Tax Planning for Retirement, Part 2: Understanding Taxation During Retirement

This is the second article in a three-part tax series I started last month. In case you need a reminder about the three parts:

  1. The Golden Decade of Tax Planning Opportunity
  2. Understanding Taxation During Retirement
  3. What Is Taxable Income? A Reminder

The purpose of Part 2 is to explain key tax planning concepts that I have shared with clients who are preparing for or entering retirement. Taxes are one area where most people just want to delegate away as much as they can. I can’t really blame them since the tax code is so maddingly complex. The 2008 annual report to Congress of the Taxpayer Advocate Service (an internal group at the IRS dedicated to advocating for taxpayers) pointed out this complexity as one of the most serious problems facing taxpayers. (You can find the 2008 report here:

At the same time, however, I don’t want people to just throw up their hands and give up on trying to understand how their income taxes work. That’s why my job is to help clients understand why we make the recommendations we do. I have tried to develop concepts that provide the big picture, and for many clients, I have seen the lightbulbs go off in their heads as I help empower them with a little tax knowledge.

Today, I will introduce three of those big-picture concepts and explain how they relate to tax planning in retirement:

  1. Earnings vs. distributions
  2. Taxable income vs. non-taxable income
  3. Controllable income vs. uncontrollable income

And I’m going to include two diagrams along with the discussion. Here is the first:

This diagram represents a person with three types of accounts. What is crucial to understand is what gets taxed! You pay taxes on income, not on assets, and as you can see, earnings in retirement accounts do not get taxed. That’s because these accounts are tax-deferred. The money gets taxed only when you take it out as a “distribution.” However, the opposite happens with a taxable account, such as a brokerage or savings account. You pay taxes each year on the earnings (and that includes selling things and taking capital gains), but taking money out of the account is simply a withdrawal. You don’t pay taxes on that “distribution.”

The second diagram delves a bit deeper:

Now we’re getting into all the potential sources of income during retirement. These sources include more than just your investment, 401(k), and IRA accounts, as you can see.

As Part 1 of this series explained, you don’t have to take distributions from your retirement accounts until you reach age 70-1/2. Then, you must start taking an annual required minimum distribution (RMD). Also, you can delay taking Social Security retirement benefits until age 70. Therefore, we have control with timing the start of some of these income streams. But once they start, they will usually continue as long as you live. This is what I mean by “uncontrollable,” or the red items in the chart. The amounts and payments are automatic. They depend on events outside of your control.

In contrast, there are a few sources of controllable income. One is additional distributions from retirement accounts—but those are taxable. Withdrawals from taxable accounts and Roth distributions are not taxable.

OK, that’s probably more than you ever wanted to learn about income taxes. Still, I hope it helped you understand your potential taxes a bit better. My partners kid me that I am way too interested in all this stuff, and I must confess, it is fun, in a nerdy kind of way.

Next month, in Part 3, I will finish up by going a bit deeper into what taxable income means—or why the most important line on your Form 1040 is Line 43. Stay tuned!