Take a fairly straightforward case like that of John and Jane Taxpayer, both age 71. John receives $25,000 per year from Social Security, $20,000 per year from a pension, and has a $20,000 required minimum distribution from his IRA. Jane receives $12,000 in Social Security. They also receive $5,000 in taxable interest and $6,000 in qualified dividends. Taking the standard deduction and exemptions, this couple will owe roughly $6,900 in federal income tax, leaving $81,100 to spend from $88,000 in receipts. We'll assume that barely covers their expenses.
John dies. Now, assume a 100% survivor benefit on John's pension and maintain the interest and dividends at the exact same level. Again keeping it simple and, since John and Jane were the same age, I will leave the RMD at $20,000. Leaving only the change to Social Security. Together they received $37,000, but now Jane gets the larger of her benefit or John's, so her checks will now total $25,000. Thus, Jane's gross receipts are reduced by $12,000 to $76,000.
Due to the compression of the tax brackets when one goes from married filing jointly to single-filer status, Jane will owe about $10,800 in federal taxes, leaving only $65,200 to spend. That's almost a 20% "pay cut." Her income went down $12,000 yet her taxes went up almost $4,000.
To cover her $81,100 in expenses, she needs another $15,900 from her portfolio. Taking the money from the IRA incurs ordinary income. Sitting squarely in the 25% tax bracket, an additional $21,200 would cover the $15,900 needed. So, looking at it strictly from the perspective of the IRA account, in an instant, the demands on the IRA more than doubles.
Taking the money from non-IRA assets is certainly less expensive from a tax perspective; however, drawing cash from these assets may reduce interest and dividend income in future years. Of course, whether tapping these taxable assets is terribly problematic depends on the particular holdings. Nonetheless, prior to John's death, we have no need to liquidate those holdings but after John's death, up to $15,900 could be required.
An assumption of $11,000 in interest and dividends suggests non-IRA assets of some size. Jane is fortunate to have these assets because a dollar in an IRA isn't worth as much as a dollar outside an IRA to a retiree. For instance, if we use all the same assumptions outlined above but we assume Jane has no assets outside of the IRA available to her, there is even more pressure to produce cash flow on the IRA.
As a married couple, if you replace the $11,000 in interest and dividends by increasing the IRA withdrawal to $31,000, the couple falls about $1,000 short of the $81,100 threshold. Gross receipts of $88,000-$7,929 tax = $80,071. This is due to the more favorable rate applied to the qualified dividends in the prior example.
Upon John's death however, to meet the spendable cash amount of the prior paragraph, about an additional $20,000 is needed. This brings the gross receipts to $97,000 and the tax bill to $16,706 netting $80,294. $20,000 more from the IRA increases the tax by $8,777 for an effective rate of nearly 44% on that IRA withdrawal. The culprit is more taxable Social Security and a higher marginal rate.
Even the simple situation I just described is hardly simple. I think these examples show that there is little fixed about a retirees spendable receipts even if much of their income is "fixed." Of course, demands on the portfolio are driven by a client's cash flow needs which are affected by expenses that often change too. I'll leave that for a future column perhaps.
Dan Moisand, CFP, has been featured as one of the America's top independent financial advisors by most leading financial advisor publications. He has spoken to advisor groups on five continents on topics such as managing investments and navigating tax complexities for retirees, retirement readiness, and most topics relating to the development of the financial planning profession. He practices in Melbourne, Fla. You can reach him at (321) 253-5400 or [email protected].