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Long-Term Tax Planning Requires Guessing. Focus on the Near-Term.

There’s a common idea that tax planning is a very precise mathematical procedure.

Some parts of it are.

But there’s also a fair bit of guessing going on.

For instance, with retirement tax planning, the process each year is usually to:

  1. Identify the various income thresholds at which your marginal tax rate would increase (i.e., points at which the next dollar of income would be taxed at a higher rate than the prior dollar of income),
  2. Select one of those thresholds, and
  3. Manage your income in such a way to keep your income below that threshold.

Step #1 is a precise mathematical procedure. And step #3 is reasonably precise as well. (It’s not to-the-dollar precise, because in some cases you’ll want to leave a bit of “fudge factor” space before the identified threshold, in case there’s some income that you forgot about. You wouldn’t want that $13 of dividends from those AT&T shares you never bothered to sell to put you just over a Medicare IRMAA threshold, thereby increasing your Medicare premiums by several hundred dollars.)

But step #2 involves a lot of guessing. Generally, the process each year is to keep taking dollars out of tax-deferred accounts (either spending those dollars or doing a Roth conversion of those dollars) if your marginal tax rate on those dollars would be lower this year than it would be if you took them out of the account at some date in the future.

So you have to estimate what your marginal tax rate will be later in retirement. But how do you do that?

At a minimum you have to come up with assumptions regarding:

  • Whether tax rates themselves will change (i.e., due to legislative changes or due to temporary tax legislation being allowed to expire);
  • Your future work income, if any;
  • How your portfolio will perform (because, for example, RMDs from a larger account result in a greater level of income than RMDs from a smaller account); and
  • If you’re married, how long it will be until either you or your spouse has passed away (because the marginal tax rate for the survivor is often higher than when both spouses were alive).

When you consider all of those things together, you’re left with quite a bit of overall uncertainty.

That doesn’t mean that retirement tax planning has no value. But the value is primarily in the near-term calculations (i.e., this year’s calculation and possibly the next few years). For those calculations, the analysis is actually reasonably precise, because we aren’t trying to make guesses so far into the future.

That is, in our three-step process from above, the value is primarily in steps #1 and #3 (i.e., identifying all the various “gotcha” provisions this year which would cause your tax rate to be greater than your tax bracket as your income crosses various thresholds, and then managing your income to avoid those “gotchas”) rather than in trying to precisely determine what your tax rate will be 10 or more years from now.

Many people put their focus in the wrong place. They spend considerable time and effort in an attempt to calculate exactly what their tax bracket will be 20 years from now. And they compare that bracket to their current bracket. And then, without realizing what they’re doing, they make a big mistake with this year’s tax planning. For example: a big enough Roth conversion to blow right through the Social Security tax hump, cross an IRMAA threshold, or lose eligibility for the premium tax credit. They end up paying tax right now at a considerably higher rate than they’d realized — and in a way that could have been avoided with precise calculations and little to no guesswork.

For More Information, See My Related Book:


Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

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