The Tax Wise Distribution Strategy focuses on reducing a client's taxation in retirement. This can have a number of results:
1.It may extend the duration of their income
2.It may reduce the amount of savings a client must have for retirement
3.It may increase the after-tax value of the estate left to their heirs
It does this by paying close attention in a tax year to how the money is being taxed. But before moving forward, a clear distinction must be made between the accumulation years and the distribution years.
How accumulation is different than distribution
During the accumulation years, as a client is receiving income, typically their withholding tax at the beginning of a calendar year will have a similar value to the withholding tax at the end of the year. This is because the employer will use a withholding table that corresponds to the frequency they are paid and the taxation is averaged per paycheck. But this is not how taxation really works.
If a client were to use actual tax tables, because of their deductions, they would pay little (if any) taxes at the beginning of the year. As they moved through the year their tax rate would increase and they would have more tax withheld. This would significantly reduce the size of their paychecks later in the year compared to earlier in the year.
An Example
Suppose a married client has combined pre-tax earnings of $8,000 per month in income in 2009.Their effective federal tax brackets, including the $11,400 married tax deduction, would be as follows:
Effective Tax Bracket for 2009 |
|
Income Level |
Tax Bracket |
$11,400 |
0% |
$28,100 |
10% |
$79,300 |
15% |
$96,000 |
25% |
In January, the client would pay no tax on their first $8,000 of income.
In February, they would pay 10% ($460) on $4,600 of income.
In April, $32,000 of income year-to-date, their tax rate would increase to 15%.
In October, their marginal tax bracket would increase to 25%. This would be their top marginal tax bracket.
A few observations
Doing a little math, we can determine how much tax and income the client would have from each tax bracket.
Taxation and Income by Bracket |
||||
|
Taxation |
After-Tax Income |
||
Tax Bracket |
Dollar Value |
Percent of Taxation |
Dollar Value |
Percent of After-Tax Income |
0% |
$0 |
0% |
$11,400 |
13.8% |
10% |
$1,670 |
12.3% |
$15,030 |
18.2% |
15% |
$7,680 |
56.8% |
$43,520 |
52.8% |
25% |
$4,125 |
30.9% |
$12,525 |
15.2% |
A few observations about the client's after-tax income and taxation:
1.The key observation is that as a client's income increases, so does their marginal tax bracket.
| Note: | Most people do not think of it this way. That is because when people are paid during a tax year, their taxation is averaged per paycheck for the given tax year--the taxes withheld at the beginning of the tax year is essentially the same as the taxes withheld at the end of a tax year. But that is not the way the tax tables work. |
2.The first $11,400 is earned tax-free.
3.When this client moves from the 15% to the 25% tax bracket, they experience a 66% increase in taxation.
4.The last 15.2% of after-tax income ($12,525) in the 25% tax bracket resulted in almost 31% of the client taxation.
The key difference
To explain the key significant difference between the accumulation phase and distribution phase, a hypothetical situation with a client will help. Imagine in October, when the client illustrated here moves from the 15% to the 25% tax bracket, and they ask their employer for a meeting. They sit down and the client shows the employer that based on their year-to-date income and the tax brackets, that they would be facing a 66% increase in taxes. The employer acknowledges what the client states. Then the client states that they do not want to pay the higher taxes and asks that the employer start paying them under the table. Preposterous you say, and if, the client is serious, they may end up looking for a different job. You are right on both counts.
But that is because the client is in the accumulation phase. In the distribution phase, where the client can control the distributions, the client can have control: they can decide which account to take distributions from.
To do this:
1.Determine what a client's tax bracket looks like during a calendar year.
2.Next, add up all of their fixed incomes a client will receive during a tax year.
3.Finally, prioritize distribution from the accounts by tax bracket:
a.Distribute the income needed for the lower tax brackets from the pre-tax accounts.
b.Distribute the income from their higher or highest tax brackets from capital gain and/or after-tax accounts.
This results in a reduction of taxes paid by the client during retirement, and extending their income and money left to their heirs.
Summary
The Tax Wise Distribution Method considers the client's after tax income needed during retirement. Where applicable, it combines the federal and state tax tables into one progressive tax table. The strategy then distributes income by tax bracket: it focuses on taking income for the lower income tax brackets from pre-tax accounts and income from the higher (or highest) tax brackets from after-tax or Roth accounts. Then the client can leverage the advantages of each type of tax account.
