If you want to keep more of what you make, then tax planning is essential to your retirement plan. Not only does it help you keep more of what you make in the accumulation phase, but never is it more important than in retirement when you’re living on a fixed income.

Now, failure to tax plan won’t ruin a retirement plan. In other words, it’s not something that must be done to have a successful retirement; but, if you’re interested in making the most of your money and ultimately keeping more of what you’ve saved and invested, it’s a must-do.

Retirement is Different

What makes tax planning different in retirement is the fact that you have more control over your income. While employed, your salary is basically your income. You can do a few small things like contributing to TSP or an HSA to lower your income, but your flexibility is limited.

Like most retirees, you are likely going to start collecting your FERS annuity immediately, but that may be the only constant for a number of years. The rest of your federal retirement income will come from Social Security and the Thrift Savings Plan or investment income. The latter two are flexible.

Each Income Source is Taxed Differently

It’s important to understand how each source of income will be taxed.

FERS annuity = taxable income except for a small portion. Approximately 95% of your FERS annuity will be taxed.

Social Security = the amount of your Social Security that is taxed depends on your provisional income. Provisional income will include your adjusted gross income from other sources, tax-exempt interest, and 50% of your Social Security that affects it.

TSP or IRA distributions = 100% taxable income.

Capital gains = long-term capital gains are taxed at a different rate which is 0%, 15%, or 20%.

Roth IRAs or Roth TSP = distributions are 100% income tax-free as long as your account has been open at least five years.

It may be easiest to understand the possibilities if we look at an example.

Retirees Joe and Jan, both age 62, have the following:

• FERS Annuity = $40,000
• Social Security at full retirement age (FRA) = $30,000
• TSP balance = $1,000,000
• Roth IRA = $200,000
• Taxable account = $220,000 ($90,000 basis) held for 10 years
• Savings accounts totaling $150,000
• They take the standard deduction of $25,100 when filing their taxes

The only income above that they must claim until age 70 is their FERS Annuity or $40,000. Social Security (SS) can start anytime up until the age of 70 and IRA distributions aren’t forced until RMDs begin at the age of 72. The Special Retirement Supplement is another possible income if they retire prior to age 62.

Like Joe and Jan, you need to know how each of your income sources will be taxed to make tactical decisions to decrease taxes over the course of your lifetime! Knowing the above helps you decide how you will “fill up” your tax bracket. “Filling up your tax bracket” is simply the process of taking advantage of the lowest marginal tax bracket you can each year.

Joe and Jane’s taxable income, while they are only collecting their FERS annuity, is $40,000 minus the standard deduction of $25,100, equaling $14,900. This puts them in the 10% tax bracket, but the 12% tax bracket goes all the way up to $81,050 for married filing jointly. To fill up their 12% tax bracket, they could choose to either sell capital gains in a taxable account or do a Roth conversion up to the top of the 12% tax bracket.

The Roth Conversion Route

Filling up their 12% tax bracket with a Roth conversion would mean taking $66,150 from their TSP and converting it to their Roth IRA. They would pay 12% income taxes on the conversion for a total of $7,938. Moving assets to their Roth has many advantages that they could potentially benefit from in the future. Keep in mind that the tax bill has to be paid on the conversion and it would be ideal if it was paid from another account. Paying the tax bill from a separate account would allow them to get the most money into the income tax free Roth shelter.

Converting to a Roth has the following benefits:

• No future RMD’s
• Tax protection from higher taxes in the future
• Assets pass on income tax-free to heirs
• Heirs can receive income tax free growth for up to 10 years after inheritance
• Income tax flexibility in the future

The Capital Gains Route

Or, this couple could decide to sell equities and pay capital gains taxes. If they choose this capital gains route, they could sell up to $65,900 while staying in the 12% tax bracket. The long-term capital gains rate for income up to $80,800 is 0%. This means that they could implement this strategy two years in a row and eliminate most (if not all) of the taxes that they would pay on their taxable account ($220,000 balance with $90,000 basis). At the normal capital gains rate of 15% they would have had to pay $19,500 in taxes. They could either reinvest the proceeds from the sale and get a new step up in basis, or they could use the funds for income needs.

The Combo Route

This would simply involve doing a combination of the two. The retirees could sell positions in their joint account to cover the taxes on the Roth conversion or use any combination of the two that they want.

Future Income Flexibility

Having more money in Roth IRAs gives the retirees more income flexibility in the future. If they start collecting SS at the ages of 67, their income will substantially increase. At that point the retirees could find themselves at the top of the 12% tax bracket or in the 22% tax bracket. Let’s say their taxable income is $70,000 and they want to remain in the 12% tax bracket. They could choose to take $11,000 out of TSP and get the rest of their income needs from the Roth IRAs. The income from Roth IRAs is completely income tax-free, meaning it does not have any impact on their taxable income. This strategy could help keep their taxes on Social Security lower as well as their total tax bill.

Impact on IRMAA

Some federal employees elect to take Medicare Part B when they turn age 65. Part B premiums can be increased depending on your modified adjusted gross income (MAGI). The Income-related monthly adjustment amount (IRMAA) can increase the retirees’ healthcare costs.

IRMAA starts for single taxpayers at $88,000 of MAGI and married filing jointly taxpayers at $176,000 of MAGI. Anyone doing a Roth conversion should be aware of IRMAA and at what income it kicks in. Access to income tax-free assets in a Roth IRA could help a retiree on the income threshold to avoid IRMAA. Again, distributions from Roth IRAs are income tax free and don’t impact MAGI for IRMAA.

Other Ways to Limit Taxes in Retirement

In my next article, I will be covering more ways retirees can reduce their lifetime taxes in retirement. But, the strategies listed above are ones that I have found to be a good fit for many retirees. If you are newly retired or retiring soon and would like a partner to help implement these strategies, you are welcome to schedule an introductory call.

Brad Bobb, CFP® is the owner of Bobb Financial Inc, and an expert in retirement planning for federal employees.