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.
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.
etirement 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.
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
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
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