An old proverb says that little leaks sink the ship. Icebergs get all the headlines but most ships lying on the seafloor didn’t hit an iceberg. While paying more taxes than necessary might not sink your retirement, it can impact how long your money lasts.
Nobody thinks they are paying more in taxes than necessary, but I have witnessed mistakes that changed retiree’s lifestyles. A $3,000 mistake for eight years straight adds up to much more than $24,000 when you include lost gains and dividends on that surplus tax paid. The problem with taxes is you can pay more than required and have no idea. Like carbon monoxide, taxes are odorless and invisible. There is no red flag on your tax return that notifies you that you paid more than you could have.
According to a national survey by Nationwide 38% of future retirees agree with the statement, “I am terrified of what taxes will do to my retirement income.” But, according to the same study 38% of people rarely consider the taxes they are paying or will pay. About half (46%) said they know how to leverage taxable, tax-deferred, and tax-free accounts.
Some retirees fail to understand that the retirement distribution game – spending assets in retirement – is much different than the accumulation game when you’re saving for retirement. As you move through retirement, you’re in an entirely different phase when it comes to taxes. And the distribution phase has new, strange rules that can catch people off-guard.
Many aspects of retirement affect your tax bill in ways different from your working years. At some point, you’ll start taking Social Security. And sooner or later, when you reach age 72, you’ll be forced to take required minimum distributions (RMDs) from your retirement accounts. Those distributions are all taxable. Don’t let your hand be forced so you pay the wrong amount at the wrong time. The interaction of capital gains, Social Security and RMDs can have surprising consequences for the unsuspecting.
The Social Security Tax Torpedo
Bill (name changed to protect the embarrassed) was surprised by paying 40.7% on a small IRA withdrawal. Bill was in his second year of social security benefits and his only other income was withdrawals from his IRA. In December Bill took out an extra $1,000 from his IRA for a trip he’d dreamed of for decades. He didn’t pass it by his advisor ahead of time because he thought it was all straightforward.
Bill was solidly in the middle of the 22% tax bracket, yet this $1,000 distribution cost him $407 in taxes. That is a 40.7% tax rate while the highest tax bracket is 35% and his income was $350,000 below that bracket. When this was pointed out to Bill the following spring, he was shocked.
Bill understood that some of his social security is taxed and some is not. What he didn’t understand was that the more income, other than social security, that he has, the more of his social security becomes taxable. Bill’s provisional income -a term used in the formula that determines how much of your social security benefit is taxed - was at a point where for every additional $1 in income, $.85 more of his social security benefit also moved from the non-taxed column to the taxed column. Bill paid $220 in regular tax on his $1,000 IRA distribution, as he expected, but then also owed an additional $187 on the added $850 of his social security benefit that was dragged over to the taxable column because his provisional income increased by $1,000. If Bill had chosen to take the $1,000 from another account, he could have avoided this additional leak.
Filling Up the Tax Bracket Method
Another important choice is which accounts you draw from first and which you leave to grow for later in retirement. What is the best order? Most people think “first take the after-tax money in the bank, then take the tax-deferred IRA money, and then take the tax-free Roth IRA money." This is conventional wisdom. It’s a good plan, but conventional wisdom isn’t always the best approach.
A little tweak to this conventional wisdom can add up over a lifetime. We call it the filling up the bracket method. First, use the taxable bank money for expenses as the conventional wisdom says. But, during the same period, also accelerate IRA distributions in lower-tax brackets, putting that money into Roth accounts where it will grow tax-free.
IRAs, 401(k)s, 403(b)s and deferred compensation plans have invisible tax liabilities tied to them. Our tax system is a pay now or pay later puzzle when it comes to these accounts. Depending on your situation, you might gain as much as an extra year of life from your savings.
If you look at the tax brackets, immediately following the 12% tax bracket comes the 22% bracket. That is a big bump and one of three changes that could be used to your advantage. For instance, if your lifestyle has you $20,000 below the top of the 12% bracket then you may have an opportunity to save taxes in the long run by paying more tax now.
Many people with large IRAs are forced into the highest tax rate of their lives in their 80s due to the required minimum distribution rules. If for ten years early in retirement, you convert enough of the IRA into a Roth to top-off the lower tax bracket you could be avoiding a lot of extra tax later when you will be forced to distribute it at a higher tax rate. The thing many people don’t realize about required minimum distributions is the portion you are forced to take out – and pay tax on - increases each year. It starts out small but steadily grows. This technique of paying more tax now to avoid paying even more later can add up to a lot of avoided tax over a retirement.
The big takeaway here is that you’ve got to plan all the way through retirement, especially around how you handle your tax-deferred savings. Watch out for those small leaks. It can be costly to leave taxes to chance. Tax planning can have an impact on your lifestyle and how long your money lasts.
And, of course, see your tax professional for tax advice.
Written By: Doug Gjerde
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