[Editor’s Note: This is a guest post from Phil Demuth, Ph.D., one of my favorite financial authors who recently finished the excellent The OverTaxed Investor. It was written in response to this post from a few months ago on Tax-deferred Retirement Accounts where he participated extensively in the discussion in the comments section. We have no financial relationship.]

Here is the problem: you’re slaving away for years, dutifully slogging money into your 401(k), 403(b), IRA, and defined benefit plans just like your accountant says. But then this marvelous tax-saving strategy tees up a brand new problem for you once you are staring down the barrel of retirement. The IRS is going to demand that you start taking required minimum distributions from these accounts at age 70. Plus, the IRS timetable requires you to pull out a greater percentage every year. Welcome to the retirement tax bracket creeps.

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Phil Demuth, PhD

As you may have noticed, the United States has a progressive tax code. It’s not that you pay more taxes if you earn more money – that would be true even if tax rates were flat.  Rather, you pay an increasing percentage of your income in taxes the higher your income goes. Instead of a peaceful retirement whittling on the porch and fishing, suddenly you find that your retirement accounts have turned into unstoppable doomsday machines disgorging ever-larger amounts of taxable income that you don’t need or want, all to be taxed at marginal rates for the greater pleasure of our taxing authorities.

Consider the case of Dr. X: retired, married, age 66, with a spouse his same age. Between them, they have $2.5 million in their IRAs and another million in a taxable account that throws off some income and capital gains. Their mortgage is paid off.  Right now, they are in tax Valhalla – the 10% bracket.  Life is good.  But look what lies in wait in the years ahead:

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Once Dr. X hits 70, the Required Minimum Distributions (RMDs) kick in. Making matters worse, Social Security payments also start the same year. He immediately jumps from the 10% bracket into the 25% bracket, and then a few short years later he will be in the 28% bracket. One of the joys of his late retirement will be crossing into the 33% bracket (if tax rates aren’t even higher by then).  Get the picture?

The chart below shows how much they will pay in taxes at each bracket as time goes by:

 What can be done?

The big idea is that Dr. X needs to do long-range tax planning. If he just plans year-by-year, he optimizes today at the expense of higher taxes tomorrow. The smart move is to pay as much of his taxes as he can in lower brackets and pay as little as he can in higher brackets. For example, at a minimum, Dr. X should do partial Roth conversions every year to completely fill up the 10% bracket. He will never see a deal this good again.

Depending on his situation, it could even be desirable to pay taxes up to the top of his 25% bracket starting immediately:

While painful, he will pay less tax in the long run, because less of his money will be taxed at 28% (the yellow columns above) and he will never taste the bitter 33% bracket. He also really wants to stay under the $250,000 income level, where his dividends and capital gains will start being subject to the additional 3.8% Obamacare tax.

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But wait – there’s more!

Dr. X could convert even more money to a Roth IRA earlier and stay within the lower bracket if he donated appreciated securities from his taxable account to charity (ideally, to a donor-advised trust that would allow him to sprinkle out the donations on his own timetable). This is not perfect, because the charitable donations would have been worth more had he made them during his peak earning years.

Dr. X could also take out a mortgage. This would provide him with more liquidity and give him a tax deduction to offset higher initial Roth conversions. Holding a mortgage in retirement is undeniably controversial, but rates are currently low and it serves as a hedge against inflation, which historically has been retirees’ public enemy number one.

Dr. X needs to allocate his assets correctly among his accounts. He should fill his retirement accounts with low-growth assets like bonds and position the stock side of his allocation to his taxable account. This will go a long way toward preventing bracket creep due to RMDs, since the bonds should not grow much faster than the rate of inflation (to which, mercifully, our tax brackets are indexed).

It goes without saying that his taxable account should be managed with ruthless tax efficiency. No playing the market. Index funds (or, my personal predilection, which I do not expect you to share: zero-dividend stocks).

If Dr. X can relocate to a low tax state like Florida or Texas, he will get to keep more of his money.

He should draw his accounts down in the correct order: RMDs from his retirement accounts, then taxable withdrawals (harvesting losses and letting winners ride), and finally from his Roth. Roth withdrawals also can be used to fine-tune his brackets year-to-year to keep him from jumping to a new level.

In sum, for most physicians, retirement will be all about careful tax-bracket management. You want to learn to ride the brackets like a broncing buckaroo.

[Editor’s Note: I agree with almost all that is written above, but wanted to make a couple of general clarifying comments and provide one small criticism. First, it is important to realize that the issue discussed in this post is one that very few people, including physicians, will ever have to deal with, although won’t be uncommon among readers of this blog. The problem is having more retirement income than you actually want to spend. Great problem, huh? A real first-worlder there. Most retirees, including physician retirees, would love to have more retirement income, even if it were taxable. For example, the $160,000 IRA RMD at age 70 in chart 2 suggests an IRA of $4.4 Million. Granted, it could be smaller if you have a big Social Security benefit or other source of taxable income. But the point remains this is not an issue you have with a half million dollar tax-deferred account as your only retirement asset like many docs. 

Second, and I’m sure Phil agrees with this but didn’t specifically say it. The solution to this issue, should you be enough of a super-saver to have it, is Roth accounts, not avoiding retirement accounts in the first place. That means Backdoor Roth IRA contributions, Roth conversions in lower income years (especially between retirement and taking Social Security at age 70), and maybe, just maybe, Roth 401(k) contributions even during peak earnings years. 

Last, Phil’s recommendation to put low-growth assets in retirement accounts is at best controversial. An excellent explanation of why this might not be a good idea can be found in James Lange’s excellent Retire Secure, (which also explains well why you usually want to deplete the taxable account first.) Basically, there is some real benefit to having a larger tax-protected account, even if its withdrawals may be taxed heavier than the dividends and capital gains coming out of a taxable account. Yes, you’ll pay more taxes, but you’ll end up with more after-tax. It is obvious to most that high growth assets are great things to put into Roth IRAs, but what most people fail to realize is that a tax-deferred account is really just a Roth IRA coupled with a government owned account and the same benefit exists.]

What do you think? Will you have an RMD problem? How do you plan to deal with it? Does it affect your Roth vs tax-deferred 401(k) contribution decision now, or will you just try to do Roth conversions later? Are you retired or semi-retired in your 50s or 60s? Are you doing Roth conversions each year? How much? How did you decide? Comment below!