How to Lower Your Client’s Retirement Tax Rate To Less Than 10%

Is it true that retirement changes everything?

No, not literally. But it does significantly change many aspects of your finances, and the more you understand your new situation, the more money you will have available to spend or save.

How you set up retirement income to be taxed is complex -- and a big part of retirement success.

I am surprised myself, in fact, by how much there is to learn. I've been studying annuities and retirement plans for 40 years and recently discovered calculations nestled within IRS schedules that might change your own plans for retirement. An important discovery was how taxes on one source of income, like dividends, are driven by how much a retiree has in another source, like taxable interest.

Know your retirement tax rate

Before we get into the nitty-gritty of how this retirement tax strategy works and whether it's right for you, you need to know the answer to this question: What is your true tax burden? By that, we don't mean what tax bracket you are in. We mean what is the percentage of your income that you actually pay in taxes, or what we call your "retirement tax rate"?

To figure it out, take the amount you paid in federal taxes and divide it by your retirement income -- which for most retirees is the sum of income from Social Security, interest and dividends from investments, annuity payments and withdrawals from your IRA.

Financial Assets $2 million, Retirees Male 70, Female 70

Retirement Income SourceAmount of Retirement Income

The traditional thinking is that retirees should keep their taxes as low as possible and invest much of their savings in programs like tax-free municipal bonds. If you are wealthy and your tax bracket is, say, 24% or higher, advisers often suggest that strategy.

But what if your retirement tax rate (RTR) is, say, 10% or lower? Then you should consider a different approach &mash; one that includes income annuities.

When your income was based on wages or other forms of pay, the big tax-planning decision was how much to set aside in your 401(k) or IRA. When you're retired, each source of retirement income has its own unique tax-planning decision. And, importantly, decisions you make about each income source will impact your RTR.

How income annuities can lower your retirement tax rate

The IRS makes you pay taxes only once on money you earn. And when you buy an income annuity from personal (after-tax) savings, you are using money on which you have already paid taxes. As the income annuity begins to pay out, the IRS considers a portion of each monthly payment to be from your original investment. Since you already paid taxes on the original investment, you receive that portion tax-free. (The interest that you earn is taxed, albeit spread over time.)

Because the taxable income from annuity payments currently is substantially lower than taxable interest, your taxes also may be reduced on other sources of income, such as 1) the amount of qualified dividends and realized capital gains that are taxed, and 2) the percentage of Social Security that is included in your taxable income. (For more, see How Your Social Security Benefits Are Taxed.) The end result could be more spending money in your pocket, instead of Uncle Sam's.

To see what that could look like in dollars and cents, let's consider hypothetical couples with three levels of financial assets who are considering two strategies that could affect their income and tax bills. Under the first strategy, they include annuity payments; in the second, they replace annuity payments with interest on corporate bonds.

Results for First Year Only of Substituting Annuity Payments for Interest on Corporate Bonds

Financial AssetsWith Annuity PaymentsNo Annuity Payments The Annuity Advantage

Assumptions: The couples have 30% of savings in a traditional IRA invested in a balanced portfolio and are taking RMDs. The "with annuity payments" strategy generates annuity payments of 6.27% a year. Other personal assets are invested in tax-free bonds (2.5% yield), taxable bonds (4% yield), and dividend-paying stocks (3.75% yield). Each couple is receiving $40,000 in Social Security benefits and is taking a standard deduction.

Note that the tax rate advantage for income annuities will eventually disappear because your previously taxed investment will be paid out over a decade or more. What happens then? You will be much closer to the time when you will likely have higher tax deductions for medical and long-term care costs. And, of course, the annuity payments are generating lifetime income at a higher rate than the alternatives.

To get the maximum tax benefit, how much of my portfolio should be in income annuities?

Although income annuities offer many income and tax benefits, as a rule of thumb no more than one-third of your savings portfolio should be invested in these annuities. Keep in mind, however, that with the security from guaranteed lifetime annuity payments, you can take more risk in your investment portfolio.

In the example above, the income annuity is replacing the 30% portion of the portfolio invested in fixed income securities, generating 4% interest after fees. For the case with $2 million in financial assets, that substitution is producing, under our calculations, an increase in spendable after-tax income of over $16,000.

Of course, don't look at the various elements of your tax bill in isolation. Increasing the allocation to immediate income annuities beyond 30% may be possible, although you may want to consider deferred income annuities like a QLAC for other tax-minimization strategies.

How does your retirement tax rate impact your financial decisions?

Set out below are some questions to consider as you gather information on how to design your retirement income plan.

Before you start, you should know your RTR, and then see if changes to your retirement income plan either increase or decrease your RTR. You need to know where you are starting before you can create a plan to improve.

Should I switch from tax-exempt to taxable bonds? You know you will be paying taxes on the higher income, but will it be better to have the extra income, even if it is taxed?

Should I switch to a high-dividend portfolio? Qualified dividends on stocks can be an important part of your income allocation plan for retirement. Stock dividends are assessed lower taxes than regular income, and the amount of taxes depends on your taxable income from other sources.

Should I exchange a deferred annuity for an income annuity? When you withdraw money from deferred annuities, the income could be fully taxed for a period of years - until all the earnings and interest have been withdrawn and you have finally started tapping into your principal. However, if you move the accumulated value of these deferred annuities into an immediate income annuity that pays regular, guaranteed income, the IRS will exclude a portion of the payment from tax. (For more, see How Annuities Are Taxed.)

Should I convert all or part of my traditional IRA to a Roth IRA? A 401(k) or traditional IRA is a good way to build up retirement savings and lower taxes while you are working. During retirement, you may want to pay taxes and convert to a Roth IRA so that distributions become tax-free. A lower RTR may reduce the cost of conversion.

Can I create the same tax benefits of annuity payments with a do-it-yourself withdrawal plan? Those retirees who don't think income annuities are fair -- or who have a shortened life expectancy -- may want to create their own withdrawal plan that combines both interest and dividends and withdrawals of capital. But analyze whether it makes tax sense.

The way you structure your income and taxes can affect other areas, too. For instance, your "modified adjusted gross income," as reported to the IRS, affects your monthly Medicare premium. How would you like to pay $100 to $200 a month less for Medicare for you and your spouse? With the right income plan, that could be a possibility.

At Go2Income, you can calculate how much you can generate in annuity payments, where to find the best prices, and also how much of your annuity payments are taxed. To create your own retirement income plan, go to the income allocation page at www.Go2income.com. Once you get your income allocation report, request an appointment so we can discuss these tax strategies. We are not intending the above as tax advice and suggest you discuss all ideas with your accountant or tax adviser.

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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.