Maximize Your Retirement Cash Flow with a Tax Efficient Income Strategy

Considering all the components of a sound retirement income strategy and the many variables that come into play, the distribution phase of a retirement plan can be far more complex than the accumulation phase. And any mistakes made along the way can have a far more significant impact because of the diminishing value of time.

Preparing for Taxes in Retirement

One very costly mistake people make is to ignore the impact of taxes on their retirement cash flow. Retirees who have multiple income streams from pre-tax and post-tax accounts need to be aware of which ones to use at which points in retirement or risk depleting their retirement assets too quickly. The biggest surprise for many retirees is when required minimum distributions (RMDs) kick in at age 73 which can exacerbate their tax problem. Having not considered the impact of taxes in retirement, many retirees can only cry out, "Why didn’t we plan for this?"

When Too Much Tax Deferral is Not a Good Thing

Many retirees are caught off guard by the amount of taxes they must pay on their retirement income. In hindsight, they might have chosen a different accumulation strategy focusing less on tax-deferred accounts, such as 401(k)s or IRAs, that generate ordinary income taxes. They could lower their retirement income tax liability by spreading their retirement savings among post-tax accounts, such as investment brokerage accounts and Roth IRAs. Capital gains from investment accounts are taxed more favorably, and withdrawals from a Roth IRA are tax-free.

If the goal is to maximize retirement cash flow, it requires a deliberate strategy that balances your income needs with the need to confine your taxable income to the lower tax brackets. Withdrawing exclusively from your pre-tax, IRA, or 401(k) accounts won’t accomplish that. And, if you delay withdrawing from those accounts too long, it will create a bigger RMD problem later, which will likely push you into a higher tax bracket.

The solution is to use a combination of sources to generate sufficient income while paying taxes at the lowest tax rate possible. It’s possible for a retiree to net $80,000 to $100,000 of income free of federal income taxes (excluding the Social Security tax).

The Tax Bucket Strategy

The key to this strategy is to consider the different tax bracket levels as tax buckets that must be filled with income. The idea is to fill the lowest tax bucket (0 percent) with as much income as possible before it spills into the next, higher tax bucket (10 percent), and so on.

If you are married and filing jointly in 2023, your first $27,700 of income ($13,850 for single filers) is not taxed due to the standard deduction. Your first tax bucket is where you stuff as much of your income that is taxed as ordinary income as possible. It could be withdrawals from your IRA or 401(k), or it could be half of your Social Security benefits if you expect your income to exceed the Social Security tax threshold ($32,000 for joint filers and $25,000 for single filers), or a combination of the two. The objective is to fill this bucket sparingly to keep your tax rate on this income at zero.

The next bucket is taxed at 10 percent, allowing up to $22,000 on top of your first bucket ($11,000 for single filers). You could choose to add more withdrawals from a pre-tax account. For the next bucket (12 percent), you can add your income from capital gains and qualified dividends from your post-tax accounts. Under the new tax law, income from these sources is taxed at 0 percent up to $89,250 for joint filers ($44,625 for single filers). Between the three buckets, that’s more than $100,000 of income taxed at an effective rate of 0 percent.

Optimize the Strategy by Delaying Social Security

However, it is essential to keep in mind that too much income from any of these sources could trigger the maximum tax on your Social Security benefits. Regardless of whether you pay federal taxes on any of your income, it is still counted as provisional income for purposes of calculating your Social Security tax. That may be one of the best reasons for delaying Social Security benefits until age 70. Better to use your pre-tax withdrawals to fill your buckets early on and leave your Social Security benefits to grow. That will alleviate some RMD pressure later, enabling you to lock in a higher Social Security payout.

Of course, a lot of this would be moot if most of your retirement income came from a Roth IRA, which generates tax-free income excluded from the Social Security tax calculation.