Tax Management in Middle Retirement (Phase 2)

This is Part 3b of our Retirement Withdrawal Strategies series.

Quick summary so far:

Today, we’ll look at “Middle Retirement” or Phase 2 in more detail. Reminder of the phases:

We’ll follow this up with Part 3c on Traditional Retirement (Phase 3), and finally Part 4 looking at a few scenarios and how it can all work in practice.

Phase 2: Middle Retirement

If you’ve made it to Phase 2, you’ve survived Phase 1, with some amount of money left (even if you’re just skidding into it by the skin of your teeth!). That’s ok, because Phase 2 is where you get access to the rest of your money:

  • Age 55: UK Pensions & SIPPs (there’s an ongoing conversation about changing this to age 57, it’s not clear yet if existing plans will be grandfathered in)
  • Age 59.5: All US retirement accounts – Traditional and Roth, 401(k), 403(b), TSP, IRA, etc.
  • Age 60: UK Lifetime ISA
  • Age 65: HSA for non-health expenses
    • This is probably in Phase 3, but conceptually fits here. I won’t go into any detail – it’s basically the same idea as a Traditional IRA unless you can use it for health expenses (even carried forward from previous years/decades!), in which case it’s more like a Roth IRA.

Three main objectives for Phase 2, carrying on from Phase 1:

  1. Ensure you have enough money to last the rest of your life without paying too much in taxes, with the boost from Social Security and/or State Pension in Phase 3.
  2. Continue setting yourself up for success in Phase 3. Three key considerations:
    • Required Minimum Distributions
    • Lifetime Allowance penalties
    • Estate planning
  3. Continue enjoying retirement!

Now that we’ve got access to all this money, with a wide variety of tax treatments, the considerations get somewhat more complicated – the “new” accounts in Phase 2 are in bold

Goal 1: Don’t Run Out of Money Before You Die

And try not to pay any more tax than you have to, along the way!

By Phase 2, you’ve likely weathered any sequence of returns risks – if you’re unlucky, your portfolio may be somewhat diminished from the beginning of Phase 1, but as long as you’ve had a sensible Safe Withdrawal Rate and maybe adjusted spending a bit, you should be ok (barring an unprecedented market collapse). If you’re more typically lucky, you’ve come out with more money than you started.

Either way, this is a good time to revisit your withdrawal plans and incorporate any updates in your plan moving forward. Maybe you’re comfortable increasing spending a bit. Maybe you’re getting a better picture of your life expectancy in light of any health issues that may or (hopefully!) may not be appearing. Maybe you want to start gifting to children or grandchildren, while they’re still young enough that it makes a big difference to their lives. And so on – it’s your call.

Once you’ve reviewed and adjusted your spending needs, if necessary, you want to start thinking about how to fill your tax-free and lower tax buckets to provide for that spending.

Starting with UK taxes:

  • Personal Allowance (£12,570 per person – all numbers are for 2021). Fill this from your tax deferred accounts:
    • US Traditional balances (IRA, 401(k), etc.)
    • UK Employer Pension/SIPP – you get to withdraw 25% tax free without counting against your Personal Allowance, so you can actually withdraw up to £16,760 if you don’t have any other wage income before you pay tax.
    • We’ll talk about which of these you want to focus on in Goal #2 – it’s all about RMDs and Lifetime Allowance – you may wind up not using much of this at all, depending on your Traditional vs Pension split.
  • Capital Gains Annual Exempt Amount (£12,300 per person). This is all from your taxable brokerage/general investment account, plus an HSA if you have one (just a taxable account to HMRC). It makes sense to fill this exemption even if you don’t need the money – capital gains harvesting, sell one investment, buy another one slightly different, and your basis increases without paying any tax.
    • Caveat: be careful of your US capital gains tax as well! You could wind up in the 15% US capital gains bracket while still under the UK annual exempt amount, especially if you have a lot of Roth conversions.
  • There are also tax-free buckets for savings interest (up to £6,000) and dividends (£2,000). These are a bit harder to manage proactively, since you’re just getting paid interest and dividends on your holdings in a taxable account, but worth considering.

And then thinking about US taxes:

  • Standard Deduction ($24,800 for married filing jointly). You can fill this from tax deferred accounts, similarly to the UK (although 100% of your UK pension will be taxable). But, you can also use Roth conversions here, which are probably not UK taxable. If you have a significant Traditional balance, you’ll probably want to focus on Roth conversions over Traditional balances, and then take out the conversions US & UK tax free after 5 years.
  • Capital Gains 0% rate ($80,000, but wage income counts against it as well as capital gains). Same idea as UK, but also need to add in any capital gains or qualified dividends in your ISA, since the US considers those as simply standard taxable accounts.
    • You can harvest capital gains in your ISA that won’t show up on your UK taxes at all, and can take advantage of the potentially larger US 0% rate. However, if you’ve got lots of Roth conversions as well, that may not leave much space.
  • The US doesn’t have a different bucket for interest and ordinary dividends, they just get taxed like wage income.

Let’s look at Goal 2 before deciding how to fill the buckets.

Goal 2: Set Up for Success

Hopefully, you’re already well on your way to managing Required Minimum Distributions, but it’s worth rechecking how you’re doing. If you’ve had more growth in your Traditional balances than you were projecting, there may be a need to readjust. Conversely, if you’ve suffered with less growth than you hoped for, there’s a small silver lining that it helps with RMDs.

You’re now also in a position to do something more active about the Lifetime Allowance for your UK Pension/SIPP, beyond just “don’t contribute so much” and “put your bond allocation here (or in a Traditional balance).” Basically, if you start to withdraw aggressively from your pension as soon as you can, you can reduce the growth of your pension and avoid going over the LTA, or at least reducing how much you go over, and thus how much attracts the 25% penalty.

There are three main drawbacks:

  1. You have to pay taxes on your pension withdrawals. Typically, 75% of the withdrawal will be UK taxable and 100% is US taxable. Very roughly, Foreign Tax Credits will usually mean the UK tax on the 75% offsets the US tax so you only owe HMRC, not the IRS. If you withdraw aggressively, it’s not hard to get into the UK 20% or even 40% brackets. Paying 40% now to escape 25% penalty and 20% income tax later is a wash at best.
  2. There are downsides to wherever you move the money you don’t spend – you can put £20k a year in an ISA, but it’ll need to be individual stocks to avoid PFIC pain, plus it’s US taxable. Your only real option is a fully taxable account, so you lose the tax deferral of the pension.
  3. Your pension isn’t part of your estate when you die, so it isn’t subject to inheritance tax. Anywhere you move that money to will be part of your estate, so could be taxed at 40% on your death. Not a big deal if you’re not expecting to leave much to your heirs, but if you’ve been fortunate and expect to have a sizable portfolio at death, it’s worth considering leaving as much of it as possible in your pension.

There’s no single clear answer on how to approach RMDs vs the LTA, but you should consider them both and come up with a plan that makes sense for you. It might be a balance of Roth conversions and pension withdrawals, might be a focus on one or the other, or you might realize that neither RMDs nor the LTA are a big deal for your particular situation – those are all valid options.

The other thing to consider here is revisiting your estate planning. Have a will up to date, start considering any gifting strategies, that kind of thing. If you’ve got a complicated situation with accounts in two countries, it’s probably worth consulting a professional, even if it’s just a one-off review, get wills and such signed, etc.

Goal 3: Continue Enjoying Retirement

You’ve now got access to all your hard-earned money, you can spend according to your plan and hopefully put most of your finances on autopilot. You’ll just need a bit of attention for withdrawals, Roth conversions, that kind of thing – hopefully something you can do with a cup of tea once a month.

Transition to Phase 3

You get to pick when you move from Phase 2 to Phase 3 – it could be anywhere as soon as 62 to as late as 70, depending when you choose to start Social Security payments. State Pension can’t be brought earlier than your State Pension age (probably between 66 and 68 for anybody reading this, may well get delayed further for some of the younger readers). The calculations can get pretty detailed – might be something I look at in a future post – but in general, the longer you wait, the more you get paid every month, but the fewer months you have remaining.

You might want to take a stab at planning out Phase 3 at the same time you revisit your plans for Phase 2, probably sometime before you get access to your pension (maybe around age 54 or 56, if you get access at 55 or 57). You’ll know your working history and can get a good idea of your Social Security and State Pension payments. We’ll talk through it in the next part, covering Traditional Retirement.

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