Retirees: Consider Tax Smoothing

keep more of your money concep on blackboardRetirees may not want to take their retirement distributions through the traditionally recommended path. The traditional path is premised upon “deferring taxes for as long as possible.” Some advisors now see another option as a more tax-efficient drawdown approach. Understand more about tax smoothing and why some advisors may advocate for it in specific situations.

What is Tax Smoothing?

Tax smoothing involves “managing distributions over time to pay some taxes along the way.” With the traditional approach, a larger tax hit is taken once the deferment period is over. Tax smoothing helps to lessen the large sum payment, and as taxes increase over time, allows investors to pay their portion of taxes at lower rates. Stephen Horan, managing director of credentialing at the CFA Institute, said:

“If you rely exclusively on taxable accounts first, what you’re doing is giving up valuable opportunities to get money out of your tax-deferred account at relatively low rates.”

Use of “low” tax brackets to draw down assets efficiently or leveraging low marginal tax rates are two methods Horan sees as options for investors.

How to Apply Tax Smoothing

Although all tax situations are unique, Horan does explain a general rule of thumb that can be applied. The strategy created should fill low brackets with the tax-deferred withdrawals, then pull from taxable accounts to serve for remaining cash-flow needs. Roth money should be preserved for as long as possible.

Retirees should consider filling up to the top of the 15% tax bracket as it allows them to make considerable taxable distributions as a relatively low level. Married couples that file jointly can stay within the 15% tax brackets while realizing $96,000 of their income, with additional factors. “Low” is relative. For wealthier investors, or those with $2 million in tax-deferred assets and Roth assets of $1.5 million, the 25% bracket would be more appropriate.

Special Considerations to the Approach

Tax smoothing requires the ideal mix of accounts to make the strategy applicable. It does not account for the “time value of money”, and investors do incur tax liability when they do not have to take RMDs. Money may be better used when allowed to grow tax-deferred and potentially offset higher marginal tax rates.

When Tax Smoothing Helps Investors

There are multiple reasons why investors may choose this strategy over the traditional route:  First, the cost basis adjustment received upon death, through which investors see capital gains tax eliminated and the new cost basis that receives a 50% positive adjustment for a jointly owned asset when one spouse dies, is one prime consideration. This is significant for estate planning and those wanting to minimize tax burden for heirs. Secondly, those who wish to maximize their Social Security income could use tax smoothing to delay claims to Social Security until the maximum age to claim, 70. They would then receive the full benefit allowed from Social Security. Lastly, low-income individuals can receive Social Security benefits tax-free, but as income rises, portions of Social Security become taxable. Take these different “ripple effects” of any of the strategies into account.  Tax smoothing may be the smarter choice for you.

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