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Tax-Leveling: A Critical Boost to Your Retirement Plan

Published by Hamilton Software, Inc. on Aug 24, 2017 | Comments

Planning withdrawals of tax-deferred savings presents a critical challenge for every retiree.  Excess taxes incurred by poor planning can substantially reduce the value of retirement savings and thus the quality of retirement life.  But a rarely discussed technique can boost retirement income significantly, and offers new hope for those worried about whether they've saved enough.

Traditional rule-of-thumb planning tends to postpone the use of tax-sheltered savings, especially when retirees are under 59½.  The required minimum distribution that kicks in after age 70 then thrusts retirees into a high tax bracket that not only consumes a large portion of their savings, but also subjects their social security to higher taxation for the rest of their lives.

Retirement planners are routinely underestimating the value of their clients' retirement portfolios by using inefficient withdrawal strategies, convincing clients to delay retirement and then wasting a significant portion of their potential income to excess tax.

Excess taxation can be avoided using a concept called "tax leveling", a planning process that spreads the distribution of tax-deferred funds over retirement in a way that minimizes the highest tax bracket to which one is ever exposed, as well as the number of years of exposure.  The calculation is complex (requiring software) but the savings can be enormous.

Tax leveling works like this...  A retiree's income can be spread out so that it never exceeds a lowest maximum tax bracket.  The maximum bracket will depend on the retiree's total taxable income, which includes pensions, social security, earnings on unsheltered savings, and withdrawals from tax-deferred savings.  A software program can determine the lowest maximum bracket by amortizing these sources over the full retirement period. 

But that's only the first step because much of the income can avoid the maximum bracket.  The next step efficiently apportions income between the maximum bracket and the next lower one using the following rules:

  • Use no more than two adjacent tax brackets throughout the entire retirement period.
  • Other than one transition year, all years will use one of the two brackets fully to the upper income limit of the bracket.
  • Use the upper bracket in the beginning years and the lower bracket in the remaining years (this is optional, but reduces the total income that will be taxed at the higher bracket).
  • Any tax-deferred distributions in excess of what is needed to pay living expenses can be converted to Roth.

Allocating income by these rules minimizes the income taxed at the retiree's highest required bracket and prevents exposure to an unnecessary bracket.  Exposure to non-adjacent brackets is inefficient and results in excess tax (for instance staying in the 10% bracket in early years, then paying at the 25% rate later on).  It's a common mistake made by retirees—and even financial planners—who prioritize withdrawals strictly on the basis of tax deferral.

Tax leveling often means retirees should take tax-deferred distributions earlier than they're required to, and earlier than they need the money to pay for living expenses.  This means paying more tax in the earlier years of retirement than they would otherwise need to.  But the reduction in taxes they will owe down the road means they will enjoy an overall increase in their income throughout retirement.

Since retirees will typically have multiple sources of retirement income (pensions, social security, other assets, etc.), following the above rules requires a computer program that considers the timing and amounts of these sources when allocating tax-deferred withdrawals.  Such complexity is not typically provided by retirement calculators offered freely online or by investment firms.

One retirement planning program that performs tax leveling the right way is EarlyRetire Pro from Hamilton Software.  EarlyRetire uses an iterative process to determine maximum retirement income while simultaneously applying tax-leveling rules to all sources.  Since retirement plans often include transitional events like moving to a retirement home or receiving an inheritance, EarlyRetire makes application of the tax-leveling rules somewhat flexible, allowing the user to find what works best.

While the current generation of soon-to-be retirees is notorious for not having saved enough according to traditional methods of retirement estimating, they do have one advantage that could save them... computing technology.  By employing new methods of retirement planning like tax-leveling, baby boomers can utilize their self-directed retirement savings much more efficiently than the designers of these plans ever anticipated.  This may ultimately prove to be the key to their future prosperity.


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