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The difference tax-free income makes

Income sources are not all created equal from a tax perspective

Income sources are not all created equal from a tax perspective. During retirement, when the bulk of an investor’s cash flow comes from Social Security, pensions, individual retirement account distributions and other savings, the distinctions become even more important.

Investors with a tax-diversified portfolio (comprising assets in taxable, tax-deferred and tax-free accounts) are best positioned to manage cash flow during retirement.

Consider the following example of two couples with the same “pretax” withdrawal amount of $12,000 a month, or $144,000 a year.

Phil and Sylvia have money saved in a variety of accounts. Assume that Phil and Sylvia’s income sources for the first year of retirement look like this: Social Security, $24,000; Phil’s 401(k) plan, $36,000; interest on savings, $3,360; qualifying dividends, $38,664; Roth IRA distribution, $41,976.

Alan and Doris also have money saved in a variety of accounts. Their income sources for the first year of retirement are similar to Phil’s and Sylvia’s: Social Security, $24,000; Alan’s 401(k) plan, $36,000; interest on savings, $3,360; qualifying dividends, $38,664; Doris’ 401(k) plan, $41,976.

Phil and Sylvia were well- positioned for retirement. After taking the standard deduction and personal exemptions (based on 2011 tax law) the amount of income subject to tax is reduced to $78,274. A large portion of that ($38,664) will be taxed at a maximum 15% rate for qualifying dividends or not taxed at all for the portion of qualifying dividends that fall in the lower tax brackets. Taxes on ordinary income will be restricted to the lowest tax brackets.

By contrast, Alan and Doris were not as well-prepared. Their income sources are exactly the same as Phil and Sylvia’s, except for one difference: All of their tax-advantaged retirement savings were in workplace savings plans, so their primary sources of income in retirement — distributions from those plans — will be subject to ordinary income tax. After deductions and exemptions, $120,250 of their income will be taxable.

The cash flow profiles for these couples are remarkably similar. But Phil and Sylvia have one big advantage — access to tax-free income from a Roth IRA. This allows them to manage cash flow in a more tax-efficient way when they need to the most — in retirement. Of course, to get this flexibility in retirement, they had to pay taxes on the amounts contributed (or converted) to the Roth IRA during their working years.

First, an important clarification — the “effective tax rate” referred to in this example represents federal taxes due as a percentage of the total cash flow received by each household. This differs from the common definition of the term, which is the total tax bill as a percentage of the taxpayer’s adjusted gross income.

Under current tax law, up to about the first $20,000 of income is exempt from taxation for a married couple who file jointly, and claim the standard deduction and two personal exemptions. Both couples we’ve studied have the same gross cash flow but substantially different AGIs, which affects both the amount subject to ordinary tax rates and the rates that apply to the qualified dividends. As a result, their taxable income — and subsequently their effective tax rates — are substantially different.

HARD NUMBERS

Alan and Doris face a total tax bill of $18,446. Phil and Sylvia — the couple that implemented a tax- efficient strategy — owe $7,278 in federal income tax. Phil and Sylvia are paying approximately $600 per month in taxes, or the equivalent of a 5% tax rate on their gross cash flow. Alan and Doris pay closer to $1,500 per month in taxes, which amounts to a 12.8% tax rate on their gross cash flow received.

Why such a significant difference? Phil and Sylvia can draw a large portion of their income from non-taxable sources; Alan and Doris cannot.

In this example, the source of tax-free income was a Roth IRA. Other sources of non-taxable income in retirement could include loans or surrenders of life insurance cash value; distributions from tax-paid assets such as interest from municipal bonds, savings accounts or recently sold assets; or non-taxable distributions such as the portion of proceeds from an installment sale that represents a nontaxable return of basis.

Investors shouldn’t wait until retirement to start tax planning; by then, their options are limited. Financial advisers who discuss tax strategies with their clients who are still in their working years — and help them structure a portfolio accordingly — provide a valuable and often overlooked service.

Craig Brimhall is vice president of retirement wealth strategies at Ameriprise Financial Inc.