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Nonqualified Deferred Compensation Plans

A deferred compensation plan is a retirement plan that allows employees to defer some of their compensation to a later date. Common types you may already be familiar with are 401(k) and 403(b) plans. If you are a key employee, however, your employer may offer one or more nonqualified deferred compensation plans (NQDC’s).

NQDC plans are governed by section 409A of the U.S. tax code and differ from most other employer-sponsored retirement plans. Whether or not you should participate in an NQDC requires some careful consideration. In this article, we explain nonqualified deferred compensation plans and whether one is right for you.

What are Deferred Compensation Plans?

First, it’s important to understand the differences between qualified and nonqualified deferred compensation plans. The Employee Retirement Income Security Act (ERISA) governs qualified plans. This legislation sets standards for health and retirement plans offered by employers to protect employees.

An NQDC plan is exempt from ERISA law’s strict rules, making them more flexible and customizable for employees. The primary purpose is to attract and retain highly compensated key employees and executives.

Qualified Deferred Compensation Plans

ERISA law ensures that qualified plans have minimum standards for vesting, eligibility, benefit accrual, funding, and the overall administration of plans. It also guarantees certain benefits for participants through the Pension Benefit Guaranty Corporation (PBGC).

Participants in a qualified plan are also subject to strict parameters that govern the plan. Required minimum distributions, annual contribution limits, and penalties for early withdrawal apply in most scenarios. The complex rules of qualified plans position the employer as a fiduciary on behalf of the plan participants.

The table below lists other common characteristics along with the different types of qualified plans.

Common types and characteristics of qualified plans

The single most important trait of qualified plans is that employee and vested employer contributions are assets belonging to the participant. This is the significant distinguishing characteristic between qualified and nonqualified deferred compensation plans.

Nonqualified Deferred Compensation Plans

A nonqualified deferred compensation plan or 409A plan, allows participants to defer some of their compensation into the future. For key employees and executives, this can be a very attractive benefit. Top-heavy and non-discrimination requirements limit key employees’ participation in qualified plans.

Additionally, highly compensated employees are subject to annual contribution limits of only $19,500 in a qualified plan. The ability to defer larger amounts of compensation into a nonqualified plan is a very attractive benefit to high-income earners.

Like most endeavors involving money, these plans do not come without risk. The compensation you defer into future years is considered an asset of the employer. This means that your NQDC plan would be at substantial risk if the company you work for becomes financially unstable.

The Benefits of Nonqualified Deferred Compensation Plans

As we just mentioned, the primary reason to participate in an NQDC is to minimize tax liabilities. Reducing compensation in the current year helps keep you out of higher marginal tax brackets.

And taking distributions in retirement years when tax rates are lower is the objective with retirement planning.

A Great Tool to Retain and Attract Key Employees

Employers want to attract and retain highly skilled executive talent. A nonqualified deferred compensation plan can be a key component of an executive benefits package. Even when the company has a qualified plan in place like a 401(k), an executive’s contribution amount faces more hurdles.

Percent of Fortune 1000 companies that provide non-qualified deferred compensation plans to key employees

The annual contribution limit for employee deferrals to a qualified deferred compensation plan is $19,500 in 2021.

There are rules in place to prevent a plan from benefiting higher-income employees over rank and file employees.

These rules limit contributions of high-income earning employees to a lesser amount.

The qualified annual contribution limit of $19,500 is less than ideal for top earners. NQDC plans don’t have contribution limits, allowing employees the option to defer a large percentage of their salary.

For example, let’s say you accept a job offer that pays a salary of $450,000. Even without any other household income, this would place you in a 32% federal marginal tax bracket.

In reviewing your benefits package, you find out that you can defer $100,000 of your salary every year. This would save you $32,000 of tax liability!

Tax-advantaged Compound Growth

There are different types of nonqualified deferred compensation plans offering various investment options (more on that later). Most plans offer stocks, bonds, and mutual funds. This can provide substantial long-term growth in addition to tax savings.

Let’s look at an example of how powerful compound tax-deferred growth is in accumulating wealth. Following our previous example, let’s assume an employee in a 32% marginal tax bracket defers $100,000 into their NQDC. The tax savings in year one would be $32,000.

Assuming the plan’s investments grow at a rate of 7% over 10 years, the $32,000 grows into $62,949! So instead of paying $32,000 to the IRS, you created nearly $100,000 of additional wealth in retirement.

Spreading Income Tax Liability into Retirement Years

Once retirement begins, household income usually decreases, which means that tax liabilities decrease as well. So it’s extremely important to have a good idea of what your income tax situation looks like upon retirement.

Coordinating distributions with other sources of retirement income is crucial for achieving tax efficiency. Deciding when to take Social Security and pension benefits should be coordinated with scheduled distributions.

The same goes for coordinating retirement dates with your spouse and accounting for Required Minimum Distributions (RMD’s). Most of us are in the highest tax brackets in our working years. So deferring taxable income to your retirement years can make a ton of sense.

The Risks of Nonqualified Deferred Compensation Plans

Funds are Assets of the Employer

Unlike ERISA plans, salary deferrals into an NQDC plan are not assets of the employee, but assets of the company. In a nutshell, your deferrals become a promissory note between you (the borrower) and your company (the lender).

Since your deferrals are assets of the company, should they become financially insolvent, your funds would be at risk. This is by far the most important consideration when choosing how much to defer into your deferred compensation NQDC plan.

There May Be Limitations of Investment Options

Aside from stock option plans, most nonqualified deferred compensation plans will have an approved list of mutual funds to choose from. This mutual fund lineup is often the same as in the company’s qualified plan like a 401k.

In the case of a stock option plan, your deferrals purchase stock in the company. This creates additional risk if your company encounters financial trouble. Even if they remain solvent, a concentrated position in the company stock could experience large declines.

Distribution Options are Limited

The year prior to deferring money into your plan, you need to decide when distributions will begin. Plans can offer a lump sum or multi-year payout options, but 5-10 years is a common election. Distributions don’t start until a triggering event occurs. There are six triggering events:

  1. A fixed date
  2. Separation from service (usually retirement)
  3. A change in ownership of control of the company
  4. Disability
  5. Death
  6. An unforeseen emergency

Distributions are difficult to change once selected and require a five-year waiting period if allowed at all.

How Nonqualified Deferred Compensation Plans Work

In some cases, the triggers for deferred comp distribution are beyond your control. For example, death or disability will force you (or your heirs) to take distributions.

Choosing a fixed date can be useful when anticipating future income needs as well. A good example is having a child enter college around the same time you retire. Scheduling distributions when the child begins school can alleviate pressure to draw funds from other sources.

No Loans in Nonqualified Deferred Compensation Plans

If you really needed to access money from your 401(k) plan, many plans offer loans. This is not the case with an NQDC plan. Section 409A of the U.S. tax code governs these plans, subjecting withdrawals only to the six triggering events above.

This means that you should consider deferrals into the plan to be irreversible. So making sure you don’t overcontribute to the plan is important. It’s helpful to create a budget including annual income tax liability to avoid an income shortfall at end of the year.

Is a Nonqualified Deferred Compensation Plan Right for Me?

Do I Need Another Retirement Savings Account?

The first place to maximize retirement contributions is qualified plans like 401k’s and IRA’s. But few options reduce taxes and provide tax-deferred growth like an NQDC. Also, there aren’t any other types of deferred compensation plans with unlimited contribution limits.

Thus the biggest advantage of deferred compensation plans is a tax-advantaged way to save annual income surplus.

How Financially Secure is the Company I Work For?

Again, since NQDC plans are assets of the employer, the financial strength of your employer is of paramount importance. Your company needs to be around in the long run for you to receive distributions from the plan. The longer you are away from your triggering event, the more risk you carry.

Concentration risk

Another consideration you want to make is how much of your wealth you tie to your employer. Do you already have other types of nonqualified deferred compensation plans? Do you already own a high concentration in company stock?

Too much concentration can be dangerous, as we saw with big companies like Chrysler in 2008 and Hertz in 2020. Having a significant amount of your wealth AND income tied to your employer can be extremely risky. If you feel comfortable with a high concentration of company stock, there are ways to obtain third-party insurance.

Key Considerations in Participating to a NQDC Plan

How Will My Tax Rate Change in the Future?

Tax savings are amongst the primary benefits of a nonqualified plan. It’s important to weigh your future income needs and tax liability when electing to participate in your plan. Accounting for all your sources of income such as Social Security and RMD’s is vital upon retirement.

Remember that your contributions are invested into a portfolio with an expected rate of return. If you are ten years away from retirement, you should estimate your contributions’ value in year ten.

This is because all distributions are income taxable. You must be careful not to defer too much and create a future tax problem. It’s recommended to consult with a financial planner or tax advisor before you make your elections since they can’t be changed.

What are My Distribution Options?

We have discussed how important it is to coordinate your NQDC distributions with your other retirement income sources. The big challenge is choosing the distribution schedule at the same time as the deferral election.

Let’s go through an example of how this works. It’s September and you receive your enrollment package to make your deferral for the following year. Your salary is $300,000 and you anticipate your bonus will be $100,000 next year.

You can defer up to 50% of your salary and 100% of your bonus. You decide to defer 33% of salary and 100% of bonus to your retirement date 10 years down the road. Your distribution options are to take a lump sum or payment over 10 years.

You must decide on which distribution to take, even though it won’t start for 10 years. To make a good decision, you will need to coordinate distributions with your future income sources. This takes some serious financial planning.

The final step is to choose how your deferral will be invested. The performance of the investments you choose will determine what the final amount will be upon retirement. As you can see, there are a lot of variables to consider when making this decision.

Key Takewaways

Nonqualified deferred compensation NQDC plans are a great tool for both employers and employees. Employers have added ways to enhance benefits packages for employees. And employees have another way to save in addition to their qualified retirement plan.

Employees need to weigh the benefits, risks, and whether an NQDC fits into their financial plan. They are a great way to reduce taxes and boost tax-deferred growth for retirement. But remember that the funds in these plans belong to the employer until the employee actually receives them.

These plans are very complex and should be discussed with your financial advisor prior to participating.

Why Baby Boomers Are Retiring in Their Early 60's

Many Baby Boomers are learning about retirement readiness first-hand during the Covid-19 pandemic. Factors such as layoffs, health, disability, and technology are why Baby Boomers are retiring in their early 60’s. Decisions in retirement around Social Security, (long-term) health care, and taxes need careful planning. The pandemic’s effects continue to ripple and are still unknown despite vaccine rollouts. The world will look very different on the other side. This means that careful retirement planning is even more important than ever.

Covid is Making Baby Boomers Rethink Their Retirement Date

Federal Reserve Chairman Jerome Powell recently cited a surge in the number of retirees. Many Americans are leaving the workforce sooner, contributing to labor shortages. As a matter of fact, 3.2 million more Baby Boomers retired from 2019 to 2020 than in the previous year.

More Baby Boomers retired in 2020 than in prior years

The Covid-19 pandemic has made many Baby Boomers reflect on their plans. Surging asset prices are making the decision easier for those that own homes and stocks. The health scare from the pandemic has spurred many to reevaluate what matters to them. 

The shutdowns caused many businesses to go into survival mode by reducing labor costs and increasing dependence on technology. The New York Fed reported a record low percentage of people planning to work beyond age 67. 

Many data points support this, including the recent Census Household Pulse Survey. It shows that 2.7 million people over the age of 65 plan to apply for Social Security Benefits. This compares with only 1.4 million stating that they will continue working.

Employers may not be able to afford the cost of all their employees returning to the workplace. Entire industries have undergone a decade’s worth of change in a year. Remote work has opened the world up to new ways of doing business and has given workers a glimpse of retirement. 

The advancement of technology is also providing more avenues for part-time work. Yesterday’s hobbies are quickly becoming today’s income. In a digital economy, the very definition of retirement may look different. 

The top three pandemic related changes impacting business owners that should continue.

Covid accelerated the move to a digital world and is still transforming the global economy. It is still too early to understand how it all plays out. But it underscores the importance of careful retirement planning now more than ever.

Late Boomers are Unprepared for Retirement and Aging

Unfortunately, many prospective retirees face financial shortfalls despite surging asset prices across the economy. This is especially true for “Late Boomers” who were 55-60 in 2020. This demographic is worse off on average, as reported by the Center for Retirement Research at Boston College.

The reason for this is that they were the hardest hit by the Great Recession of 2008-2009. Unemployment, underemployment, and early retirement were all contributing factors. 

Workers in their 50’s forced to search for jobs find it more difficult than younger people entering the labor force. Many of them settle for less pay, as we saw in 2008 and more recently in 2020. Thus poor labor market outcomes from the last crisis left many ill-equipped for this one. 

The Late Boomer demographic has contributed most to 401(k) plans but has the least amount of defined contribution assets compared with other generations. Those that sold assets at the bottom of the market crash realized losses at the worst possible time. The housing crash in 2008 also affected home equity values for Late Boomers the worst. 

Retirement Age Expectations Clash with Reality

For those over the age of 60, 40% of them are no longer working full-time and rely primarily on Social Security, averaging $17,000 per year. A Stanford study in 2014 found that 30% of all Baby Boomers had no money saved in retirement plans. 

Life expectancy has also increased by about a decade since 1960. Too many have to fund longer lives with lower asset levels and shorter careers.

Thus, many plan to keep working into their golden years, yet the data does not bode well for this. The annual Retirement Confidence Survey indicates that half of the retirees surveyed retire earlier than expected.

The study underscores the importance of honest assessments and avoiding unrealistic expectations. Half of those surveyed expected a gradual transition to retirement. In reality, 73% experienced a full-time stop. 

Seventy-five percent of Baby Boomers expected to earn extra income in retirement while only 30% did so. This statistic has been consistent throughout the survey’s 31-year history. Studies also show that most retirees who planned retirement at age 65 are retiring closer to age 62.

And those planning to retire earlier than age 65 end up retiring later. The main takeaway: many people are unrealistic, overconfident, and underprepared for retirement.

Retirement age expectations clash with reality. A comparison of the actual age of retirement compared with the expected age of retirement.

Planning Your Retirement Lifestyle

What makes retirement different than other stages in life is that you gain an extremely valuable non-financial asset – control of your time. You no longer have to answer to your boss. And if you are the boss, you no longer have to oversee the business.

Children are close to or have reached adulthood in most cases. And of course, you can’t take your financial resources with you after retirement. It’s a great time to reflect deeply on your values and goals that will lead to your most fulfilling retirement.

So get that bucket list out and start prioritizing your goals. What does that have to do with creating retirement income? You have to know how much you need to spend each year to reach your goals. Here are some common lifestyle goals that newly minted retirees need answers to:

  1. Feel confident and secure while transitioning from saving to spending what they’ve earned
  2. Have the confidence to explore new opportunities in retirement
  3. Provide gifts to children and grandchildren during your lifetime
  4. Spend your life doing what you love to do, not what you have to do
  5. Retire to your dream destination
  6. Have plenty of money every month to support your desired lifestyle
  7. Leave a legacy and support future generations
  8. Enjoy total financial independence
  9. To have the same feeling of security you had while working
  10. Donate to charitable causes and organizations

Once you have determined how much you need to spend (and this changes every year in retirement), you can construct a plan to maximize your financial resources.

The Conversations that Couples Need to Have Before Retiring

It’s important to begin talking to your partner now about potential retirement dates. The majority of couples have different ages, which means that Social Security Benefits, Pensions, Medicare, and RMD’s begin at different dates for each spouse.

In some cases, one spouse may retire while the other continues working. Or one or both spouses has the option of continuing to work part-time in retirement.

Another challenge that some face is having a dependent child enter college at the same time the couple plans to retire. The cost of college continues to rise at a rate greater than normal inflation and can contribute to higher income shortfalls in retirement.

The danger is that large withdrawals from retirement funds earlier in retirement can significantly increase the risk of outliving assets.

Spouses should coordinate their retirement dates to maximize their financial resources and ensure a smooth and gradual transition. Think hard about the kind of life you want and what you will need to realize it. 

Discuss your goals with a fee-only financial advisor so you have an actionable plan to accomplish them. Leave no stone unturned. Don’t forget to factor in costs like dependent expenses and health insurance until you reach the age for Medicare eligibility. 

The Biggest Decisions Baby Boomers Need to Make in Retirement

Retirement brings about a number of complicated decisions. It causes serious contemplation around finances, quality of life, legacy goals, and health concerns. Couples want to know the financial ramifications of the passing of a spouse or the need for long-term care.

According to The Center for Medicare Services, annual health care spending reached $11,582 in 2019. Americans now spend 17.7% of Gross Domestic Product on health care. In addition to rising healthcare costs, there are many other retirement decisions that need to be coordinated between spouses:

  1. Retirement dates
  2. When and how to take Social Security Benefits
  3. Determining the optimal pension payout option
  4. Which retirement accounts to withdraw from in retirement
  5. How to create the retirement income that you need as expenses continue to rise
  6. Reducing taxes
  7. Planning for RMD’s
  8. Having adequate life insurance for your heirs
  9. Planning for a long term care event
  10. Formulating an investment strategy both spouses are comfortable with

Let’s face it, there is a lot to consider when making your permanent exit from the labor force. But all of these decisions tie into the most important decision -replacing your paycheck after you retire.

Replacing Your Paycheck When You Retire

Once you identify how much annual income you need, the next step is to figure out how to maximize any income sources in retirement. The most common types of income streams in retirement are Social Security, pensions, and rental income.

There are a number of different payout strategies when it comes to Social Security and pension payout options. It’s important to perform some careful analysis to determine which option provides the maximum financial benefit.

After you know how much income you will receive each year, subtract that number from your total expenses. You are left with either a surplus or a shortfall. A shortfall represents the amount of “income” that you need to generate for yourself.

It’s time to finally start tapping into your nest egg for income. A good understanding of how taxes work is needed at this stage to make optimal financial decisions.

Know How Retirement Distributions are Taxed

There are three main types of accounts you can withdraw from to satisfy your income needs in retirement. The primary differentiator between them is how distributions are taxed:

  1. Taxable (Joint, Trust, or TOD Accounts) – In these accounts you pay taxes as you go along. There is no special tax treatment like there are in IRA’s. So it’s to important to pay attention to how this account is invested. Avoid investments that aren’t tax-efficient and understand how capital gains work.
  2. Tax-deferred (IRA’s, 401k’s, pensions, etc) – These are accounts are where deductible or pre-tax contributions are made. This means that you never paid tax on any of the contributions or growth in the account. When you make distributions, the entire amount is income taxable to you. The percentage of tax you pay depends on your federal & state marginal tax bracket.
  3. Tax-free (Roth IRA & Roth 401k) – When you contribute to a Roth, you forgo any current tax benefit. That means you contribute after-tax monies to these accounts. Therefore, all distributions from these accounts are 100% tax-free, with a few exceptions.

Since distributions from these accounts have different tax ramifications, it’s EXTREMELY important to understand the tax consequences for each. The decision of which account to withdraw funds from depends on other factors like your current income.

Of course, the ultimate goal in determining your withdrawal strategy comes down to paying the least amount of tax possible.

Ultimately, deciding to take Social Security or pension benefits needs to be coordinated with your withdrawal strategy and tax reduction plan. Since income fluctuates year-to-year in retirement, there are often plenty of unique tax planning opportunities available to retirees.

Final Thoughts on Why Baby Boomers Will Retire Sooner

The Covid-19 pandemic has jolted our collective interpretation about what matters. For Baby Boomers at the end of their careers, these feelings are more pronounced.

There are many strategies and investment vehicles available to implement an optimal retirement plan that accomplishes your goals. If you plan to do it by yourself, it’s extremely important to know your limitations. Thorough knowledge of the tax code and time value of money calculations are just the tip of the iceberg.

The challenge with retirement planning is that changes in one area often impact other areas. As an example, a large capital gain realized in a taxable account can push your other income into a higher marginal tax bracket. It can even subject a greater portion of your Social Security Benefit to taxation!

The average retirement timeline is about 30 years. Mistakes made today can be very costly over such a long timeframe.

If working with a financial advisor, your plan should be custom-tailored to your goals and circumstances. Avoid a “one size fits all” approach to your retirement plan. A good plan is centered around your needs and goals first.

The good news is you don’t need to do it alone. An experienced fee-only Certified Financial Planner™ can help reduce uncertainty and avoid mistakes. Nowadays, you can even find a fee-only CFP® that specializes in retirement planning.

Above all, you want to make financially optimal decisions to turn your uncertainty into confidence to make the last chapter of your life the best chapter.

Retirement Tax Planning - 6 Things You Must Know

Tax planning strategies are an essential component to maximizing retirement income. And the more income you have, the more you get to spend or pass down to your heirs.

There are a lot of retirement tax planning articles out there. But our goal is to provide more of a “how-to” so you aren’t just relying on someone else’s word. So we’re going to explain the importance of retirement tax planning – 6 things you must know.

Anytime I am at a social gathering and people find out I’m a financial planner, the response is always an inquisitive, “Oh?” I can see them scrambling through their brain trying to think of a financial question for me. As you can guess, I’ve had some really interesting conversations with strangers. Some of the most common questions I get are:

What will my tax rate be when I retire?

Will my Social Security Benefits be taxed?

How can I plan ahead for retirement?

You are going to get answers to these and many other questions by the end of this article.

How Much Income is Needed in Retirement?

Whether you work with a financial planner or not, a successful plan starts with you. You and only you have to decide on what your life in retirement will be.

If you’re anything like me, you are going to want to know how often you can dine out. Or how many weeks you can live abroad every year. Or….maybe you just want to order that $4 side of guacamole and without feeling guilty.

The point is that the first step is to figure out how much we need to spend. And that is unique to each of us.

Creating Your Personal Financial Statements

So now that you know what you need to spend in retirement, it’s time to figure out how to make it happen. You are going to want to know how much you need to withdraw every year…and where to draw it from.

Your balance sheet is the first financial statement you will need. It contains a list of your assets and liabilities in separate columns. The difference between these amounts is your net worth.

Then you will list your annual income and expenses on your personal income statement. The difference between these amounts is your income shortfall.

Think of your net worth like your water well and your income shortfall as the water. You have to make sure there is always enough water in the well or you’ll go thirsty. Or in our case, you risk outliving your assets.

Income Needs Will Increase Over Time

One of the biggest obstacles for retirees is inflation. Every year the cost of goods and services increases. Luckily, Social Security benefits have a cost of living adjustment (COLA) to help keep pace.

But if you have a private pension, there may not be any COLA included. That means that your income will lose purchasing power over time.

As you can see from the chart, inflation has averaged over 2% over the last 20 years. It’s a lower rate than the historical average of 3.1% since 1913. But it still takes a big bite out of your purchasing power.

The Impact of Inflation Over Time

Something that cost $100 in 1913 would cost $2,555 now! That’s why it’s important to know how much you need to spend now and in the future.

How Much of Your Income Will be Taxable?

The good news is that it’s all up to you. The bad news…um yeah, it’s all up to you. You have nearly full control of your income decisions in retirement. The goal is clear: to maximize your income while paying the least amount of tax.

The first thing you need to know is how our tax system works. You’re going to have to know Social Security and retirement account rules. There will also be plenty to know about tax-efficient investing.

But that’s why you’re here in the first place, isn’t it? So let’s start with some retirement tax planning basics: how taxes in retirement work.

How Taxes are Calculated

Ordinary Income Tax Rates

Our federal income tax system is progressive. That means that the percentage of tax increases along with income levels. Ordinary income can consist of wages, salaries, and interest. But more concerning for retirees are taxable Social Security benefits and IRA withdrawals.

We all pay federal taxes starting at a rate of 10%. The federal marginal tax brackets go all the way up to 37%. If you look at your most recent tax return, line 10 on schedule 1040 gives you your taxable income. Looking at the table, you can see which marginal tax bracket that number puts you in.

Any extra dollar that’s earned will be taxed at your marginal tax rate. As an example, let’s say a single-filing taxpayer has taxable income for the year of $40,000. They are close to going from the 12% marginal tax bracket to the 22% bracket. But their bank account is running low and they need another $30,000 for living expenses.

If they take the $30,000 needed from an IRA account, the entire amount counts as ordinary income. That means they pay federal income tax at a marginal tax rate of 22%. Keep in mind that this does not include state income taxes (depending on your state of residence).

If you withdraw the $30,000 from a Roth IRA or taxable account you could avoid the extra tax bill. So you need to think twice about where your income will come from each year.

2021 Ordinary Income and Capital Gain Tax Rates for Single and Married Filing Jointly Taxpayers

Capital Gain Tax Rates

Favorable capital gain tax rates are a key retirement tax planning tool. When you sell a capital asset for more than what you paid for, the result is a capital gain. Capital assets include stocks, bonds, real estate, precious metals, cryptocurrency, etc.

If you sell a stock for a profit and hold it for one year it is taxed as a long-term capital gain (LTCG) as shown in the table. You can see that these rates are always lower than your marginal tax rates.

If you sell a capital asset for a gain that was held for less than a year, the gain is taxed as ordinary income. This is called a short-term capital gain (STCG) and will be subject to your federal marginal tax rate.

What if you sold a capital asset at a loss? In that case, here is how you would treat the loss:

List all your realized short or long-term losses

Offset short-term gains with short-term losses

Offset long-term gains with long-term losses

Finally, compare your net long-term gain/loss vs. your net short-term gain/loss

Here is how the results are treated:

A Net LTCG – taxed at long-term capital gain rates

A Net STCG – taxed at your marginal income tax rate

And if there is a net loss? Whether short or long-term, you can use $3,000 of the loss as a deduction in the current tax year. The remaining losses carry forward indefinitely. They can be used to offset gains in future years. In years with no gains, you can always use up to $3,000 of your carryforward losses as a deduction against your ordinary income. 

Withdrawals from Retirement Accounts

Retirement account withdrawals are where you can save BIG on taxes in retirement. This is where all that prudent saving you did in your working years pays off. Without an income distribution plan, you can kiss a lot of those savings goodbye to taxes. But not you. You are going to use your newly acquired retirement tax planning skills to turn the tables in your favor.

Taxable Accounts

Taxable accounts are any non-retirement accounts. Think of your bank or brokerage accounts or that stock certificate your granny gave you as a kid. For married couples, these accounts are usually jointly owned or in the name of their trust.

The capital gain rates that we discussed earlier apply to assets owned in these accounts. In your taxable account is where you need to pay attention to the cost basis and holding periods. 

Qualified dividends from stocks held in a taxable account are also taxed at lower capital gain rates. But interest income held in a taxable account will be treated as ordinary income, along with STCG’s.

As you can see, a sale of an asset here can be subject to two different tax rates. As can the income an asset produces, dividends and interest. And with capital loss rules at your disposal, you can save yourself a lot of money with a good investment strategy. More on that later… 

Tax-deferred Accounts

Tax-deferred accounts are the most common types of retirement accounts. Think of 401k’s, 403b’s, IRA’s, and pensions. Every time you contributed to these accounts, that money avoided taxation.

There should be a lot of growth from compounding if you have invested it well. But you see that number at the top of your statement that says “Account Value?” That’s not all yours. No, you have a silent partner named the IRS that is waiting for your distributions to begin.

And when they begin, they are taxed at the highest rates. So you want to be extra careful when making withdrawals or rollovers from these accounts.

Tax Diversification: Tax-Free, Taxable and Tax-deferred

Tax-free Accounts

Roth IRA’s and Roth 401k’s are the only retirement accounts that provide tax-free distributions. Roth accounts are funded with after-tax contributions, so no immediate tax benefit is received. in exchange for that immediate benefit, all the growth in the account is tax-free.

A Roth is a great account to have in retirement because they allow you to spend more without climbing into a higher marginal bracket. So, when you find out you need a new roof, you won’t have an extra tax bill to make things worse.

Every year you should calculate your income needs and tax bracket and then choose the most efficient withdrawal strategy. When your nest egg consists of all three types of accounts, you have what we call tax diversification. It is the foundation of your retirement tax planning strategy.

Will Your Social Security Benefits be Taxed?

Social Security is a big part of most American’s retirement income. It is also very complex and takes some careful analysis to ensure you are making the best decision. Next, we’re going to focus on three tax-related factors that impact Social Security Benefits.

When You Should Take Social Security Benefits

Take a look at your most recent Social Security Benefit statement or view it by logging in to your account. Find where it states your benefit at full retirement age (FRA). This is the age that you can begin receiving your full benefit. On your statement, you can also see a reduced benefit if you take it at age 62. You can also delay to age 70 for a higher benefit.


Take it at your earliest age and you face a reduction in benefits of over 25%. But delaying it allows it to grow at about 8% per year. There aren’t many things you can invest in and get a guaranteed 8% return! However, when you should take it depends on how much you have saved as well as health factors. And of course, how much tax you will pay on your benefit. 

Taking Social Security While Working

This is quite fine if you start your benefits at your FRA. But if you are under full retirement age for the entire year, your benefit is reduced by $1 for every $2 you earn above the annual limit.

For 2021, that limit is $18,960. In the year you reach full retirement age, your benefits are reduced by $1 for every $3 you earn above a different limit.

In 2021, the limit on your earnings is $50,520. Your earnings are counted up to the month before you reach your full retirement age, not your earnings for the entire year. 

How Your Social Security is Taxed

Your Social Security income is either 0%, 50%, or 85% subject to taxation. In other words, if your benefit was $30,000 and 50% was taxable, then $15,000 would be added to your ordinary income. Subject to – you guessed it, your marginal tax rate. The key factor in determining how much is taxable is your other sources of income as you can see from the formula below.

Social Security Taxation Formula

Since half of your Social Security benefits are included in the calculation, most of us will pay tax on about 85 percent of benefits. Here are the Internal Revenue Service (IRS) rules. If you:

file a federal tax return as an “individual” and your combined income is between $25,000 and $34,000, you may have to pay income tax on up to 50 percent of your benefits. More than $34,000, up to 85 percent of your benefits may be taxable.

file a joint return, and you and your spouse have a combined income that is between $32,000 and $44,000, you may have to pay income tax on up to 50 percent of your benefits. More than $44,000, up to 85 percent of your benefits may be taxable.

are married and file a separate tax return, you will probably pay taxes on your benefits. In summary, the timing of your Social Security benefits is a huge part of controlling taxes in retirement. To oversimplify, you want to keep as much of your benefit in your pocket.

There is a lot of thought that goes into selecting the right Social Security strategy. It’s a balancing act between maximizing your benefit and protecting it from taxes. Social Security and pension benefits must always factor into your retirement tax planning decisions.

Retirement Tax Planning Strategies

You should now have a good idea of how our tax system works and how to create retirement income. You now have some great tools to reduce your tax bill! But there is still so much more you can do…

Plan for RMD’s

Employer-sponsored retirement plans are the primary retirement savings vehicles for retirees. One reason is that the contribution limit is much higher than that of IRA’s. In 2021, the contribution limit for a defined contribution plan is $19,000 per year. In contrast, the annual IRA contribution limit is only $6,000.

Uniform Life Expectancy or RMD Table for 2021 and 2022

These accounts are where most Americans have saved their nest egg. And as we mentioned earlier, the IRS wants to collect its share of the pie. So, at age 72, you must begin taking Required Minimum Distributions (RMD’s) from these tax-deferred accounts. And the penalty for not taking your RMD is 50% of the amount!

A big mistake that many people make is not planning ahead for RMD’s. When you add that income to your other retirement income sources, it can easily put you in a higher marginal bracket.

It typically is not a good strategy to avoid distributions from your tax-deferred accounts. It may make sense to take some out during years when your tax bracket is extremely low. This ensures the income is taxed at lower rates.


Convert to a Roth IRA

Another great retirement planning strategy is Roth Conversions. It consists of transferring money from your Traditional IRA to your Roth IRA. The entire amount of the conversion gets treated as ordinary income.

But the benefit here is converting at tax rates that you know are less than or equal to future tax rates. If you retire at 60, you probably do not have any fixed income sources. This is when your marginal tax rates are usually the lowest. It may make sense to pay tax now and allow for tax-free growth going forward.

Roth Conversions also reduce your tax-deferred balance, which lowers future RMD’s. Lastly, they help your wealth transfer strategy since beneficiary withdrawals are also tax-free.

Contributions to Retirement Plans

It’s very common for one spouse to continue working after the other retires. This can present the opportunity to contribute to their 401k or other employer plans.

They could also be eligible to make Traditional or Roth IRA contributions for themselves and their retired spouse. Yet another tool to lower your income or contribute more to tax-free accounts.

Charitable Gifting in Retirement

There are several ways to give to charities and reduce taxes. You can give away your RMD through a qualified charitable distribution (QCD). You have to be age 72, but you won’t have to report RMD income using this strategy.

Gifting highly appreciated stock is another common tax reduction strategy.
It allows the taxpayer to avoid paying capital gain tax.
A donor-advised fund is another way taxpayers can give charitably and get a tax break.

It is like a charitable investment account that supports charities of your choosing. There are several more charitable gifting strategies for investors that donate to charities. 

Invest Tax-efficiently

Earlier, we stated that income from taxable accounts can be taxed at ordinary income or capital gain tax rates. There are a lot of portfolio management strategies you can use to control taxes. If you work with a financial advisor, don’t be shy in asking how they are managing your portfolio. 

Tax-efficient Investment Vehicles

Mutual funds are professionally managed investment vehicles that provide market exposure. There is a fund today for any asset class you can think of – like the Proshares Pet Care ETF (PAWZ).

But when it comes to selecting funds, you first need to know if you are investing in an active or passive fund. Not only are they higher in cost, but most active funds are not tax efficient. The manager is buying and selling positions throughout the year.

This turnover can generate capital gains that you have to pay tax on. As a matter of fact, your fund could have an unrealized loss for the year and still distribute capital gains!

Index funds and ETF’s focus on tracking a benchmark. An example of a benchmark is the S&P 500. Since these benchmarks have minimal turnover, the respective funds also have low turnover. Investors also benefit by paying much lower expense ratios in passively managed funds.

Depending on your tax bracket, municipal bonds can also make a lot of sense in taxable accounts. These are state-issued bonds that provide state and federally tax-exempt interest. To qualify, you must reside in that state of issuance. They pay lower interest than taxable bonds, so you have to do some math to see if they fit in your portfolio. 

Tax-loss Harvesting

When you buy an asset in a taxable account and you sell it for a gain, you pay capital gains tax. And you know now that 1 year is the holding period that determines whether it is short or long term.

Since you need to liquidate securities frequently in retirement, it’s important to use capital losses wisely. Tax-loss harvesting does just that by using market volatility to your advantage. It is best to use an example to explain it.

Let’s assume you invest $50,000 in a fund and the market subsequently declines, decreasing your fund’s value to $40,000. You don’t want to panic and sell it and go to cash. And you can always just ignore it and wait for the markets to bounce back.

Or you can sell the fund and immediately purchase a substitute fund in its place. This way, you can still recover your $10,000 paper loss. But since you sold your initial investment, you have now created a capital loss.

Going back to our capital gain rules, you can use the loss to offset gains in the current year. If there are no gains, you can carry forward the losses. And you can deduct $3,000 of losses every year against your ordinary income. For large taxable account balances, tax-loss harvesting is a popular retirement tax planning tool. 

Asset Location

Asset Allocation is the process of investing in different asset classes to balance risk/reward. This means selecting the right weighting of stocks, bonds, and other asset classes in your portfolio.

But you may have never heard of asset location. This strategy involves determining which accounts should hold each asset class. The goal is to maximize after-tax returns and it works like this…

If you have all three types of accounts and you could pick where you want the most growth, which would it be? Well, we know that Roth accounts will provide tax-free distributions. So, it would make sense to hold your high-risk/return asset classes in Roth accounts.

Then it also makes sense to hold low risk/return asset classes in accounts with the highest tax rate. Of course, this is to keep your ordinary income lower in retirement. Bonds for example are great to hold in tax-deferred accounts.

And we already discussed many of the benefits and strategies to help control taxes in taxable accounts. Even if you only have two types of accounts, asset location is still key to your after-tax investment returns. 

Final Thoughts on Retirement Tax Planning

Give yourself a nice pat on the back if you have made it this far! We threw a lot of information at you readers, and you may feel a bit overwhelmed. But now you can start planning your retirement today!

The first step is to really think hard about what your retirement will look like. This will give you the answer to a key variable – how much income you need. Next, you need to get familiar with how the U.S. tax code works.

You also need to decide on Social Security and retirement account withdrawal strategies. Not to mention making sure your financial advisor is managing your portfolio in the most tax-efficient manner. Lastly, don’t miss out on any other tax-planning strategies like Roth Conversions or charitable gifting.

Taxes are at the center of all your retirement planning decisions. If this part isn’t clear to you, we highly recommend you get the help of a fee-only financial planner or other tax professional.

You only retire once. The less tax you pay, the more resources you have for a rich, fulfilling retirement.