Taxes in Retirement – Case Studies

Key Takeaways:

  • Your sources of income will change, but you will still owe taxes in retirement.
  • In general, your principal (or “cost basis”) will be returned to you tax-free.
  • A diversified portfolio protects in down markets and provides flexibility when planning for taxes.



When you’ve spent your adult life working and saving, retirement is a big change. One item that will both change and remain the same is taxes. Your income sources will be different, each with their own intricacies in the tax code, but at the end of the day, you will still likely be paying at least something to Uncle Sam. Below we will discuss several of the common scenarios we encounter when helping clients plan for taxes during retirement.


High Income Earner


The High-Income Earner has spent much of their career as a W-2 employee. They diligently saved into one or more tax-advantaged accounts (i.e., IRA, 401(k), 403(b), 457(b), etc.), and the bulk of their assets are in these accounts. In addition to these tax-advantaged accounts, this investor also saved into a taxable investment account (i.e., brokerage or joint account). At retirement, most of the investor’s retirement assets have never been taxed: they took a tax deduction for the contributions each year and the funds have grown tax-free. When they take distributions from the tax-advantaged accounts, the investor will pay ordinary income tax on the entire amount.


An easy, but the potentially short-sighted strategy is to use the taxable funds as the first source of income. The investor will pay lower capital gains rates on the growth portion of these assets that have been held for more than one year. Once these taxable assets are exhausted, or when the investor reaches Required Minimum Distribution (RMD) age, the investor’s tax liability will increase dramatically.


A different strategy involves using a combination of IRA, qualified, and taxable assets to create the retirement income stream from the beginning. By doing this, the investor can create a relatively level and more predictable tax liability each year.


An even more advanced strategy would involve converting some portion of the pre-tax assets to Roth. This would mean paying tax in the year of conversion, but it would reduce RMDs and create more flexibility in later years.


Business Owner


The Business Owner built their company from the ground up. They took some profits for a comfortable salary each year but did not save as much for retirement. Now with an eye on retirement, the business owner knows proceeds from selling their company will constitute the bulk of their nest egg.


Ultimately, the Business Owner/seller will be taxed on the profit (i.e., sales price minus adjusted basis) from selling their business. The way the sale is structured will have a dramatic impact on the tax consequences. Thus, the big decision here is how to structure the sale.


One option, often called an earn-out, is that the owner can be bought out by a high salary over time. This will allow the seller to spread the tax liability over multiple years, but it also means paying ordinary income rates on the salary. A similar spreading of income and tax liability can be achieved by agreeing to installment payments over time.


When the seller and buyer agree on a price, they also agree on how to allocate the price. For instance, they can agree on how much of the purchase price is allocated to the building, the equipment, the inventory, the client list, a non-compete agreement, goodwill, etc. The tricky part is that what is better for one party in terms of tax treatment is often worse for the other.


For example, the seller would want a higher amount allocated to goodwill, because the seller will pay capital gains rates on selling goodwill. On the flip side, the buyer would want a lower amount allocated to goodwill because the buyer cannot depreciate the purchased goodwill.


Very commonly, business sales involve a combination of these and a multitude of other sales structures. From the Business Owner’s/seller’s perspective, the structure of the sale is among the most important decisions they will make in aiming to minimize taxes to maximize net proceeds.



Real Estate Investor


The Real Estate Investor has bought and sold properties over the years and has a portfolio of residential rental properties. The properties generate a stream of income that has provided for the investor for many years. One reason real estate tends to have a higher return on investment as compared to stock market investing is that it is an active investment.


To maximize return, the Real Estate Investor must personally do the routine maintenance and simple repairs that a property management company would do – and for which they would charge a fee. But what happens when this investor wants to retire? For them, “retirement” is less of a change than for the traditional W-2 employee, but there are still differences.


If they hire a property manager to take over the day-to-day tasks, expenses will increase which means income will decrease. This may not be a problem for some, but others may want to look at a second option: selling real estate.


Selling presents another set of considerations. Many times, the properties were purchased years ago the property values have increased significantly. This is a great “problem” to have because while the value has increased, so too has the potential tax bill – especially if the owner has depreciated the property down close to zero. In that situation, there will be little (if any) tax-free return of basis and nearly all the proceeds will be taxable to some degree.


Another consideration is whether the real estate owner has children to whom they wish to leave their estate. It may be morbid, but when the investor passes away, the inherited property gets a step-up in basis to fair market value. In that situation, the investor must decide whether to sell the property to provide a lump sum for their retirement or rely on the rental income in retirement to leave the property to their children so they can receive a step-up in basis.


Diversified Investor


The Diversified Investor is a fan favorite. With a combination of the three above, this investor has money in both tax-advantaged and taxable accounts, they have ownership in a small business, and they even have some rental real estate. The major advantage this investor has is that their diversification provides flexibility.


With so many different asset types and sources of income, this investor will rarely, if ever, be forced to choose between continuing their desired retirement lifestyle and efficiently structuring their taxes. The key is year-by-year management.


For all the hypothetical investors described here, planning to minimize surprises will always lead to a better outcome. We do our best to help our clients, both working and retired, formulate and execute tax-efficient retirement income plans. Many of the tax rules discussed here have exceptions on top of exceptions. Because of the inherent complexity involved with the tax code, we often achieve the best results for our clients when we collaborate with their CPAs and other tax professionals.


We start planning for retirement income with an eye on taxes decades in advance, and there are almost always methods to optimize a plan at any age. It’s never too early or too late to begin or adjust. At Ballast, we all take great pride in creating tax-efficient financial plans for our clients, and we would love the opportunity to help create a plan for you.



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