William Reichenstein: Avoiding Tax Headaches in Retirement

Episode Summary

Executive Summary: Morningstar’s Christine Benz and Jeff Batak interview William Rickenstein on tax-efficient retirement income planning. He argues that retirees should coordinate Social Security claiming, Roth conversions, and withdrawal sequencing to avoid high marginal tax rates created by Social Security taxation and Medicare IRMAA surcharges, often favoring delaying Social Security to age 70 and drawing down tax-deferred assets earlier.

Main Topics: Tax-efficient withdrawal sequencing (Priority: 5/5): Rickenstein argues conventional taxable-then-tax-deferred-then-Roth sequencing is often suboptimal; retirees should fill low tax brackets early with Roth conversions and manage withdrawals around future Social Security and Medicare tax effects. Social Security claiming strategy (Priority: 5/5): He explains why delaying Social Security often increases lifetime benefits and serves as a superior fixed-income return for most retirees, especially those with normal or long life expectancies. Social Security taxation and the tax torpedo (Priority: 5/5): The discussion details how provisional income drives taxation of benefits, creating a large jump in marginal tax rates as more Social Security becomes taxable. Medicare IRMAA spikes (Priority: 5/5): Rickenstein emphasizes that income-related Medicare premium surcharges can create massive marginal tax-rate spikes, making year-by-year planning and software especially valuable. Roth conversions and account location (Priority: 4/5): He recommends Roth conversions during low-income years and discusses locating assets—generally stocks in taxable accounts and bonds in tax-advantaged accounts—while maintaining target allocation. Safe withdrawal rates and retirement outlook (Priority: 3/5): He suggests lower expected returns imply a safe withdrawal rate closer to 2.8%–3.0% rather than 4%, though he does not see a universal retirement crisis for households that have saved adequately. Policy change and future planning (Priority: 3/5): The conversation touches on the permanence of current-law assumptions, historical Social Security reforms, and the growing importance of Roth accounts for younger workers facing heavier retirement taxation.

Key Arguments: Retirees should plan withdrawals around marginal tax rates, not just nominal withdrawal rates or account balances, because Social Security taxation and IRMAA can materially raise the effective cost of income. For moderate-wealth retirees, delaying Social Security to age 70 often maximizes lifetime benefits and provides a high real return comparable to an inflation-linked bond. Conventional sequencing—taxable first, tax-deferred second, Roth last—often wastes low-tax years and can force later withdrawals into much higher marginal brackets. Roth conversions in the 0%, 10%, 12%, and sometimes 22% brackets can reduce future taxes because later withdrawals may trigger 185% of the tax bracket due to Social Security taxation. Social Security benefits are best viewed as part of an extended fixed-income portfolio; delaying them can be better than drawing them early and investing the proceeds. The tax torpedo means each additional dollar of income can cause up to 85 cents of Social Security to become taxable, sharply increasing effective marginal tax rates. IRMAA thresholds create very steep penalty cliffs; going even a penny above a threshold can increase Medicare premiums substantially two years later. Software is nearly essential because Roth conversion decisions affect not only current taxes but also future Social Security taxation and Medicare premiums. For wealthy retirees already beyond the tax torpedo, Roth conversions may still be attractive if they help avoid future IRMAA spikes. Younger savers should favor Roth contributions because retirement tax rates may be higher than today and future policy is likely to continue targeting retirement accounts. Asset location should optimize taxes without violating overall allocation targets; in general, taxable accounts are better suited to tax-efficient stock exposure and tax-deferred/Roth accounts can hold more bonds. A lower safe withdrawal rate, around 2.8% to 3%, is more realistic than 4% in today’s low-return environment.

Data Points: Delayed Social Security credit: 8% per year - Rickenstein describes delayed retirement credits as the best fixed-income return available for many retirees. Taxable Social Security threshold for singles: $25,000 and $34,000 - Provisional income thresholds where Social Security benefits begin to be taxed more heavily. Taxable Social Security threshold for married couples: $32,000 and $44,000 - Combined-income thresholds for taxation of Social Security benefits. Taxation range on Social Security benefits: Up to 85% - Once provisional income is high enough, up to 85% of benefits can be taxable. Marginal tax rate effect: 185% of the tax bracket - When another dollar of income causes 85 cents of Social Security benefits to become taxable. Example combined marginal tax rate: 46.25% - Illustrated for a 25% tax bracket where additional income also triggers Social Security taxation. Medicare premium spikes: 5 major IRMAA spikes - Income-based Medicare surcharges create multiple sharp increases in marginal tax rates for higher-income retirees. Example portfolio size for moderate-wealth planning: $2 million or less - Rickenstein uses this as a rough cutoff for a moderate-wealth retiree strategy discussion. Break-even age, claiming at 67 vs 70: About 82.5 years - Approximate age where delayed claiming catches up for a single retiree in his example. Break-even age, claiming at 69 vs 70: About 85 years - Approximate break-even age for waiting one more year. Example monthly benefit at FRA: $2,000 per month - Illustrative benefit used to show how delaying changes real monthly payments. Delayed benefit example: $2,480 per month - Illustrative age-70 benefit after a 24% increase from waiting. Roth conversion/Medicare impact: More than $2,900 - A small income increase can raise future Medicare premiums by over this amount if it crosses an IRMAA threshold. Medicare marginal tax rate illustration: Over 290,000% - Rickenstein uses this to dramatize the penalty of crossing an IRMAA threshold by a penny. Historical stock allocation in retirement funds: 40% or less - He cites target-date retirement funds as commonly recommending lower equity exposure than the 50% used in some withdrawal studies. Safe withdrawal rate estimate: 2.8% to 3% - His estimated safe withdrawal rate in today’s low-return environment. Current nominal Treasury yields: Around 2% to 2.3% - Used to argue fixed-income returns remain low even after recent increases. IRMAA-related income thresholds for singles: $91,000 and $114,000+ - He references much lower single thresholds compared with married thresholds, emphasizing widowhood planning. Qualified charitable distribution age: 70.5 - Age at which QCDs become available for tax-efficient charitable giving. Year Roth IRAs became available: 1997 - He notes Roths are relatively recent and thus not available for most of his retirement career.

Pivotal Quotes: "What you want to do is you want to maximize... how much of that can you spend during your retirement? Well, spending requires after-tax dollars." — William Rickenstein: On why taxes—not just withdrawal rates—should drive retirement income planning. "The best returning fixed income asset right now... is delaying Social Security benefits and getting the 8% delayed retirement credits." — William Rickenstein: On why Social Security should be treated like part of an extended bond allocation. "That strategy, it sounds good. Let's save taxes early. But no... in your earlier years, you're in a 0% or maybe a 10% tax bracket... In the middle years, you're going to be in this 25% with a marginal tax rate of 46.25%." — William Rickenstein: On why taxable-first withdrawal sequencing is often inefficient.

Implications: Retirees should integrate Social Security, taxes, and Medicare into one plan. Delaying claims, using Roth conversions, and avoiding IRMAA cliffs can materially improve after-tax lifetime income, while software or advisor guidance becomes increasingly important.