Plan ahead to smooth retirement income and taxes

Doug May
Doug May

The January 2013 tax hikes make tax planning more important than ever.  Two strategies we’ve identified are of particular interest to retirees trying to make their savings last as long as possible. Perhaps some of these strategies will help you think about your income and expenses during your retirement years. Planning is the key to enjoying a successful retirement.

The higher tax rates and lower deductions already passed by Congress — along with the new “means testing” of entitlement programs that’s likely to come — make it more important than ever to smooth out income sources. Spikes in annual income result in onerous tax rates and, more than likely, will result in reduced benefits from Social Security and Medicare during high- income years.

Retirees need to think about smoothing earnings to the degree that’s possible. Having money in an Individual Retirement Account (IRA) is good because gains aren’t reported until money is distributed. Outside of the IRA, gains tend to be more “lumpy.”  However, all money taken as a distribution from a traditional IRA is taxable at ordinary income rates, so retirees who are taking $60,000 to $80,000 in traditional IRA distributions are pushing themselves up into pretty high tax brackets.

It would be better, if possible, to spread money between a Roth IRA — with “after tax” money so distributions aren’t taxable — and a traditional IRA. A retiree taking out $30,000 to $40,000 from each type of account will enjoy a much better tax situation than if it all the money comes out of a traditional IRA. Make Roth conversions during low-income years and take advantage of that account as a non-taxable source of cash during normal years.

Similarly, pre-funding charitable giving also can help smooth taxable income. If cash allows during big income years, a person could put several years worth of taxable donations in a charitable giving account and receive a large deduction to offset the large amount of income.  In subsequent years, rather than giving a portion of taxable income, less (taxable) income can be recognized while still meeting charitable giving obligations through the charitable giving account. For tithers, rather than having to earn $111,000 to maintain a $100,000 spending lifestyle and paying high marginal tax rates on the extra $11,000, the year’s tithe could be paid from the pre-funded tax-deductible charitable giving account.

A community foundation offers a great place to establish a charitable endowment fund as a legacy planning strategy. However, the Western Colorado Community Foundation is best suited to provide a long-term philanthropy strategy.  To create a bucket to build up giving for one to five-year stretches, it likely would become necessary to use charitable giving organizations set up by Schwab or Fidelity Investments to accommodate donor giving strategies.

A charitable giving account also could be useful as part of a college financial planning program as well, although it’s really only useful for people who maintain some control of their reportable income.

For salaried workers, there’s not much that can be done. On the other hand, salaried employees tend to have much smoother income streams than entrepreneurs, who often experience lean years that hopefully offset by the occasional windfall.

Entrepreneurs selling businesses can structure a sales to smooth reported income. Rather than taking a large lump sum, it might make sense to retain real estate assets that can be leased to create a smooth, long-term revenue stream. An entrepreneur might want establish a consulting contract that stretches out several years to reduce the size of a lump sum payment that would push them into the high tax bracket or consider an installment sale instead of a large single payment.

Finally, retirees can look at the expenses they incur as well as other interests to see if there’s a way to convert household expenses into legitimate business deductions.  A couple planning to travel in an RV, could fund those large travel expenses through an equally large taxable income. Instead, travel could be combined with a business that involves travel — selling quilts at craft fairs across the country, for example. A little extra research and effort could make travel expenses tax-deductible business expenses as long as the effort constitutes a legitimate business enterprise.

Don’t succumb to the temptation to over-emphasize tax planning, however. It’s an important consideration, but certainly not the most important consideration. After all, planning for retirement isn’t about the money. It’s about your life!