Tax-Efficient Planning with an Inefficient Tax Code

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In the late 1990s, less than a dozen tax provisions had a limited lease on life and needed to be renewed every year or so. Today, there are 141 temporary provisions. This level of uncertainty complicates planning and discourages hiring and investment. Most people understand the importance of planning and saving, yet few actually understand how to do so tax efficiently. I’m still amazed at the number of folks who simply save money in their company’s 401(k) and spend everything else. When these people enter retirement, they’ll have nothing but their tax-deferred savings to draw on.

Tax efficient retirement planning is all about diversification. You wouldn’t invest all your money in one stock. You also don’t want to save all of your money in one type of account. You need to diversify your savings between tax-deferred, after-tax, and tax-free accounts.

Diversification will be especially important in the next few years as the IRS becomes even more aggressive in taxing assets. Aggressive taxation goes against what we were originally told – IRA and 401(k) accounts were created so we could defer current income until we retire and enter a lower tax bracket! Instead, it appears likely the opposite will happen; we may be seeing the lowest tax brackets now. The growing national debt and huge number of retiring baby boomers will probably put a greater strain on government finances in the future leading to higher taxes.

R/D Factor™ Explained

The key to properly diversifying your retirement savings begins by understanding your R/D Factor™. Your R/D (or retirement distribution) Factor™ is the percentage of your retirement income that won’t be taxable. It lets you know if you’ve done enough to balance your savings and reduce your taxable retirement income. Your Factor is based on a scale running from 0 to 100; 0 means all your retirement income is taxable and 100 says all your retirement income is tax-free. Ideally, you should aim for an R/D Factor™ of 50. This would provide a balance between tax planning for today and saving for retirement.

Once you’ve determined your ‘factor’, you can improve your tax situation by either creating a balanced retirement plan or rebalancing your existing plan to make it more tax-efficient upon your retirement. Trying to save everything in tax-free accounts so you don’t have to pay retirement taxes may not be advisable for two reasons:

  1. There are immediate tax benefits to using IRA and 401(k) accounts you don’t want to ignore. Your annual tax planning should take into consideration the level of pre-tax savings that will keep you in a lower tax bracket. Itemized deductions are reduced on your total Adjusted Gross Income (AGI). Alternative Minimum Tax (AMT) calculations are also based on your AGI. Pre-tax savings accounts are often the only tool we have to minimize the AMT burden.
  2. There are limits to putting money into a Roth IRA; unless you have a Roth 401(k) offered through your employer you may not even be able to contribute to a Roth if your income is too high. Even using these strategies, it would still be difficult to put 100% of retirement savings into a Roth without ignoring some significant tax issues.

How the R/D Factor Works

John and Mary Pritchard expect to have $1 million in tax-deferred IRA/401(k) accounts, $1 million in their joint after-tax account, and $1 million in their Roth IRA tax-free accounts. Their total retirement savings of $3 million can be expected to distribute 4% ($120,000) per year.

To calculate the R/D Factor™ for the Pritchard’s, we assume 1/3 of their income will be drawn from each of the three sources.

The Pritchard’s will be left with $70,000 in taxable income to report. If this was their only taxable income in 2011, and they filed a joint return – claiming only the standard deduction ($11,600) and personal exemptions ($3,700 each) – they’d owe tax on $51,600. This amount would put them in the 15% bracket, meaning the tax bill would be about $7,650 on $120,000 of income. It may be even lower if the income from the after-tax account is generated from qualified dividends and/or long-term capital gain which are taxed at zero in the 15% bracket. Not bad!

Their R/D Factor™ is 42, since 42% of their retirement income will be non-taxable. And when they retire, they can adjust this factor by changing the amount they’ll distribute from the three accounts. They have a lot of flexibility with this until they reach the age of 70½ and have to start taking minimum distributions from the tax-deferred accounts.

In order to maximize the 15% bracket, the Pritchard’s may want to withdraw more from the tax-deferred accounts when they retire. Once they start drawing Social Security they may opt to increase their R/D Factor™ by taking more from the after-tax and tax-free accounts to minimize the amount of their Social Security benefits that are taxed.

Determining your R/D Factor™ is an ongoing process that should be done annually to take advantage of your tax situation for that year. The rule here is to accelerate taxable income in low tax years and to minimize taxable income when needed to stay in a lower tax bracket. Don’t neglect to do tax planning today for your tax-efficient retirement. Tax laws change frequently; therefore, you’ll want to take advantage of tax incentives now, since they may not be there later. Consider working with a knowledgeable tax advisor to develop strategies to use the R/D Factor™ to your advantage.

Will Your Money Last Through Retirement?

No one wants to run out of money. But without goals and a solid plan,
how can you know for sure whether you’re on the right track?

Will I be able to maintain my current lifestyle?

What will my monthly income be in retirement?

Can I protect my hard-earned savings and still
have the income I want?

Rodgers & Associates answers questions like these every day.

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