How Can Retirees Avoid the Tax Bomb in Their Portfolios? with David McClellan

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[164] – Is there a tax bomb hiding inside your retirement portfolio?

In this episode, Jeremy Keil speaks with David McClellan, Partner at Forum Financial Management, about how you can avoid the huge tax bills and Medicare surcharges that some retirees face. They explore how saving in tax-deferred accounts can lead to a growing tax liability in retirement, pushing retirees into higher tax brackets and affecting Medicare means testing. They highlight the importance of good financial planning to manage taxes over one’s lifetime. David also covers the potential tax liability that heirs may inherit from traditional IRAs and strategies to mitigate these tax risks.

Jeremy and David discuss:

  • What the potential tax bomb in retirement portfolios is
  • How tax-deferred accounts can lead to growing tax liability in retirement
  • Why it’s beneficial to smooth out taxes over one’s lifetime
  • How RMDs can snowball and result in large tax bills
  • What Medicare means testing and the “widow tax” are
  • How to minimize tax risks with Roth conversions and asset location
  • And more

How Can Retirees Avoid the Tax Bomb in Their Portfolios?

What is the retirement tax bomb?

The retirement tax bomb is a stealthy financial threat looming over many retirees. Stemming from the correlation between heavy reliance on tax-deferred accounts and the eventual obligation to take required minimum distributions (RMDs), this tax liability snowballs over time.

While the advice to save diligently for retirement in tax-deferred accounts is well-intentioned, the unintended consequence is a growing tax burden in later years. RMDs, initially perceived as manageable in lower tax brackets, could lead to unexpected tax implications and push individuals into significantly higher tax brackets.

Understanding the mechanism behind RMDs and the mathematical snowballing effect from tax-deferred accounts provides a clearer perspective on this lurking issue, emphasizing the critical need for strategic financial planning to balance tax burdens across your lifetime.

While you should project out and calculate your current and future RMDs with a RMD Calculator, what’s helpful is understanding how your RMDs grow over time.

At 73 you’ll be forced to take out roughly 4% of your account balance.
At 80 you’ll be forced to take out roughly 5% of your account balance.
At 84 you’ll be forced to take out roughly 6% of your account balance.
And at 87 you’ll be forced to take out roughly 7% of your account balance.

With the percentage you have to take out each year growing you need to learn how RMDs work and how to avoid the RMD tax bomb.

How to calculate your Required Minimum Distribution RMD

  1. Determine the RMD rules apply to your plan.
  2. Use a worksheet to determine your required minimum distribution.
  3. Look into the idea of Qualified Charitable Distributions as a way to reduce the taxable part of your RMD.
  4. Take out your Required Minimum Distribution RMD by the deadline.
  5. Consider Roth Conversions as a way to lower your future RMDs.

How do RMDs Work Now that Secure Act 2.0 Passed?

What does “Medicare means testing” mean?

‘Medicare means testing’ refers to the income-related Medicare adjustment amounts, signaling a reduction in the government subsidy for Medicare Part B premiums based on your income. The intent is to alleviate fiscal pressures on Medicare by making higher-income retirees pay more for their Medicare premiums.

The potential surge in premiums becomes particularly pertinent for retirees with substantial required minimum distributions (RMDs) or occasional additional income spikes. Even though the income threshold for higher premiums seems high at $194,000 for married filers, it’s a figure that many retirees may encounter due to factors like RMDs or sporadic additional earnings.

Notably, the means testing operates on a two-year look-back period, where premiums for 2023, for instance, are derived from income reported in 2021. This underscores the stealthy nature of the impact, as an action taken in one year only reveals its effect two years later, catching many by surprise.

What is the Widow Tax?

The Widow Tax reflects the financial complexities faced by surviving spouses, primarily centered around the ramifications of transitioning from joint to single-filer tax status upon the death of a partner.

When a spouse passes away, the surviving partner’s financial circumstances notably shift. They are placed in a situation where their income, once calculated within a joint filing framework, is now subject to a single filer’s tax table.

This transition, often coupled with inherited IRAs from the deceased spouse, potentially amplifies the tax burden. This change in tax status and the impact of inherited IRAs, particularly in scenarios where one spouse is significantly older or less healthy, contributes to what’s referred to as the “Widow Tax.”

It underscores the need for prudent planning to mitigate the potential financial burdens faced by surviving partners after the loss of a spouse.

What is the inherited tax liability?

The inherited tax liability is a financial burden that primarily concerns the passing on of tax-deferred accounts to heirs upon the original owner’s passing. The ongoing growth of these accounts, even after required minimum distributions (RMDs), culminates in a significant tax burden for the heirs inheriting the accounts.

Formerly, a ‘stretch IRA’ permitted beneficiaries to draw RMDs based on their own life expectancies, offering extended withdrawal periods. However, recent regulatory changes stipulate a condensed 10-year distribution timeframe, resulting in potentially substantial taxable income for the inheritor.

he consequence is a substantial tax hit during the span of the distribution period, potentially pushing the heirs into higher tax brackets. To circumvent this issue, proactive measures such as strategic planning, like Roth conversions, can mitigate the tax liability for both the original account holder and their kids, offering a more tax-efficient inheritance strategy.

How can I minimize my retirement tax risks?

The most effective approach to minimize tax risks in retirement planning is through a combination of asset location and Roth conversions.

Firstly, utilizing Roth conversions is a strategic tactic. Undertaking conversions in the early stages of retirement, prior to Social Security or RMD income avoids peak earning years. This maneuver helps to alleviate substantial tax burdens on the converted amounts.

It’s important to strategize Roth conversions tailored to your individual circumstances. For those in their earlier career stages, Roth conversions are particularly advantageous, providing more extended periods for tax-free money growth.

Additionally, market conditions play a pivotal role; executing Roth conversions during a bear market becomes a wise move as it reduces the associated tax liability more significantly. However, be careful during peak earning years, as Roth conversions might add to the existing tax burden.

Secondly, asset location, an often underexplored concept, emphasizes placing diverse asset classes into different tax buckets. The aim is to optimize tax efficiency by capitalizing on tax-free growth potential in Roth accounts and reducing growth in tax-deferred accounts. Ideally, high-return assets like stocks are positioned in tax-free Roth accounts, while low-return assets like bonds are allocated to tax-deferred accounts, aiming to manage the tax burden over a lifetime by spreading it across varied tax rates.

Asset location may be challenging to implement but is crucial for optimizing tax efficiency. The focus is on segregating assets based on their expected returns, aiming to curtail the tax burden by smart placement into different tax buckets.

These strategic moves, combined with meticulous planning and timing, offer a proactive approach to address and minimize tax risks throughout the retirement lifecycle.


To learn more about tax planning for retirement and ensuring all your bases are covered, check out the resources below!

If you have any questions, feel free to contact us or our guest, David McClellan, using the contact information provided below!


Connect With David McClellan:

Connect With Jeremy Keil:

About Our Guest:

David McClellan joined Forum Financial Management in 2015. He is a Partner and Financial Advisor at Forum. From his practice in Austin, David focuses on retirement planning and financial life coaching. He loves helping people achieve financial independence and a secure retirement. David is also an executive at AiVante, a machine learning technology firm that is helping the wealth management industry improve planning for client healthcare costs in retirement. David has 30 years of professional experience, primarily in wealth management. He held executive sales, product and strategy roles at Morningstar and Pershing and previously worked as a strategy consultant. He has a Chicago Booth MBA with concentrations in strategy, finance and marketing. He earned a bachelor’s degree with honors in economics and history from the University of Texas at Austin while lettering on the swim team, which won several national championships. He brings the work ethic of a champion swimmer to how he works with clients. David is passionate about creating a safe and limitless future for everyone, a theme running through his volunteer activities. He was a founding parent and trustee of Urban Prairie Waldorf School in Chicago; he mentored entrepreneurs at the 1871 incubator in Chicago; he served as the volunteer event director for Swim Across America Chicago, which raised more than $1 million for cancer research at Rush University Cancer Center; and he served on the board of the Alliance for the Great Lakes. David resides in Austin with his wife, two children and yellow lab. He serves clients nationwide.



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