Tax Management in Traditional Retirement (Phase 3)

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

Quick summary so far:

Today, we’ll look at “Traditional Retirement” or Phase 3 in more detail. Reminder of the phases:

I’ll eventually follow this up with Part 4, looking at a few scenarios and how it can all work in practice. If you have any particular scenarios you think I should model, I’d welcome your input in the comments – I’ll definitely do one that roughly matches my situation (move to the UK in mid-career, so balancing both US and UK retirement accounts), but happy to do a few more that might help my readers!

Phase 3: Traditional Retirement

Phase 3 is retirement for the masses, as well as those who retired early. You already have access to all your retirement accounts in Phase 2, and now you start picking up income streams. On one hand, this is great – more money, and it’s mostly guaranteed money (State Pension and Social Security), so your chances of running completely out of money drop to zero, although you could still run out of savings and be eating cat food on the monthly payments…hopefully not! On the other hand, the fact that you now have income that you can’t control once you start receiving it means that your tax situation can become more challenging.

Here’s what you’re likely dealing with:

  • Age 62 to 70: US Social Security – you get to pick when you start taking this, and that’s a complicated subject all on it’s own. My post on Estimating Social Security can help you get started.
  • Age 65: HSA for non-health expenses – this is conceptually a better fit in Phase 2, since it’s basically a Traditional IRA at this point, but the age cutoff is after the earliest Social Security option.
  • Age 65-68ish: UK State Pension (you can check your specific age on gov.uk) – you don’t get to pick as much as Social Security, although you can delay it if you want
  • Age 72: Required Minimum Distributions from your Traditional 401k/IRA/etc.
  • Age 75: Final Lifetime Allowance Benefits Crystallisation Event (BCE) in your UK workplace pension or SIPP

Three main objectives for Phase 3, carrying on from Phase 2 or even if you start retirement in Phase 3:

  1. Ensure you have enough money plus income from Social Security and/or State Pension to last the rest of your life
  2. Execute your plan for Phase 3, managing your tax liabilities and planning for the future. Three key considerations:
    • Required Minimum Distributions
    • Lifetime Allowance penalties
    • Estate planning
  3. Continue enjoying retirement!

The universe of accounts doesn’t change a whole lot in Phase 3, but now we’ve got everything on the chart that we ever will:

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

And we’d still rather not pay more tax than we have to along the way!

If you retired significantly before Phase 3, you’ve handled any sequence of returns risks – they might even be decades in the past. Hopefully your Safe Withdrawal Rate and withdrawal planning have stood the test of time, and you’ve still got a comfortable nest egg to carry you through Phase 3, bolstered by State Pension and Social Security. Very likely, at least based on most past returns, you have significantly more money than you started with.

You now also have a pretty good idea of how much you’ll be getting from your State Pension and Social Security, and have decided when you’ll start drawing Social Security. Any changes to these plans now are likely tweaks around the edges – how do they change with inflation, does the UK triple lock survive, etc. But you aren’t in the situation you might be at age 25, wondering if the programs will even survive long enough for you to get anything.

You’ve probably also got a pretty good idea of how much you spend in retirement. Sure, your spending will continue to change over time – a 92 year old is probably spending differently from a 62 year old – but most of these are likely to be reductions, not increases in spending. The big caveat there is nursing home care, which you may need to plan for specifically, depending on your health and family situation and if the Government ever finds a way to address the issue.

Knowing the State Pension and Social Security pieces plus your spending so far in retirement, it’s worth reviewing your withdrawal planning again. If things have gone well, you might choose some one-off expenses (renew your wedding vows somewhere tropical? Pay for grandchildren’s university or house deposit?), increases in your spending, or start putting a gifting strategy in place. If things are more challenging, you can adjust as needed, incorporating your new income streams.

And once you know how much you need to withdraw, you’ll want to figure out how to fill your tax-free and lower tax buckets. The strategy changes a bit compared to Phase 2 though, because now you have these income streams.

Starting with UK taxes:

  • Personal Allowance (£12,570 per person – all numbers are for 2021).
    • First off, you don’t get any choice to fill some or all of this:
      • State Pension: about £9,500 a year if you have the full 35 qualifying years, reduced proportionately if less.
      • Social Security: the amount will depend on your number of years and Social Security income history and could vary significantly. For most people who left the US in mid-career (say 10-20 years of earning history), you’re looking at something close to or more than $10,000 a year – call it £7,000+.
      • Required Minimum Distributions: These will also vary massively, and might only start a decade after you start getting Social Security, if you start as early as possible. But these can be very significant – for illustration, on a £100k Traditional balance, they start at £3,906 at age 72, and climb with age.
      • Put those three together, and you can easily have filled your Personal Allowance, so that anything above it is taxable. You might even get pushed into the 20% bracket just from these three.
  • Capital Gains, Dividends, & Interest don’t really change from Phase 2, but as a reminder:
    • 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, so you 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.
    • 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.
  • If you’re still in need of more money for spending once you’ve accepted State Pension, Social Security, and RMDs, plus taken advantage of capital gains and any other tax free buckets, you’re into the realm of paying tax on income, capital gains, and/or dividends, or drawing from tax-free accounts like ISAs and Roth IRA. If you’ve been doing Roth conversions through Phases 1 and 2, your Roth IRA may be quite a healthy balance, allowing you to minimize income that spills over the tax-free buckets.
    • It’s not really possible to give generic guidance at this point – you’ll need to weigh up what is important to you and what options you have based on your investments.
    • This also ties into your estate planning – you may not want to draw from your UK Pension because it’s excluded from your estate, for example.

And then thinking about US taxes:

  • Standard Deduction ($24,800 for married filing jointly). Much like the UK, this will get filled up somewhat by State Pension and RMDs (not by Social Security, at least – the US/UK tax treaty gives only the UK the right to tax Social Security as long as you’re resident in the UK). Depending on the size of your Traditional balance and your taxable income situation, you might consider continuing Roth conversions, or you might have more than enough! At this point, Roth conversions aren’t helping you get money early, but you’re choosing to have the conversions taxed only by the US, instead of Traditional withdrawals or RMDs that get taxed first by the UK, usually at a higher rate. You can also fill this from tax deferred accounts, like UK pension or US 401k.
  • Capital Gains 0% rate ($80,000, but wage income counts against it as well as capital gains). No change here from Phase 2 – it’s the 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 Social Security, State Pension, RMDs, and/or 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.
  • Just like the UK, you may find that your tax-free buckets are overflowing, so you’ll need to consider whether you need more money for spending, and if so whether you’ll accept paying some taxes on it or draw from your Roth IRA tax-free.

Goal 2: Execute Your Phase 3 Plan

In Phase 2, you should have made a plan for Phase 3 and done what you could to prepare. This would include how you’re going to manage Required Minimum Distributions, Lifetime Allowance and any penalties there, and estate planning. As you enter Phase 3, it’s a good idea to see how you’ve done preparing and put in place any modifications.

This part does get really specific to individual situations – some people may have RMDs that are more than enough to pay for all their spending and then some. Others may not being worried about RMDs but are pushing to avoid Lifetime Allowance penalties from taking too big of a bite. And estate planning is very personal – are you making gifts now, trying to preserve a legacy, donating to charities, and so on.

If you want to modify that plan based on how Phase 2 actually turned out, that’s fine, just update your plan, check how it affects your taxes, and put it on autopilot.

Goal 3: Continue Enjoying Retirement

Hopefully, you’re in a pretty comfortable place now. You’ve got access to all your money, you’re collecting your State Pension/Social Security, and can pretty much put your finances on autopilot. The more you can keep things simple, the better – at some point, you may need help with your finances, so if a spouse, child, or other trusted person can make sense of your plan instead of it only working in your head, all the better!

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