As a retiree leaves the workforce and the steady paychecks behind, there is usually a period of time between when W-2 earnings cease and Social Security starts that creates a huge opportunity to reduce taxes in the current and future years. As the earliest years of retirement often rely upon redemptions of IRAs and investment accounts, later years usually result in shifting a larger portion of incoming cash flow to Social Security. Because of the way the IRS (and, recently, the state of Connecticut) tier how Social Security, pensions and long-term capital gains are taxed, it is crucial that each family plans ahead and gives careful consideration to where each dollar of cash flow is coming from in order to keep taxes in check.
Below is a high-level overview of the considerations that should be taken into account when determining your cash flow and how different sources can affect your taxes. Some of the illustrations are generalized for the convenience of the reader. The information provided is meant to be educational and it is critical that your unique situation be discussed with a qualified, experienced professional with access to the right planning tools.
Income <> Cash Flow
It's very important to consider what we're defining as "income." Income is traditionally thought of as interest, dividends, capital gains, or a periodic payment like Social Security or pensions. But what is important to a retiree is not income, but cash flow. If you want to be well-diversified and have the most tax control possible, you need to frame your reference point about money coming in and think of cash flow as the money you receive that you use to pay your bills and expenses, regardless of the source. Traditional "income" sources should only be a portion of the overall cash flow. A return of capital or return of your original investment can be an incredibly powerful way to control taxes and still produce regular cash flow.
IRA/qualified plan withdrawals
The investment bedrock of most clients that come to Springboard lies in the family's "qualified" assets, which include balances in IRA, 401(k), 403(b), 457, TSP, ESOP, etc. And for the time between retirement (the cessation of W-2 earnings) and when the clients start receiving maximum Social Security, this is often the most utilized source of cash flow.
Note: I'm going to assume for simplicity that a) once retired, all qualified assets are rolled into IRA accounts and b) that there are no after-tax assets in the account.
It should come as little surprise that withdrawals from IRAs are taxed dollar-for-dollar. In other words, one dollar of withdrawals is one dollar added to AGI and taxable income. But because several other sources of cash flow are taxed at a rate determined by your total taxable income, one dollar of IRA withdrawals may have the tax effect of taking out two dollars... or even more.
From the standpoint of your federal taxes, pension and annuity income is treated like a withdrawal from an IRA. However, effective for tax years 2019 and beyond, the State of Connecticut put in some reductions for filers that fall under certain total Connecticut AGI (CAGI) thresholds:
|For married filing jointly||CAGI under $100,000|
|For others||CAGI under $75,000|
For 2019 and beyond, if the CAGI limitations above are met, a portion of pension and annuity income is exempted from CT taxes per the increasing thresholds below:
Percent exempt from CT income tax
For more details, see the summary for 2019-R-0098 here (opens PDF in a separate window)
Long-term capital gains and qualified dividends
If your portfolio contains assets that have unrealized capital gains, you may be able to pay as little as zero taxes and still generate significant cash flow. The best opportunities to do this fall in the years between retirement (cessation of W-2 income) and when you start to collect Social Security (as high as 70 years old). The key to success in this strategy is to have some investments outside of retirement plans and IRAs well before you enter retirement. The Taxable Income thresholds (not AGI) and how they affect long-term gains rates that apply for 2020 are:
|LTCG/QD* Tax rate/filing status||Single||Head of Household||Joint|
|0%||< $40,000||< $53,600||< $80,000|
|20%||> $441,450||> $469,050||> $496,600|
*Long-term Capital Gains and Qualified Dividends
Here's a real-life example of how this can work. A client came to Springboard right at the end of 2018 who had set up taking monthly distributions from the husband's IRA (he was recently retired) to supplement what wage earnings (W-2) were coming in from the wife's employment. After reviewing the portfolio in its entirety, the suggestion was made (and implemented) to sell some stocks that were held outside the retirement portfolio to produce the cash flow for the year instead of relying on the IRA withdrawals. This resulted in tax savings of $8,949 federal and $1,453 state from the prior year. Just by restructuring cash flow sources and paying attention to capital gains taxes!
In another example, for tax year 2018, we were able to accomplish something similar for another client. We'd been working with this family for several years but in 2018 some large expenses came up and by structuring a combination of IRA withdrawals and long-term capital gains rates at 0%, we were able to produce a total cash flow to meet their needs that netted only a 1.5% federal and 2.2% state tax rate (based on cash flow).
These scenarios only worked because the clients had a balance of both retirement and non-retirement investments, which is one important reason to not focus only on workplace savings when putting money aside for the future but to invest outside that retirement plan as well.
Note that the Connecticut does not use the same reduced tax rate that the federal return does for LTCG/QD and instead lumps those earnings in with other earned income sources.
As complex as the above-mentioned topics are, Social Security taxation brings us into a completely different league, especially in Connecticut. The most important consideration is to remember that the tax rate of Social Security is completely interrelated to the other sources of taxable income you realize during the year.
The first step to take in determining how much of Social Security will be taxable is to determine your "Provisional Social Security Income". In broad strokes:
|Start with one-half of your Social Security benefits for the year|
|Determine total income from 1040 NOT including Social Security|
|Determine any tax-exempt income|
|Total the three lines above to arrive at PSSI|
Now, based on the total above, the amount of your Social Security that is taxable will fall into one of these tiers with the maximum taxable amount capping at 85%:
|PSSI range/SS included for federal taxes||Married filing jointly||Other filers|
|SS not included||< $32,000||< $25,000|
|Up to 50% included||between||between|
|Up to 85% included||> $44,000||> $34,000|
(This is the rough calculation for federal tax purposes, you can learn more in IRS Publication 915, particularly worksheet 1.)
So, what happens for families that are taking Social Security and have federal Taxable Income (essentially AGI minus deductions) of $44,000 or less is that every dollar of taxable income not only becomes taxable as earned income, but now another 85 cents of Social Security becomes taxable! So that $1 of IRA withdrawals (or W-2 earnings, or capital gains, etc) is almost double-taxed!
Ok, but that's just the Federal taxes. The State of Connecticut has their own thresholds. If we refer back to 2019-R-0098, Social Security is completely deductible (i.e. not taxed at all) for single filers up to $75,000 of AGI, and joint filers and head-of-household get up to $100,000 before becoming taxed on Social Security. And those that exceed their AGI thresholds are still able to deduct 75% of their Social Security benefits for the year.
Other Connecticut tax considerations
Another reason total knowing your total taxable income can be very important is the somewhat recent introduction of tiered personal exemptions by the State which can exempt up to half your income from Connecticut taxes!
|Filing status||Connecticut AGI||Exemption from CT taxes||Max AGI for exemption|
|Head of Household||<= $38,000||$19,000||$56,000|
|Married filing Jointly||<= $48,000||$24,000||$71,000|
For every $1,000 of AGI above the Connecticut AGI above, the exemption goes down by $1,000 until the Max AGI for exemption is reached.
Cash flow structure is important!
As you can see, the different sources of cash flow have an impact on each other and how each is taxed. A change in one variable can have a ripple effect that is magnified and can have a very significant impact on how each other component is taxed. Without engaging an experienced professional that has access to tools specifically for income and tax-planning, you are very possibly setting your family up to overpay on taxes each and every year.