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.

Know your retirement tax rate

The traditional thinking is that retirees should keep their taxes as low as possible and invest much of their savings in investments like tax-free municipal bonds. If you are wealthy and your average tax rate is, say, 25% or higher, that strategy might make sense.

But what if your average retirement tax rate (RTR) is, say, 10% or lower? Then you should consider a different approach. Because 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?

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, your major sources of income are Social Security, interest, dividends, annuity payments and withdrawals from your IRA. Each source has its own unique tax planning decision. And, importantly, every decision you make about your RTR impacts the others.

How income annuities can lower your retirement tax rate

The IRS only makes you pay taxes 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 your taxable income from annuity payments is lower, your taxes are also reduced on other sources of income, such as (1) the percentage of qualified dividends and realized capital gains that are taxed, and (2) the percentage of Social Security that is included in your taxable income. 

The table at the end of this article shows RTRs for retirees with and without annuity payments.

The tax rate advantage 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.

How does your retirement tax rate change your financial decisions?

Set out below are some questions to consider as you gather information on how to move forward.

Before you start you need to know your RTR, and what you’re paying on your current sources of income. 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 as 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 exhange 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. However, if you move the accumulated value of these deferred annuities into an income annuity that pays regular, guaranteed income, the IRS will exclude a portion of the payment from tax.

Should I convert all or part of my traditional IRA to a Roth IRA? A 401(k) or 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 have a shortened life expectancy — may want to create their own withdrawal plan. But analyze whether it makes tax sense.

Knowing your RTR will help you with these decisions.

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. However, with the security from guaranteed lifetime annuity payments, you can take more risk in your investment portfolio.

In the example below, the income annuity is replacing the 30% portion of the portfolio investing in fixed income securities generating 4% 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 $15,000 – or an increase of over 65% from that part of your portfolio.

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. 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.

Specialists are available to figure out the retirement tax rate for a portfolio like yours. Let us help create more spendable income from your savings.

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.