Taxes in Retirement – Case Studies

Frank Yozwiak

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 provides protection in down markets, and also 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 the majority of their career as a W-2 employee.  They have had the opportunity to save into an employer sponsored retirement plan, such as a 401(k), 403(b), 457(b), etc., and the bulk of their assets are in one or more of these qualified plans.  In addition to maxing out retirement plans and IRA contributions each year, this investor has also saved into a taxable investment account, such as a brokerage or joint account.  At retirement, the majority 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 it comes time to start taking distributions from the IRA and qualified plans, the investor will pay ordinary income tax on the entire amount.


An easy, but potentially short-sighted strategy is to use the taxable investment account as the first source of income withdrawals.  The investor will pay the generally lower capital gains rate on only the growth portion of assets that have been held for more than one year at the time they are sold.  Growth on assets held for less than one year at the time they are sold are taxed at ordinary income tax rates.  Once these taxable (or non-qualified) assets are exhausted, or when the investor reaches age 70 ½ and has to start taking out Required Minimum Distributions (RMDs) from the IRA and qualified assets, the investor’s tax liability will increase dramatically.


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


An even more advanced strategy would involve converting some portion of the traditional IRA and qualified assets to Roth.  This would mean owing a tax liability in the year of conversion but would reduce RMDs and create more flexibility in later years.


Business Owner


The Business Owner has built their company from the ground up and it provided a great quality of life throughout the years.  The owner took some out of profits for a comfortable salary each year but did not save as much for retirement as they would have liked.  Now with an eye towards retirement, the business owner knows that proceeds from selling their company will constitute the bulk of their nest egg.


Ultimately, the seller and buyer will agree on a sale price.  The seller’s profit is the difference between their adjusted basis and the sale price.  In general terms, basis is the amount of money the owner has put into the company, with adjustments made for things such as depreciation.  Also, in general terms, basis is returned to the seller tax-free.  The profit, however, will be taxed, and the way the sale is structured will have a dramatic impact on how it will be taxed.  Thus, the big decision here is how to structure the sale.


One option, often called an earn-out, is that the owner can stay on as an employee, advisor, or consultant and be bought out by means of a high salary over a period of time.  Payments received under a buyout or other similar arrangement are taxed as ordinary income in the year they are earned.  This can be beneficial in that the seller can spread out the tax liability over several years rather than receiving a large sum all in one tax year, but this option comes with the disadvantage of paying ordinary income tax rates.  This spreading of income, and the resulting tax liability, can also be achieved by agreeing to a price and installment payments over an agreed upon period of time.


When the seller and buyer agree to a sales price, they also agree on how to allocate the price to certain aspects of the business.  For instance, they can agree to a dollar number or percentage to be allocated to the building, the equipment inside, the inventory on hand, the client list, a non-compete agreement, and goodwill, among a host of other categories.  The tricky part here is that, with an eye on taxes, what is better for one party is often worse for the other?  For example, the seller would want a larger number or percentage to be allocated to goodwill, because the seller will pay the lower capital gains rates on goodwill.  On the flip side of that coin, the buyer would want a lower percentage allocated to goodwill because the buyer loses the benefit of being able to amortize the purchased goodwill going forward.


Very commonly, business sales involve a combination of these and a multitude of any 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 as they aim to minimize taxes as much as possible to maximize funds available for retirement or their next venture.


 Real Estate Investor


The Real Estate Investor has bought and sold properties throughout their life and has ended up with a portfolio of several valuable residential rental properties.  These properties generate a steady stream of rental income that has provided for the investor for many years.  One reason real estate tends to have a higher return on investment is that it is an active investment as compared to passively investing in the stock market.


To maximize their investment return, the real estate investor is answering tenants’ phone calls at all hours, driving to the properties to change light bulbs in common areas, re-lighting pilot lights, and fixing a leaky sinks and showerheads.  They are mowing the lawn, pulling weeds, and raking leaves when it’s warm, and shoveling snow and putting down ice-melt in the driveway when it’s cold.  The real estate investor is very much an active investor, and their return on investment reflects that.


But what happens when the real estate investor wants to retire?  For this investor, “retirement” is less of a change than for the traditional W-2 employee, but there are still differences.  Perhaps they want to travel more.  Maybe they physically cannot, or simply do not want to be as involved on a hands-on level anymore.  If the real estate investor hires a property manager to take over the day-to-day tasks, expenses will increase and retirement income will decrease.  This may not be a problem for some, but others may want to look at a second option: selling the real estate.


Selling the property presents another set of considerations.  Let’s assume the property was purchased years ago and since that time the owner has fixed the place up and the neighborhood has become one of the more desirable areas in town.  This is a great problem to have, but it presents the issue of a large tax bill.  Again, assume the property was purchased long enough ago that the owner has depreciated the property to where their adjusted basis is next to nothing.  Nearly all proceeds from the sale of the property will be taxable – granted it will be at the capital gains rates, but there will be little if any tax-free return of basis.


Another piece to consider is the situation where the real estate owner has children to whom they wish to leave their estate.  It’s a morbid conversation, but when the investor passes away and leaves the real estate to their children, the property gets a step-up in basis to fair market value.  So the real estate investor is faced with the decision of whether to sell the property to provide for their retirement, or use rental revenues as income and leave the property to their children to receive a step-up in basis.


Diversified Investor


The Diversified Investor is a fan-favorite.  As a combination of the three above, this investor has money in an IRA, an employer sponsored plan like a 401(k), and a taxable account.  A diversified stock portfolio provides protection in different market cycles, but to be as prepared as they can be, this investor also owns a share of a small business and some rental real estate.  The major advantage this investor has is that their diversification provides flexibility.  Doomsday scenarios aside, very few things can throw this investor’s retirement plan out of whack.  A huge benefit here is that the diversified investor has the most control over how and when to pay taxes.  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 structuring their taxes as efficiently as possible.  The key here is that year-by-year management is important.


For all of the hypothetical investors described here, planning ahead to minimize surprises in the future 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 in this article have exceptions, and exceptions to 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 retirement income with respect to taxes decades in advance for our clients, 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.