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Tax Management Issues For Retirement Accounts


A tax-efficient withdrawal strategy can be employed by structuring income into taxable, tax-deferred and tax-free pools, known as a Tax Triangle.


Ever since Individual Retirement Arrangements (IRAs) were introduced by the Employee Retirement Income Security Act (ERISA) in 1974, they have allowed millions of Americans to save for retirement. They were a novel way of providing income to retirees. For most of the post-war era, Americans relied on income from pensions funded by their employers mainly, sometimes with help from union dues. Four years before the enactment of the ERISA, forty-five (45) percent of all private sector workers were covered by a pension plan. Both pensions, known as “defined benefit” plans and IRAs, which are “defined contribution” plans improved the lives of American workers, who at the beginning of the twentieth century were expected to work as long as they were able. At that time, roughly 75 percent of all males over 65 were working; if they weren’t, it was because they had some sort of disability.


Those ‘good old days’ have luckily receded into the past. Now IRAs dominate the retirement landscape. They rose to prominence as a way of patching the flaws in the pensions systems; the major one being the possibility that a company would mismanage the assets in the fund and thus leave workers bereft of benefits. IRAs are different; their management is left to the worker who, very often, delegates that responsibility to a financial institution or other trustee. While IRAs give employees decidedly more control over their retirement futures, a number of tax-related issues affect their effectiveness. The major types of IRAs, Backdoor Roth IRAs, the effect of Required Minimum Distributions (RMDs) on AGI, tax harvesting, the Tax Triangle and pending legislation are all issues that can determine whether an IRA provides adequate income to fund retirement.   


Some proposed changes in the tax code, such as the one reversing the 2010 law that made Backdoor Roth IRAs possible, would have an adverse effect on retirement incomes. To compound this, Required Minimum Distribution (RMD) rules may apply to Roth IRAs in the future. And a proposed change to accelerate to 5 years the RMD period on non-spouse inheritances of a 401(K) or IRA is being contemplated. Nevertheless, with proper retirement tax planning, many of these threats can be avoided or turned into opportunities to maintain and increase retirement income.


Three important considerations should underpin your tax planning:

(I) the state you choose to live in after retirement



(ii) deciding between taxable, tax-deferred and tax-free accounts and the order in which you will withdraw from those accounts



(III) Social Security and Medicare taxes. Generally, Social Security benefits are not taxable but, depending on provisional income, up to 85 percent may be taxed. Provisional income is gross income plus tax-free interest plus 50 percent of Social Security benefits.


A state may have no income tax but property, sales, gas and vehicle taxes may negate that advantage. Other caveats exist. For example, contributing or converting to a Roth IRA or Roth 401(K) now and moving to one of the seven states with no state income tax (Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming) means paying taxes today on income that would be tax-free in retirement.


A tax-efficient withdrawal strategy can be employed by structuring income into taxable, tax-deferred and tax-free pools, known as a Tax Triangle. Withdrawal from each pool will then depend on your projected tax bracket for that year.


Unless this tax treatment flexibility is in place, there may be exposure to a Tax Time Bomb, since income from Social Security, pensions and 401(K) plans or IRAs are taxable at undeterminable rates in the future. When retirement income is derived from taxable accounts, tax-deferred ones like a 401(K) and tax-free sources like municipal bonds, risk management is improved. How accounts are structured will depend, partly, on whether your rate in retirement is likely to be higher or lower than at present. Roth IRAs (discussed below) are an important consideration at this stage.


A traditional IRA is funded with pre-tax dollars and can be started by anyone with earned income before the age of 70 ½. The contributions that fund it are tax deductible on both state and federal tax returns. The growth of and income from investments in the account are tax-deferred until distributed. Although, typically, distributions are mandated from age 70 ½ or retirement, they can begin from 59½ without incurring penalty. A 50% penalty is imposed on withdrawals that fall below the RMD. However, it is possible to postpone RMDs with a Qualified Longevity Annuity Contract. 


A Qualified Longevity Annuity Contract (QLAC) allows RMD funds not immediately required, to be invested tax-free in a fixed annuity, i.e., the QLAC, which pays lifetime income.The QLAC, which is similar to an immediate, fixed annuity except that payouts begin in the future, pays out from ages 70½ - 85. Funds invested in a QLAC are not counted against RMDs. A return of premium death benefit will guarantee that upon the contract holder’s death, the beneficiary receives any excess of premiums paid over receipts from the annuity.


A Roth IRA differs from a traditional IRA in, at least, three important ways: (I) it is funded with income on which tax has already been paid; (ii) there is no mandate on withdrawals during the owner’s lifetime; and (III) withdrawals (distributions) are tax-free. However, like a traditional IRA, there is no tax on the income and growth of investments in the fund. And like a traditional IRA, penalty-free qualified distributions are allowed from 59½, although, the first contribution must be at least five years before qualified distributions begin.




There are income limits. In 2017, if a married couple has MAGI exceeding $196,000 or a single person has an MAGI in excess of $133,000, they cannot make any Roth contributions. MAGI is Modified Adjusted Gross Income. However, these limits may be circumvented by contributing to a traditional IRA, which is later converted to a Backdoor Roth IRA. A Backdoor Roth IRA is created by, first, making contributions to a traditional IRA and then converting it to a Roth IRA.


A Roth IRA can help avoid a tax torpedo, which is created when too much taxable income flows in from RMDs from a traditional IRA and Social Security receipts. Indeed, RMDs may increase income and, consequently, taxes on Social Security benefits. And that increased income could drive up Medicare premiums and trigger the 3.8% Medicare surtax on net investment income.


Roth IRAs do not have RMDs, so there is no forced taxable income at age 70½. Consequently, distributions from Roth IRAs do not increase your MAGI. And the choice between a traditional IRA and a Roth IRA has been likened to choosing between paying taxes on the seed or harvest.


Generally, your tax- deferred accounts should consist of tax-inefficient investments such as bonds while tax-efficient investments such as stocks should be in your taxable investment accounts. Bonds are tax-inefficient because the interest is taxed at your marginal rate. In a taxable account, losses on securities will offset taxable income. Taxes can be paid at the lower long-term capital gains rate or the tax-free principal can simply be withdrawn.


The order in which withdrawals are made can reduce taxes. Typically, withdrawals are made from taxable sources first, followed by taxable IRAs next, and then tax-free Roth IRAs. Sometimes, a different pattern of withdrawals may be more beneficial. For example, if you are in a low tax bracket and you plan on leaving money to an heir in a high tax bracket, it will make sense to take IRA money out first. Again, you may have a Roth IRA that is a combination of contributions, rollovers and conversions. If withdrawals are not taken out in the right order and reported properly on your tax returns, that so-called “tax-free” Roth may not be as tax-free as you thought.


Many types of investment are allowed in an IRA including stocks, bonds, mutual funds, unit investment trusts, exchange-traded funds, real estate and annuities. However, annuities offer tax-deferred growth just like traditional IRAs do and so there is no advantage to including an annuity in your IRA unless a guaranteed living benefit rider or other attractive features are included.


Non-IRA annuities have special rules for withdrawals. For lump sum withdrawals, a “Last In, First Out” (LIFO) rule applies: growth is taxed as ordinary income, while principal is tax-free. Periodic withdrawals are subject to a blended withdrawal rule, which like a mortgage payment is made up of principal and interest.

The rate applied to the top slice of your income is your tax bracket. A look ahead may indicate tax bracket increases in later life. If so, present tax brackets can be filled by “topping off” with IRA withdrawals or Roth conversions. Taxes on the income is paid at a lower rate now rather than a higher rate then.

Tax advantages are also possible with non-IRA accounts like index funds, exchange-traded funds (ETFs), municipal bonds, master limited partnerships (MLPS) and real estate investment trusts (REITs).


Tax gain harvesting occurs when a security is sold to realize capital gains that will escape tax. This is possible since capital gains for the 10% and 15% brackets are zero. On the other hand, tax loss harvesting occurs when securities that have depreciated in value are sold and the loss applied to reduce taxable income and capital gains.


Estate tax is a tax on the transfer of property at death. Currently, the first $5,450,000 is exempt from taxes and from filing. However, even for estates less than this amount, filing is a good idea so as to take advantage of the Deceased Spousal Unused Exclusion  (DSUE). This portability of the DSUE allows a wife’s estate, for example, to have an exemption from estate tax exceeding the $5,450,000 limit by adding the unused portion of her deceased husband’s exemption.


Gifts may also reduce your taxable estate. Up to $14,000 per year per person, for as many people as you like, is allowed. Gifts exceeding that limit will be taxable and their value included when estate tax is computed. Bear in mind that the $5,450,000 exemption is a “unified credit” that applies to gift and estate taxes combined.


Our odyssey through the tax landscape has revealed some major issues that most retirees will face. At first, since the issues are so many and so intertwined the job of sorting it all out may seem Sisyphean. However, a few guiding principles will reduce the amorphous mass of tax complications to a polished plan more likely to yield the income to fund your retirement lifestyle. As in the retail business, location can make you or break you and deciding where you are likely to live after retirement has important implications. At present, seven states do not tax earned income, which means income from IRAs are tax-free. If you’re planning on moving to one of those seven states, then despite all the advantages of a Roth IRA, there is simply no point in contributing or converting to one. Why pay taxes today on income that will eventually be tax-free?


To maintain flexibility, assets in the IRA should be structured into taxable, tax-deferred and tax-free pools, known as a Tax Triangle. Depending on your tax bracket in a particular year, withdrawals should then be made from the pools that minimizes taxes.


Traditional IRAs are tax-deferred vehicles that allow you to invest part of your income before it is taxed. However, timing is everything. A traditional; IRA comes with mandatory RMDs, which can push you into a higher tax bracket at the wrong time. Roth IRAs, in contrast, are funded with after-tax dollars and so, of course, no tax is paid on withdrawals. Moreover, they have no mandatory RMDs.


Roth IRAs are ideal if you expect your marginal tax bracket to be higher in the future. This is a likely scenario. As you progress in your career, your earnings are like to increase and so too will your highest tax bracket. Of course, if can’t choose between a traditional IRA and a Roth IRA at this point, you can always contribute to a traditional account and covert later to a Roth.