A comfortable retirement is a goal for many of my clients (and myself!). I spend a lot of time with people helping them plan how to make that goal happen, and it’s one of my favorite parts of my job.
There is an important aspect of retirement that isn’t talked about frequently. I’m talking about the “trough years” — a time in early retirement when your current taxable income might be lower than your future taxable income. Thankfully, there are often significant tax planning opportunities one can take advantage of during these years.
Defining “Trough Years”
The trough years are the time after you retire but before other forms of income kick in. People in this period can go from a time of high earning capacity (the end of their working years) to very little income for a handful of years (the ‘trough years’) back up to somewhat high income once pensions, Social Security, and required minimum distributions (RMDs) start.
The length of time you are in the trough years depends on when you retire. For example, if you retire at age 65, begin Social Security at age 67, and begin RMDs at age 73 (or 75 for those born in 1960 or later) you would have anywhere from two to nine years where income is relatively low.
The relatively low income during the trough years often translates to a lower-than-usual tax rate. Conventional wisdom says that a low tax rate is a great thing. After all, who doesn’t like seeing a smaller tax bill?! However, for those with a tax planning background and a keen eye toward the future, we see the trough years as a period ripe with opportunity to pull in income at lower rates than later in retirement. The typical income-producing strategies utilized in this kind of planning include Roth conversions and realizing capital gains. More on this below.
Of course, in addition to the trough years being a great opportunity for tax planning, there will also need to be a plan for cash flow during those low-income years. This is where working with a financial planner will be especially important, as a cash flow plan will be highly personalized based on your spending needs and assets available to you.
Roth IRA Conversions
A Roth conversion is when a taxpayer moves funds from a Traditional IRA into a Roth IRA. The money moved out of the Traditional IRA is reported as taxable income. The idea is that you pay the tax today, and once in the Roth IRA, these funds grow tax-free. Why would a person want to do this in the trough years? Let me give you an example looking specifically at the federal tax rates:
Let’s say I have a 65-year-old client, and during trough year #1 (tax year 2024). They are currently projected to be in the 12% marginal federal tax bracket. As we look out into the future, based on Social Security and RMD estimates, their marginal federal tax bracket could be as high as 28% at their age 73. It can make a lot of sense to do a partial Roth Conversion today that, at a minimum, fills the 12% marginal federal bracket. Depending on the client’s situation, I may even encourage a partial Roth Conversion that also fills the 22% or 24% marginal federal bracket. This way, they’re paying up to 24% federal tax today, while their future federal tax rate at their RMD age could be as high as 28%! Not only are they potentially saving 4% in taxes (the difference between 28% and 24%) they are also reducing their Traditional IRA balance.
If this Roth Conversion tax bracket planning is done over several trough years, the client has the opportunity to reduce their future RMDs, because the balance of their Traditional IRA is shrinking and the balance of their Roth IRA is growing. A smaller RMD, in some cases, can mean a smaller future marginal federal rate than if they had done no Roth Conversions during those key ‘trough years.’
A growing Roth IRA is a valuable asset as the growth is tax free. For example, if a person invests $100,000 in a Roth IRA conversion, and that investment happens to earn 7% per year, in 20 years, they will have $388,000 in their Roth IRA, or a $288,000 tax-free gain. These funds can be used to enhance your lifestyle or be part of very attractive tax-free bequest to your heirs.
Between the tax-free growth on the Roth IRA, the likely lower income tax brackets in the trough years, and the reduced required IRA distributions down the line, a Roth conversion can be a very valuable strategy.
Realized Capital Gains
Another planning opportunity in the trough years is realizing capital gains. Realized capital gains are the profit made on the sale of an investment. To determine your profit, subtract what you originally paid for the investment from the amount that you sold it for adjusted for other factors like reinvested dividends or capital gains. That profit is often reported on your tax return, unless it occurred in a tax-advantaged account, such as an IRA, 401K, 529 plan, or H.S.A.
At the federal level, the tax rate you pay on the profit depends on if the investment was held for less than a year (short-term gain) or if the investment was held for more than a year (long-term gain). Short-term gains are taxed federally as ordinary income, where the tax brackets range from 10% to 37%, and in most cases should generally be avoided. Long-term gains are taxed at a special federal “capital gains rate” where the brackets range from 0% to 20%. Where an investor lands in the federal “capital gains rate” depends on their taxable income. For example, a single filer with federal taxable income below $47,025 for tax year 2024 will find that their long-term capital gains are taxed at 0% federal. For a retiree in the trough years, taxable income can be relatively low, meaning a potential opportunity to realize gains at the 0% federal capital gains rate.
Potential Taxes and Costs
As you consider strategically adding to income during the trough years it’s important to be mindful of extra taxes and costs that are triggered once you reach certain income thresholds.
The first potential increased cost is an extra charge for Medicare Part B and D, also known as IRMAA (income-related monthly adjustment amount). What you pay for Medicare Part B and D is based on your federal modified AGI (MAGI) from two years prior. If you are set to begin Medicare at age 65, your MAGI from the year you were 63 is used to determine your Part B and D premiums. For a single filer, if their federal 2022 MAGI was $103,000 or less, they will pay the standard amount for Medicare Part B and no additional cost for Part D in 2024. However, if their federal 2022 MAGI was more than $103,000, they will pay an extra cost for both Part B and Part D. How much extra depends on where their MAGI from two years prior happened to be.
The second potential increased cost is an additional federal tax called the Net Investment Income Tax, or “NIIT.” NIIT is an additional 3.8% federal tax on the lesser of certain net investment income or excess MAGI over the following thresholds: $200,000 single, $250,000 married filing jointly.
Lastly, it’s important to consider that you often need to pay state taxes on these transactions. State taxes can vary widely, and in my home state of Minnesota the top tax rate is 9.85%, which is relatively significant. Another thing to think about – are you planning to move to a different state during the ‘trough years?’ If so, work with your CPA to carefully evaluate your current state tax rate vs. your potential new state tax rate. Depending on the circumstances, it may be compelling to emphasize tax planning either before or after the move.
When working with clients and their tax professionals, I wrap these potential additional costs into all of the various considerations. Sometimes it makes sense to develop a plan that avoids these increased costs altogether. Other times, we may find that the client could still net out ahead even with the additional cost (whether IRMAA or NIIT). What route makes the most sense is highly individualized to each person’s situation. There is no “one size fits all.”
Getting Started
Many clients come to us for exactly this kind of planning. There are so many factors to consider in creating a retirement income strategy, including how much to take, how to invest, how to do smart tax planning, and how to wrap in estate planning goals. As I work with clients who are getting ready to retire, I often start the process of looking ahead to the trough years and start to tee up the opportunities we’ll discuss during those years.
For my clients currently in the trough years, I work closely with the client and their tax professional to determine a strategy that makes sense for the client. Afterall, the trough years don’t last forever, and it’s well worth taking a close look at what makes the most sense for your individual situation.
To get started, I recommend starting to think about this as you see retirement in your future. Then, work with your financial planner and tax professional to develop a strategy.
Mallory is a Wealth Manager and Shareholder. She listens deeply and helps simplify complex financial situations to help clients move into an easier, clearer future. She aims to give financial advice that is compassionate, wise, and easy to understand.
