“Tax planning” sounds like something mysterious done only for the Rockefellers or Carnegies.  In reality, it’s an important part of every financial plan.  In an effort to make this typically opaque topic a little more real, we’ve created a case study that helps demonstrate how real people can save money throughout their lifetime using readily available strategies.

Tax Planning Clients

Meet Bob & Mary Ann. Bob and Mary Ann were recently referred to Shakespeare by their attorney after mentioning their pending retirement in two years.   They want to make sure their ‘financial house’ is in order before they sail off into their retirement sunset.  Let’s take a look at their tax situation and potential tax saving strategies as they prepare for life before and during retirement.

Note:  Although Bob and Mary Ann’s situation is similar to many clients we work with, they are fictitious people. Any similarities to you or anyone else you know are purely coincidental.

Retirement Income Planning Data

Bob is Vice President of a local company and Mary Ann is a nurse working 30 hours a week at a local hospital.  They both plan to retire in two years, although Bob plans on working 20-30 hours a week for a few years with one of his key customers, who has been trying to recruit him for years.   He expects to make $50,000 in his ‘retirement’ job.

Demographics

• Bob: DOB 4/1/1957
• Mary Ann: DOB 7/4/1961

Income

• Bob Salary: $175,000
• Mary Ann Salary: $45,000
• Consulting Income: $50,000

Assets

• Bob IRA: $50,000
• Mary Ann IRA: $250,000
• JT Brokerage Assets:  $350,000
• Bob 401k: $600,000
• Mary 401k:  $160,000
• JT Bank Assets:  $100,000
• Deferred Comp: $150,000

Real Estate

• Home Value: $450,000
• Property Taxes: $6,000
• Mortgage: $200,000
• Cottage ‘Up North’: $250,000
• Property Taxes: $3,000
• HELOC: $18,000

Net-worth:

• $2,142,000

Other:

• Mortgage Interest: $8,000
• Charitable Contributions: $6,000

Tax Planning Strategies

Based on the facts listed above, let’s review a few tax saving strategies.

401k Deferral

Bob and Mary Ann have been contributing 10% to their 401ks since their kids were in high school, and have never revisited their saving strategy.  After further review, each of them is able to contribute the maximum to their retirement plans.  By boosting their savings to the maximum contribution limit, they will reduce their taxable income by over $30,000.  In doing so, they will defer almost $7,000 in federal taxes plus any state income taxes.  When they retire and are expected to be in a lower tax bracket, we’ll facilitate needed withdrawals to take advantage of this tax arbitrage opportunity.

Tax Deductions

Their current tax deductions are $26,000.  This includes State and local taxes = $10,000 (capped) + Mortgage Interest $8,000 + Charity $8,000 = $26,000.  With a standard deduction of $27,700 in 2023, they aren’t receiving any tax benefit from making charitable contributions (nor from any of their other deductible expenses).  If they double up on their charitable contributions (shift charitable contributions from year 2 into year 1), they will boost their itemized deductions to $34,000.  In year 2, they will use the standard deduction of $27,700.  By shifting next year’s charitable contributions into year 1, they have created $6,300 more tax deductions and will save approximately $1,400 in federal taxes.

Brokerage Assets

After reviewing their brokerage account, we learned they owned several individual securities that were at a loss. By selling these securities, we realized $20,000 of capital losses. We used these losses to sell several of their mutual funds which were at a gain. These funds were generating unwanted year-end capital gain distributions and were adding $10,000 to their taxable income each year.  We invested the proceeds of these sales into Exchange Traded Funds, which are more tax efficient and provide greater tax control. We will leverage this tax control as they enter retirement and we need to begin structuring their income sources. See Householding below. The potential tax savings from this strategy is approximately $1,500 – $2,000 per year.

Social Security Planning

Although Bob has reached full retirement age, we elected to defer his social security benefit until he reaches age 70 (year 4).  This was done for two reasons.  First, the added income from Social Security would increase their tax liability while they are still working and would likely push them into the 24% federal income tax bracket.  By deferring the benefit until Bob’s age 70, they will likely be in a lower tax bracket and keep more of this income.  In addition, the benefit will grow by 8% each year he waits to file.  That larger amount will also be the survivor benefit, which will be paid out over both their lives. This provides longevity protection, in addition to tax planning benefits, in the event one of them lives well into their 80s or 90s.  Mary Ann will begin her benefit as soon as she retires or reaches full retirement age, whichever comes first.

Charitable Planning

Mary Ann’s deferred compensation plan is slated to payout six months after her retirement (year 3).  This windfall will increase their tax liability in year 3 and was also a factor that influenced the deferral of Bob’s Social Security Benefit (above) to age 70 (year 4).  Much like we accelerated charitable contributions from year 2 into year 1, so too will we accelerate charitable contributions into year 3.  After reviewing all future income sources and deductions, it was determined that we should accelerate charitable contribution for several years (4-8) into year 3 using a Donor Advised Fund.  This was done because year 3 should be the highest tax year for the foreseeable future and Bob and Mary Ann are expected use the standard deduction in all other years.

RMD Planning

In year 6, Bob turns 72 and would need to begin taking Required Minimum Distributions (RMDs). This would generate approximately $25,000 – $30,000 of additional taxable income.  As Bob would still be working, it was identified his new employers plan accepts 401k rollovers.  Because he’s not a 5% or greater owner of the company and he’s still employed, he’s able to defer all of his RMDs in his 401k until he’s fully retired. This deferral provides for greater tax planning opportunities, both now and in the future. We’ll use Mary Ann’s retirement accounts for Roth Conversion opportunities (see below) and will take her RMDs when she turns 72.

Roth Conversions and Capital Gains

We’ll be evaluating Bob and Mary Ann’s taxable income each year relative to their tax bracket.  In low tax years, if they have room between their taxable income and the top of their respective tax bracket, we’ll accelerate income by doing Roth Conversions or harvesting Capital Gains.  Although it may sound counterintuitive to generate additional taxes through these techniques, so long as they are in a similar to lower bracket than future years, this strategy may make sense.

Householding

A sophisticated strategy to lower lifetime taxes entails the placement of tax inefficient assets such as bonds into retirement accounts first, and then allocate tax efficient assets such as equity ETFs into brokerage accounts.   This is a complex strategy, but when coupled with the other strategies above, is another tool in controlling taxes.  Note, sophisticated software and a knowledgeable financial advisor are required to implement this strategy efficiently.

Medicare Planning

Bob is on Medicare and Mary Ann has health insurance coverage through work until she turns 65.  Their Medicare premiums will be a function of their previous years Modified Adjusted Gross Income (MAGI).  There are several income thresholds that will determine their premium.  If they exceed a given threshold by $1, their premium jumps to the next higher amount.  As a married couple on Medicare, if their MAGI exceed the $194,000 threshold (2023) by $1, their overall Medicare premium will increase by almost $1,900 per year.  We consider this premium increase to be a tax that should be avoided if possible. It will be important for Bob and Mary Ann to avoid exceeding these thresholds, which can happen when they or their advisor unnecessarily realize capital gains, own tax inefficient assets in brokerage accounts, or take unneeded IRA withdrawals.

The Future of Tax Planning

Keep in mind our current tax code is in effect until December, 2025. After that point, we revert to a more onerous tax structure, so any tax saving strategies that we can do between now and then will be amplified when the tax law changes. Each of the above strategies does not exist in a vacuum, but rather they are intertwined together. Using multiple strategies together accentuates the benefits of tax planning but requires great skill and planning to achieve the best results. To learn more, give us a call at 262-814-1600.