Tax Minimization with High Withdrawal Amounts

[DawgMan]

I am still currently a high earner (self-employed) with plans to significantly downshift starting in 2020 (expect income to start dropping significantly). While I have reached FI (DW and I are 55), I enjoy most of what I do and am able to effectively work part time at this point so plan on letting the market (my industry) dictate when I truly hang up the spurs. My guess is the market could keep me in the game another 1 - 3 yrs before I need to tap my assets. I am in the top tax bracket so my focus has been maximizing all my tools to minimize current taxes.

Here is my first world dilemma as I look forward to the days I start living off my assets... currently my investments are split +/- 50/50 in taxable and tax deferred accounts. My plan is to withdrawal $300K+/yr (highly discretionary). While I have followed many of the Roth conversion discussions, I am not sure how practical that is in my case as my current income is significantly above my planned withdrawal amounts. As someone who subscribes to the Total Return approach, I figure my RE income will come from interest and dividends first followed by capital gains and/or some combination of partial tax differed account withdrawals up to a specific marginal tax bracket. Frankly, that's as far as I have really strategized at this point. Candidly, I have also just thought about pulling only from the taxable account until it is dry and then facing the Tax Reaper with my tax deferred withdrawals at that time.

For those of you who are withdrawing higher amounts, what, if any, tax strategies have you employed to keep the Tax Reaper away?

 

[Bigdawg]

While I have followed many of the Roth conversion discussions, I am not sure how practical that is in my case as my current income is significantly above my planned withdrawal amounts.

For the few years left where you will have earned income I suggest back door ROTH's. That way you will at least dip your toes into the ROTH world.

 

[pb4uski]

I think the general principal to do tax deferred withdrawals or conversions to the top of the tax bracket that you expect to be in once pensions, SS and RMDs have started is still sound advice no matter the size of the withdrawal.

That said, the difference between 22%, 24%, 32%, 35% and 37% are harder to get excited about than the difference between 12% and 22%.

 

[DawgMan]

That said, the difference between 22%, 24%, 32%, 35% and 37% are harder to get excited about than the difference between 12% and 22%.

Yep, I was hoping for some "super secret" strategies to be revealed.

I may just have to face the music when I get there.

 

[RunningBum]

Most people don't convert while they are working, because your income is likely higher than it will be in retirement. I don't know that a back door Roth makes sense either, because they is essentially a conversion, right?

The conversion window comes after you retire, before you start collecting SS, perhaps a pension, and have to take RMDs. If this is a low income point for you, look to do conversions then.

One reason not to drain the taxable account is that you can pass that on to heirs with a stepped up basis. If that's a goal, keep that in mind.

If charitable giving is a goal, there are a couple of good strategies:
- Open a Donor Advised Fund and put highly appreciated equities in it. Do this if you itemize taxes. You can deduct the current value on it, without paying taxes on the gain.
- Do Qualified Charitable Donations when you get to RMD age. This works even if you don't itemize because the donation is deducted from your income.

All these things are usually just tweaks to your tax minimization. You deferred a whole lot of income, and you (or your heirs) are eventually going to have to pay taxes. There's no silver bullet, no magic to make taxes disappear. But anything to lower your lifetime tax bill helps. I prefer to do what I can rather than be dejected that it doesn't seem like much.

 

[pb4uski]

Yep, I was hoping for some "super secret" strategies to be revealed.

I may just have to face the music when I get there.

Yup. Suck it up buttercup. [emoji3]

Think of it as a success tax! Congratulations on your success! Now pay up. [emoji16]

 

[Midpack]

I think the general principal to do tax deferred withdrawals or conversions to the top of the tax bracket that you expect to be in once pensions, SS and RMDs have started is still sound advice no matter the size of the withdrawal.

That said, the difference between 22%, 24%, 32%, 35% and 37% are harder to get excited about than the difference between 12% and 22%.

With all the unknowns/variables there’s no “right answer” and there are non $ factors —- but the above is the same conclusion I’ve come to after a couple of months of careful detailed self study (with help from others here). We’ll be converting to 22% for the next 6-7 years which will put about 2/3rds of our TIRAs into Roth’s. We’ll be in the 22% bracket for 6-7 years versus the rest of our lives in the 22% (likely higher IMO) bracket if we don’t do any Roth conversions.

 

[jebmke]

Two of the biggest potential tax levers are philanthropic plans and estate plans - which should be integrated if at all possible. Depending on how important those are in your future life plans, a competent tax professional (usually a tax trained partner at a law firm that also has a strong estate planning capability) might be worthwhile.

 

[Chuckanut]

I think the general principal to do tax deferred withdrawals or conversions to the top of the tax bracket that you expect to be in once pensions, SS and RMDs have started is still sound advice no matter the size of the withdrawal.

+1

I've been doing Roth conversions based on PB4's above strategy. It hurts somewhat to pay the taxes. But, then I consider what the taxes will be once I get my full SS check at 70 and the RMD kicksin, I take a nap, and the concerns go away.

 

[Animorph]

It's all tax minimization, which is highly variable by individual.

You should be in a great position for Roth conversions, living off your taxable accounts while Roth converting tIRA's. You want to avoid any large tIRA withdrawals for any one year that would increase your marginal tax rate beyond some sustainable minimum. That means withdrawing/Roth converting enough to fill up a reasonable tax bracket for you. You must estimate what RMD's will do to your taxes when you hit age 70. That might be the big withdrawal bump you need to avoid.

I optimize my income by determining my optimum tIRA withdrawal each year, regardless of need. Any portion of that withdrawal that is not needed for expenses is Roth converted (pre-RMD's). Currently that means it's all Roth conversion while I live on taxable accounts. Currently I convert up to $250k AGI, avoiding the extra healthcare tax.

In a couple of years I'll convert much less. I'll be closer to Roth withdrawals, and the benefits of Roth converting at the same tax rate as RMD's will see will be less due to the shorter time frame. I'll be Roth converting just to the top of the 10% bracket and taking advantage of 0% capital gains for a few years until SS and RMD's start.

When the taxable accounts run out, then I'll still take out the optimum tIRA withdrawal, or RMD when necessary, and withdraw from the Roth IRA as needed to meet expenses. This allows me to avoid larger tIRA withdrawals into an unnecessarily high tax bracket. It also preserves some tIRA to fill in the lower tax brackets if your other income allows.

All of that allows us to stay within the 22% tax bracket during retirement. YMMV depending on how much room you have in your top tax bracket without tIRA wihdrawals.

 

[DawgMan]

It's all tax minimization, which is highly variable by individual.

You should be in a great position for Roth conversions, living off your taxable accounts while Roth converting tIRA's. You want to avoid any large tIRA withdrawals for any one year that would increase your marginal tax rate beyond some sustainable minimum. That means withdrawing/Roth converting enough to fill up a reasonable tax bracket for you. You must estimate what RMD's will do to your taxes when you hit age 70. That might be the big withdrawal bump you need to avoid.

I optimize my income by determining my optimum tIRA withdrawal each year, regardless of need. Any portion of that withdrawal that is not needed for expenses is Roth converted (pre-RMD's). Currently that means it's all Roth conversion while I live on taxable accounts. Currently I convert up to $250k AGI, avoiding the extra healthcare tax.

In a couple of years I'll convert much less. I'll be closer to Roth withdrawals, and the benefits of Roth converting at the same tax rate as RMD's will see will be less due to the shorter time frame. I'll be Roth converting just to the top of the 10% bracket and taking advantage of 0% capital gains for a few years until SS and RMD's start.

When the taxable accounts run out, then I'll still take out the optimum tIRA withdrawal, or RMD when necessary, and withdraw from the Roth IRA as needed to meet expenses. This allows me to avoid larger tIRA withdrawals into an unnecessarily high tax bracket. It also preserves some tIRA to fill in the lower tax brackets if your other income allows.

All of that allows us to stay within the 22% tax bracket during retirement. YMMV depending on how much room you have in your top tax bracket without tIRA wihdrawals.

Ok, following the bouncing ball. As I am currently hitting the max marginal tax rate it is clear it makes zero sense in converting now. Fast forward to when I am drawing around $300K it would appear the extreme ends of the spectrum are A) take 100% from my retirement account and pay up to 24% marginal tax rate (using 2019 rates) vs. B) taking the $300K all in taxable accounts paying lower capital gains taxes. If I do B), where is the benefit in Roth converting if I have already taken out the $300K? Would i not be further pushed into a higher marginal tax bracket? Perhaps I am missing something here in the strategy? I was thinking my only strategy would be to take a blend of A) & B) limiting my retirement account withdrawals to a certain bracket and then taking the balance from my taxable accounts. The thinking is this may help balance the potential RMD hit. I am all about getting the Roth conversion in the mix if it makes sense, but I am not seeing how the math plays out in my case. I suppose converting at 24% is better than 32% if you think RMDs will push you back into the highest tax bracket.

None the less, I like the ideas... if they work.

 

[RunningBum]

These things have so many moving parts so you have to have all the information, and take the time to figure out what works best. So it's going to be tough for any of us to give you advise on exactly what to do.

Generally speaking, I would most like to get as much as I can into a Roth, because future gains grow tax free. That means I would take a serious look at spending from taxable, and converting what makes sense to a Roth. This seems better than spending money out of a tIRA because you've missed your chance to get that money into a Roth.

Whether this applies to your situation, I can't say.

If you're talking about drawing $300K for an extended time, I would think you are looking at high tax rates. There's no supposing a 24% tax rate and tax free growth is better than 32%. It is. By a lot.

If it were me, I'd be doing spreadsheets with various scenarios of converting none, some, or a lot, and comparing where you'll be, and how much you'll save in taxes. If you're not a spreadsheet person, it would seem very worthwhile to pay for some financial advisor and/or tax attorney time to do it for you.

 

[Sunset]

OP - since you are self employed, and hopefully have a self-401K, you could put approximately $56,000 into the ROTH 401K, plus $7,000 or $8,000 into a separate roth, plus a separate roth for spouse.

This may have value to get money into a Roth, even if you make $300K right now, as later when withdrawal from IRA for spending of $300K , conversions would mean extra withdrawal and higher tax rates.

 

[pb4uski]

Ok, following the bouncing ball. As I am currently hitting the max marginal tax rate it is clear it makes zero sense in converting now. Fast forward to when I am drawing around $300K it would appear the extreme ends of the spectrum are A) take 100% from my retirement account and pay up to 24% marginal tax rate (using 2019 rates) vs. B) taking the $300K all in taxable accounts paying lower capital gains taxes. If I do B), where is the benefit in Roth converting if I have already taken out the $300K? Would i not be further pushed into a higher marginal tax bracket? Perhaps I am missing something here in the strategy? I was thinking my only strategy would be to take a blend of A) & B) limiting my retirement account withdrawals to a certain bracket and then taking the balance from my taxable accounts. The thinking is this may help balance the potential RMD hit. I am all about getting the Roth conversion in the mix if it makes sense, but I am not seeing how the math plays out in my case. I suppose converting at 24% is better than 32% if you think RMDs will push you back into the highest tax bracket.

None the less, I like the ideas... if they work.

I'm trying to avoid taking money out of taxable at this point. For one, my unrealized gains are about 50% of value... so if I take out $100k to spend that means $50k of capital gains and $7.5k of capital gains tax... but it also means that is $50k less of tIRA withdrawals or Roth conversions.

I'm betting on stepped up basis for taxable accounts when one of us dies or both die and taxable equities are inherited... in that event the embedded gain never gets taxed... and I like that idea.

Another reason that I am prioritizing tIRA withdrawals for spending money and Roth conversions to the top of my ultimate tax bracket is because if one of the other of us dies, we might be catapulted into a higher tax bracket so the lower the tax-deferred balances the better.... probably less of an issue for us realistically depending on future investment results but possibily an issue for others.

 

[kaneohe]

Most people don't convert while they are working, because your income is likely higher than it will be in retirement. I don't know that a back door Roth makes sense either, because they is essentially a conversion, right?

...............................................

wondering about the last statement......OP's income is too high to deduct TIRA contribution so other alternative is to invest in taxable. In either case OP will pay taxes on that income. If you do backdoor Roth (assuming no deductible contributions in any other TIRAs), there will be no tax on conversion so contribution will end up in Roth with no further taxes so OP can do Roth or taxable with same tax consequences. Better to be in Roth?

 

[Animorph]

Ok, following the bouncing ball. As I am currently hitting the max marginal tax rate it is clear it makes zero sense in converting now. Fast forward to when I am drawing around $300K it would appear the extreme ends of the spectrum are A) take 100% from my retirement account and pay up to 24% marginal tax rate (using 2019 rates) vs. B) taking the $300K all in taxable accounts paying lower capital gains taxes. If I do B), where is the benefit in Roth converting if I have already taken out the $300K? Would i not be further pushed into a higher marginal tax bracket? Perhaps I am missing something here in the strategy? I was thinking my only strategy would be to take a blend of A) & B) limiting my retirement account withdrawals to a certain bracket and then taking the balance from my taxable accounts. The thinking is this may help balance the potential RMD hit. I am all about getting the Roth conversion in the mix if it makes sense, but I am not seeing how the math plays out in my case. I suppose converting at 24% is better than 32% if you think RMDs will push you back into the highest tax bracket.

None the less, I like the ideas... if they work.

It sounds to me like B is the start. You sell from your taxable account. $300k for the income you need. Then, what is your regular income tax rate if you have, say, $150k all in capital gains and nothing else?. You should be able to Roth convert at least up to the standard deduction and pay zero extra taxes. Then it gets more complicated as you increase the conversion amount as some of your 0% CG taxes will become taxed, as well as the extra income. Once into the 22% bracket your marginal rate should be a simple 22%. That gets you $100k Roth converted at less than a 25% tax rate, and a lot more if you go into higher tax brackets. Of course your taxes won't be that simple.

Not only do you get a lower tax rate than you pay now, you also reduce RMD's in the future and can hopefully stay out of a higher tax bracket then.

In addition, at 32% tax rate you own only 68% of the money in your tIRA. 32% of it belongs to the IRS. On the other hand, you own 100% of your Roth account. So if you convert $100k, pay $32k in taxes from your taxable accounts, and put $100k into your Roth, that's $32k that used to be in your taxable account that is now in your Roth account, tax free from then on. That can be a big advantage when you have a long time before making Roth withdrawals.

You know your tax situation. Big Roth conversions are possible when you retire and your income goes way down. That can open up tax rates lower than you're used to, and probably lower than when RMD's hit. If that's the case, take advantage of them.

 

[RunningBum]

wondering about the last statement......OP's income is too high to deduct TIRA contribution so other alternative is to invest in taxable. In either case OP will pay taxes on that income. If you do backdoor Roth (assuming no deductible contributions in any other TIRAs), there will be no tax on conversion so contribution will end up in Roth with no further taxes so OP can do Roth or taxable with same tax consequences. Better to be in Roth?

Yes, I think you're right. I keep forgetting how that backdoor Roth works.

 

[sanfanciscotreat]

My accountant told me in the early 80s when I complained about paying so much tax: "If you do not want to pay so much tax, earn less money". I disregarded his advice.

 

[DawgMan]

These things have so many moving parts so you have to have all the information, and take the time to figure out what works best. So it's going to be tough for any of us to give you advise on exactly what to do.

Generally speaking, I would most like to get as much as I can into a Roth, because future gains grow tax free. That means I would take a serious look at spending from taxable, and converting what makes sense to a Roth. This seems better than spending money out of a tIRA because you've missed your chance to get that money into a Roth.

Whether this applies to your situation, I can't say.

If you're talking about drawing $300K for an extended time, I would think you are looking at high tax rates. There's no supposing a 24% tax rate and tax free growth is better than 32%. It is. By a lot.

If it were me, I'd be doing spreadsheets with various scenarios of converting none, some, or a lot, and comparing where you'll be, and how much you'll save in taxes. If you're not a spreadsheet person, it would seem very worthwhile to pay for some financial advisor and/or tax attorney time to do it for you.

To your point, I will need to run a number forecasting scenarios out once I go into withdrawal mode. Appreciate the insight.

 

[DawgMan]

OP - since you are self employed, and hopefully have a self-401K, you could put approximately $56,000 into the ROTH 401K, plus $7,000 or $8,000 into a separate roth, plus a separate roth for spouse.

This may have value to get money into a Roth, even if you make $300K right now, as later when withdrawal from IRA for spending of $300K , conversions would mean extra withdrawal and higher tax rates.

Current income is too high. My wife is on my payroll so we max out all of our 401K options (not Roth) as i save at the highest marginal tax rate. At a $300K withdrawal I will be in a lower marginal tax rate. As other have said, I suppose marginal tax rates are all relative when doing Roth conversions.

 

[DawgMan]

I'm trying to avoid taking money out of taxable at this point. For one, my unrealized gains are about 50% of value... so if I take out $100k to spend that means $50k of capital gains and $7.5k of capital gains tax... but it also means that is $50k less of tIRA withdrawals or Roth conversions.

I'm betting on stepped up basis for taxable accounts when one of us dies or both die and taxable equities are inherited... in that event the embedded gain never gets taxed... and I like that idea.

Another reason that I am prioritizing tIRA withdrawals for spending money and Roth conversions to the top of my ultimate tax bracket is because if one of the other of us dies, we might be catapulted into a higher tax bracket so the lower the tax-deferred balances the better.... probably less of an issue for us realistically depending on future investment results but possibily an issue for others.

As it relates to my taxable account, I am assuming roughly half of the $300K will come naturally from dividends/interest and the other half from capital gains. To your point, like many in this long bull market, I have many winners so not sure of the impact of the actual gains at this point.

 

[DawgMan]

My accountant told me in the early 80s when I complained about paying so much tax: "If you do not want to pay so much tax, earn less money". I disregarded his advice.

so that's the secret sauce...