The Tax-Efficient University Retirement

Despite the complexities surrounding taxes and retirement, there are methods to appropriately align your tax requirements with your future needs. For professors on the path to retirement, opportunities abound to tax-efficiently build a successful foundation for the rest of their lives. Use this article as a checklist and speak with your adviser about implementing strategies you are not currently using.

1) Fill Up Lower Tax Brackets

Imagine pulling up to a gas station and finding out that on this particular day, the gas is $1 per gallon. Would you pump one gallon, pay the dollar, and leave? Of course not! You’d fill it up to the brim, go home, switch cars, and fill that one up too. This sounds obvious, but people rarely follow the same logic when it comes to filling up their tax brackets.

Academics in their 60s, especially those in higher tax brackets, have a unique window of time to control their income sources and create substantial tax savings. This is especially attractive if you retire before age 70 and salary is out of the picture. Filling up low tax brackets can help set you up for tax savings that will last the rest of your life. Start by projecting your income at age 70 and beyond. At this age, Social Security has reached its maximum benefit and Required Minimum Distributions begin shortly thereafter at age 72. By determining what your future bracket looks like, you can make an informed decision to fill up any relatively low brackets now. Once you know how much room you have, there are many advantageous ways to change your income. One of the unique advantages of being in academia is the option to participate in supplemental retirement saving plans (403(b) and 457) that have higher contribution limits than IRAs. Roth contributions may be available to you as well.

2) Avoid Shadow Tax Brackets

It’s year-end and you decide to pull $10,000 out of your retirement account for gifts and a vacation, or you decide to take a lucrative consulting job that year. How much should this cost you in taxes? If you were in the 22% tax bracket, you would think it would be $2,200. However, some retirees in a modest tax bracket could pay as much as 55% on that distribution, even though the top tax bracket is 37%. How is this possible? Millions of academic retirees with six-figure incomes fall prey to what may be called “Shadow Tax Brackets.”

The tax code is wildly complex. Retirees usually have income like Social Security, capital gains, and qualified dividends that are subject to complex phase-ins and alternate rate structures. At the low end of the income spectrum, these income sources are tax-free. As income increases, more and more become taxable, creating a cascading effect. Retirees often also have deductions like health care expenses that are subject to income-based limitations. Additionally, Medicare premiums increase with your income, acting as another layer of tax. All those dynamic sliding scales can create effective tax rates that are much higher than the stated rate. Carefully plan and design your income to avoid these Shadow Tax brackets whenever possible. 

3) Diversify Your Tax “Buckets”

The different “buckets” in which you hold assets like taxable accounts and retirement accounts each have their own unique tax considerations. For instance, the bucket in which you buy stocks will have a direct result on the after-tax return you receive. In the industry, we call this strategy Asset Location.

Myriad factors incentivize us to hold stocks in taxable accounts and ordinary-income producing assets, like bonds or TIAA Traditional, in tax-deferred accounts. Many stocks pay qualified dividends, which are taxed at lower rates than ordinary income. The price appreciation you receive on your stocks is only taxable upon sale and subject to the same favorable rates as qualified dividends. You control the timing of when this capital gain income is recognized. Capital gains can be donated to a charity or passed down to your family at death, effectively eliminating the taxable gain. Additionally, taxable gains can be offset by taxable losses via a tax-loss harvesting strategy.

By holding bonds and TIAA Traditional in tax-deferred accounts, like retirement accounts, the ordinary income they produce is shielded from tax. Bonds have a lower expected return profile, which leads to relatively lower growth in retirement accounts and subsequently lower Required Minimum Distributions in the future.

4) Patience is Rewarding

You have options when it comes to claiming Social Security. The majority of benefits are claimed as soon as they become available, while only 4% of people wait until age 70.

Deferring Social Security can increase your benefits by about 8% per year, giving a big boost to your overall retirement cash flow. The patient few may also receive enhanced tax-free benefits: in that period between retirement and age 70, you may be able to strategically recognize hundreds of thousands of dollars in income with little or no taxes. Roth IRA conversions may reduce future taxes via lower RMDs and provide a powerful mechanism to pass tax-free wealth to the next generation. Others may sell appreciated assets and fill up the 0% capital gains bracket as they decrease risk in their portfolio.

Many academics choose not to fully retire, through phased retirement plans or other income-producing activities, and end up working past age 72. In this case, RMDs can be postponed until full retirement is achieved. Consider rolling your assets into a university plan to provide hefty tax savings. With the bulk of your nest egg in the university benefits plan, you won’t have to pull a single dollar out while you are still working.

5) The Modern Era of Charitable Giving

With the 2017 modifications to itemized deductions, millions of Americans are no longer getting the benefit of a tax deduction for the generous donations they make. However, tax benefits are still available to those who carefully curate a charitable giving plan.

To increase the tax benefit of charitable giving, consider lumping multiple years’ worth of contributions into a single donation to ensure your itemized deductions exceed your standard deduction. Further enhance this advantage by donating appreciated assets to a Donor Advised Fund (DAF). Contributions can be made with an upfront tax deduction, while you maintain control of the charitable distributions over time. Funding the DAF with appreciated assets also removes capital gains from your portfolio that would otherwise be taxed.

Another relatively new charitable strategy is the Qualified Charitable Distribution (QCD), though only available to those aged 70½ or older. Instead of writing a check to a charity, the QCD allows you to distribute cash directly out of your IRA to a charity and have it count against your Required Minimum Distribution. The QCD is excluded from income, and you still receive the full benefit of the contribution, regardless of itemization. This may also have an added benefit by reducing your Adjusted Gross Income, which can result in lower Medicare surtax or lower Medicare IRMAA premiums. QCDs are only allowed through IRAs, not university retirement plans, so talk to your advisor about effective strategies to move assets into an IRA for tax-efficient gifting purposes. 

6) Schedule C for Consulting

Many university professionals have side income from consulting work, book royalties, and other forms of self-employment. All income, business expenses, and write-offs related to this work are recorded on a Schedule C. Be sure to stay up-to-date on your expenses and keep detailed records of transactions. These expenses may even reduce your Social Security and Medicare tax, paid via the self-employment tax.

You may wish to lean more heavily on consulting work after officially retiring from the university, in which case you’ll need to look back on past transactions to determine the most tax-efficient times to make certain moves. For example, take as many deductions as you can in the years you anticipate being subject to the highest tax rate and forgo expenditures when you don’t need the deduction. You can also play around with your billing and invoice cycle to receive income (and be subject to income taxes) at an advantaged time.

Self-employed academics may also wish to consider health insurance premium deductions (if unable to continue with the university group plan), using charitable contributions as business expenses, and determining their liability under the Alternative Minimum Tax (AMT). There are also unique opportunities to defer self-employment income such as a SEP IRA that go above and beyond the annual limits in your university retirement plans.

There are many strategies to consider here. End the year confident in your financial plan by speaking with your advisor to determine which options best suit you. 

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