a tax-efficient withdrawal strategy that prioritized Roth conversions in the early years of retirement when John's income was lower, minimizing the tax impact. He then used the taxable brokerage account to supplement retirement needs. Finally, when RMDs were required, Benjamin would tap into the 401k for remaining expenses. This allowed for control of John's taxable income in retirement.
Benjamin also explored the possibility of strategically using charitable donations to further reduce John's tax burden through itemized deductions.
Technical Implementation
The development of John's retirement tax strategy involved a combination of analytical tools and financial planning expertise.
- RightCapital Retirement Planning Software: Pacific Gate Capital utilizes RightCapital for detailed retirement planning projections. This software allows Benjamin to model different withdrawal scenarios, project tax liabilities, and assess the long-term impact of various tax planning strategies. He inputted John's current financial information, including his account balances, projected pension income, and estimated Social Security benefits. The software then generated projections of John's retirement income, expenses, and tax liabilities under different withdrawal scenarios. This allowed for a side-by-side comparison of the tax implications of different strategies.
- Marginal Tax Rate Analysis: Benjamin meticulously analyzed John's marginal tax rates in retirement, considering the impact of each additional dollar of income on his overall tax liability. This was crucial for determining the optimal amount to withdraw from each account each year. He calculated that keeping John's taxable income below a certain threshold would allow him to avoid a significant increase in his marginal tax rate.
- Sequence of Returns Risk Analysis: Beyond tax efficiency, Benjamin also considered the sequence of returns risk. Early negative returns during retirement can significantly deplete retirement savings. He stress-tested John's retirement plan under various market scenarios to ensure that it could withstand potential market downturns.
- Roth Conversion Ladder: To minimize future tax liabilities, Benjamin implemented a Roth conversion ladder. Over the next five years (ages 62-67), he strategically converted a portion of John's traditional 401(k) to a Roth IRA each year. The amount converted was carefully calculated to keep John within a lower tax bracket. While these conversions were taxable in the year they occurred, the future withdrawals from the Roth IRA would be tax-free.
Results & ROI
The implementation of Pacific Gate Capital's comprehensive retirement tax strategy is projected to generate significant financial benefits for John:
- 15% Increase in After-Tax Retirement Income: Before the strategy, John was projected to have an effective tax rate of 25% on his retirement income, leaving him with approximately $60,000 per year after taxes (based on a need for $80,000 pre-tax). The new strategy is projected to reduce his effective tax rate to approximately 12%, resulting in an after-tax income of approximately $69,000 per year – a 15% increase.
- Significant Reduction in Lifetime Tax Liability: By strategically utilizing Roth conversions and optimizing withdrawal strategies, John is projected to save over $150,000 in taxes over his retirement lifetime (assuming a 30-year retirement horizon).
- Greater Financial Security: The increased after-tax income provides John with greater financial security and flexibility during his retirement years. He can now comfortably afford his desired lifestyle and pursue his hobbies and interests without worrying about running out of money.
- Optimized Social Security claiming strategy: By delaying the start of social security benefits until age 70, this provided an increase in monthly payments in the future, even after adjusting for inflation.
Key Takeaways
Here are three key takeaways for other RIAs and wealth managers:
- Comprehensive Tax Planning is Essential: Don't treat tax planning as an afterthought. Integrate it as a core component of your retirement planning process. Conduct a thorough analysis of your client's income sources, projected tax liabilities, and potential tax-saving strategies.
- Leverage Technology for Efficient Analysis: Utilize financial planning software like RightCapital to model different scenarios and project the impact of various tax strategies. These tools can streamline the analysis process and provide valuable insights.
- Consider Roth Conversions Strategically: Don't shy away from Roth conversions. They can be a powerful tool for minimizing future tax liabilities, especially in scenarios where clients are in lower tax brackets early in retirement.
- Focus on After-Tax Income: Help clients understand how different strategies affect their after-tax income. People retire on the money they keep, not the gross amount. Highlight the impact on their financial security and ability to achieve their retirement goals.
About Golden Door Asset
Golden Door Asset builds AI-powered intelligence tools for RIAs. Our platform helps advisors identify tax optimization opportunities and create personalized retirement plans for their clients, resulting in improved client outcomes and increased AUM. Visit our tools to see how we can help your practice.