Episode #9: Rules Gone Awry – A Lower Tax Bracket Part 1

Episode #9: Rules Gone Awry – A Lower Tax Bracket Part 1

The Smart Take:

Let’s continue our series on breaking down some of the retirement “rules” that have gone awry. This week, we’ll begin a two-part series on the retirement rule that you should plan to be in a lower tax bracket in retirement. Is that really true?

Listen below or through your favorite podcast service to find out. Prefer to read? No problem, show transcription is below too.

Read the Kevin’s original article about the Modest Millers by clicking here.

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The Host:

Kevin Kroskey – AboutContact

Speaker 1:           Welcome to Retire Smarter with Kevin Kroskey. Find answers to your toughest questions, and get educated about the financial world. It’s time to retire smarter.

Walter Storholt:                Thanks for joining us for another edition of Retire Smarter. I’m Walter Storholt alongside Kevin Kroskey. He is the President and wealth advisor of True Wealth Design in Northeast Ohio with offices in Akron and Canfield. You can find us online and listen to past episodes of the podcast by going to truewealthdesign.com. That’s truewealthdesign.com. You can even click the “Are We Right For You” button to schedule your 15 minute call with an experienced financial advisor on the True Wealth team if you’d like. That’s truewealthdesign.com.

Walter Storholt:                Excited for today’s program. Kevin, thanks so much for taking some time out to join us. How are you sir?

Kevin Kroskey:  I’m good Walter. I’m a little bit under the weather. I’m drinking my hot tea here to try to get my voice in shape, but we will do our best and we will talk some taxes today.

Walter Storholt:                Make sure you add some honey, that’s the old broadcaster secret. A little bit of honey in the tea will have you up and running in no time.

Kevin Kroskey:  I was not aware. I put cream in there. I know if you put, well actually I guess it’s lemon that will make you curl, so good to know for future reference.

Walter Storholt:                There you go. When I was in broadcasting school my big thing was milk. My nickname growing up was The Milkman when I played peewee football. I’ve just always been a big milk drinker. In broadcasting school one of my professors, he just could not believe it because he always taught his students never drink milk if you’re a broadcaster. Don’t do it. Don’t do it to try and soothe your throat. It’s like the worst thing for you. It apparently is just not good for your throat, but I’ve just always had milk and it’s always served me well. Maybe your creamer is not that big of a faux pas, although I think my old broadcast teacher would probably beg to differ.

Kevin Kroskey:  My lactose intolerant wife would agree with him for different reasons.

Walter Storholt:                There you go. Yes. What’s up with milk getting all of this abuse from all sides these days? I don’t understand it. We’ve got a great programming on the way today. We’re going to talk about things other than tea and milk and all those kinds of things. We’re going to talk, as we kind of continue our series here, on different retirement rules gone awry. Today’s is such a big and important topic Kevin that we’re actually going to do two podcasts on this particular topic. It’s this retirement rule that’s gone awry that says you really need to plan to be in a lower tax bracket in retirement. The findings that you’ve kind of discovered over the years of doing this and helping people plan for retirement is that that’s not always going to be the case for everybody that comes through the door. There’s going to be two sides to this story.

Kevin Kroskey:  For sure. If you think about any rule or any average, an average is just that. Basically you can say it’s going to be half right and half wrong, it’s right in the middle. Whether or not the rule or the average applies to you, usually is only by chance. We always believe in doing the math, running the numbers, taking a look at it, and then using that to make an informed decision about what we can do to make our situation better. As it goes to taxes, the traditional rule is hey I’m going to be in a lower bracket in retirement and that’s true for some people, so I’ll kind of give the rule some credit and it may be truer than a lot of other rules that we’ve gone over in prior episodes, but for a lot of people it isn’t and there’s also some kind of gotchas if you will that retirees particularly need to be mindful about.

Walter Storholt:                All right, well take us through the landscape and what we need to know as we first begin evaluating this conversation.

Kevin Kroskey:  Yeah, sure thing. It can get pretty complicated, but let me just try to keep it simple and effective if you will. A basic concept that I just want everybody to keep in mind is any time that you can pay a lower tax rate today versus what you pay in the future, or what you would otherwise pay in the future, you should do that. That’s a good trade. That’s really the gist of a lot of tax planning. For instance, hey do I put money into my 401K and get a tax deduction or do I pay the tax and put the money in a Roth. Well again it depends on hey what’s my rate today versus what’s the rate that I would pull out down the road in the future.

Kevin Kroskey:  Another thing is that whenever you think of taxes and you’re arriving at your tax rate you have to remember it’s not your gross income that you pay tax on, it’s not your adjusted gross income, it’s your taxable income. If you ever look at your 1040 it’s about halfway down on page two of the 1040. You have your gross income, you’re going to have maybe some adjustments to it, and then you’re going to have some deductions, well it used to be personal exemptions, actually don’t have those anymore in 2018, but at minimum if you’re a married couple filing joint you get $24,000 off the top. Just do some simple math real quick.

Kevin Kroskey:  Suppose you have $100,000 of gross income. That’s income from working, or pensions, or taxable IRA distributions. You’re going to get $24,000 off the top in a standard deduction just for you being you, and for being married in that regard. You come down and basically you have $76,000 of taxable income. So you’re only paying tax on the $76,000. You’re not paying tax on the $100,000 gross. That’s important to remember as is you really need to evaluate what your tax rate is today versus what it’s likely to be in the future. I say likely, certainly we don’t have a crystal ball, but there’s different things that you can do to kind of estimate that. Certainly you have to go ahead and at least think about what tax rates are likely to be in the future. We’ll kind of wrap up this episode with that.

Kevin Kroskey:  Marisa Buyer and I in my office last week were meeting with clients, and I’ll of course change the names just to protect some confidentiality here, but let’s call them Rick and Mary. Rick and Mary were referred to us and they were new clients that we’re just starting to work with. Household income is about $120,000. Kids are already grown, out of the house and self-sufficient, haven’t boomeranged back or anything like that. When you look at Rick and Mary they were, again if we just take $120,000, what they’re making gross income, and take that $24,000 standard deduction, now we’re just down to about $96,000. They were putting some money in their 401Ks. They’re still working. No matter how you slice it they were still in a 22% tax rate.

Kevin Kroskey:  Rick and Mary for what they’re living on and what they’re likely to live on in retirement, they’re not going to be in that tax rate in retirement. The rule is actually going to work in their favor. They’re going to be in a lower bracket in retirement. So for Rick and Mary the rule is going to hold. That’s great. However, one of the things that Rick and Mary were doing, which sounds completely logical but doesn’t make sense when you actually look at the numbers, is this. It was really important to both of them that they have their mortgage paid off by retirement. Common goal, very rational, hey let’s get rid of that fixed expense, let’s get rid of this mortgage. For most people debt is a four letter word. Actually, I guess for everybody it should be a four letter word. Right Walter?

Walter Storholt:                I think so.

Kevin Kroskey:  I was waiting for you to pick up on that buddy.

Walter Storholt:                I was like wait is that a four letter. Oh yeah, yeah, okay. I was a little slow on the uptake on this one.

Kevin Kroskey:  I know financial humor, it’s a stretch particularly for me.

Walter Storholt:                I need to pull out the rim shot sound effect there for you.

Kevin Kroskey:  Thank you.

Kevin Kroskey:  So they’re in this higher tax bracket. They’re putting money on their mortgage that was costing them about 4%. We just were talking through this and hey why would you want to have it paid off, why are you doing this. They explained by retirement and what have you. Again, completely rational goal, but completely wrong way to go about doing it. I say that because again they’re in a 22% tax bracket right now. They’re going to be 12% bracket in retirement. That’s a 10% differential. That’s pretty substantial. Even if the mortgage is costing them say 4% per year, what would you rather save, 4% or 10%?

Walter Storholt:                I mean 10% sounds like the obvious answer.

Kevin Kroskey:  Yeah, not a trick question there. You start down this path of a rational goal of having the mortgage paid off by retirement, but when you actually look at the math the tax rate today is definitely going to be higher than what it’s going to be in the future. Rather than putting the extra money on the mortgage, more money should be going into the 401K, getting the tax deduction, and then you can even pull the money out, you can accelerate it, all the way say to the top of the 12% tax bracket and pay off that mortgage, any of the outstanding balance that may exist in the first couple years of retirement. Literally for Rick and Mary we looked at it and said look guys you’re going to be able to save a lot more today, probably going to be able to retire. It’s not like it’s going to be necessarily a huge game changer for them, but it’s going to be thousands of dollars and probably going to allow them to retire maybe three or four or five months earlier, which they were certainly enthused about.

Kevin Kroskey:  But we said, when we looked at it and crunched the numbers, they were going to be able to completely pay off their mortgage by three years into retirement and they were going to be able to save in the tens of thousands of dollars by doing what we were talking about doing. For Rick and Mary, and it took a little bit of coaching, not only the financial part but kind of emotionally. I mean it had been a goal of theirs for quite some time, but we showed them. We said look if the important goal to you was not only to have the mortgage paid off but be able to live comfortably in retirement, this is going to allow you to do it a little bit of a smarter way rather than the current path that you’re on.

Walter Storholt:                And those savings aren’t just a handful of dollars for all of that work. I mean that’s significant tangible savings right there.

Kevin Kroskey:  It’s tangible, it’s significant, and it’s just proper planning. It’s not having to predict the future about investment returns or to make a big change in their lifestyle. We’re just simply redirecting money they already have in their monthly budget to a different tax area, into 401K in this instance, that is going to get better results for them. Mary specifically, the market has been volatile recently, and we said look Mary you don’t even have to take stock market risk. We can put it in their 401K. They actually had something called a stable value fund, which is kind of like a money market, high yield money market account, so it’s paying a stated rate of interest. It was really about the tax savings. Any investment return that they’re going to get on top of it is only going to be icing on the cake. This was purely a tax move. It was just shuffling things around a little bit to get a better result for them to get them in a better position to be more comfortable and more secure and retire maybe a few months earlier than what they otherwise would have.

Walter Storholt:                Pretty cool to hear those kinds of real life stories, how people are able to come in with a problem and get it solved, or in some cases come in not knowing that they have an opportunity, it’s not so much a problem as it is an opportunity, to have a more efficient and a better structured plan. It sounds like that’s a great example of when that’s the case. Sometimes you don’t want to go looking for a problem Kevin, but sometimes you do want to go looking for opportunities. It sounds like that they fit into that bill.

Kevin Kroskey:  Oh completely. Yeah I mean you want to look for opportunities. You certainly want to manage risk or avoid threats as much as possible, but that mortgage one that I just talked about for Rick and Mary, incredibly common. Again, starts off with very rational well intentioned goal, but there’s just a better way to go about doing it for them that ultimately once they saw that path and understood the reasoning, and frankly we tied it to what their goal really was. It wasn’t to have the mortgage paid off. Really the big goal was to make sure that they can retire comfortably and feel confident and secure in what they were doing. Having the mortgage paid off was part of it, but we showed them that there’s a better way to it, and ultimately the main goal. The mortgage was really just kind of a part of it if you will.

Kevin Kroskey:  We’ve had a lot of meetings recently, so there’s another one that comes to mind too. A little bit different. I’ll of course change some names here, but this was, let’s call them Jim and Shelley. I’ll have to get maybe a little bit more creative here with names in the future, but we’ll keep it short and sweet. Kim and Shelley have been working with us for years. They were coming in for their meeting. This was a few weeks ago. They are mid-60s. They’re taking Social Security benefits on one of the spouse’s records and they needed some more money. We went through the planning update, showed them hey things are still looking good, they’re on track. The money that they were pulling out of the accounts was in line with what we were projecting, so their plan spending was on point, which was good.

Kevin Kroskey:  Something had come up that we hadn’t foreseen before, hadn’t talked about, and so really they needed about $7,500 to go ahead and do some improvements that they wanted to do on their home. In fact, they were just enclosing a patio that they had previously and making it more of an all season room. For the size they figured about $10,000 was going to get them where they needed to be. Jim is fairly well read. He said hey tax rates are lower this year right because we had tax reform in 2017. I said yes. He said well how about we just pull that $10,000 out of the IRA. In their case of course they’d have to pull out a little bit more to net the $10,000. But when I explained it to him and actually looked at their tax return, one of the things that really trips people up is how Social Security is taxed.

Kevin Kroskey:  Because they had Social Security coming in we actually looked at it and said Jim if you pull that $10,000 out of the IRA, even though it looks like you’re going to be in a 12% tax rate, as you pull the more money out of the IRA more of your Social Security is going to be taxable. The actual rate that you’re going to pay is about 22%. Jim was kind of confounded by that at first. We certainly didn’t walk him through all the calculations on how Social Security is taxed, but we just explained that hey it’s a little wonky, it’s kind of a reciprocal calculation. We showed him on the first page of his tax return that all the Social Security that you’re receiving is not taxable at the maximum amount just yet. For each additional dollar you take out of your IRA, or $1,000, or $10,000 as in this case, it’s going to make more of that Social Security taxable.

Kevin Kroskey:  What we showed him because of the 22% tax rate, we said hey let’s not take it from there. Let’s actually just draw down your cash reserves a little bit more and then we can go ahead and replenish them a little bit more smartly next year when we’re reconfiguring your distribution plan for 2019. Jim and Shelley like to keep about $30,000 in cash, so to pull it down a little bit below that, say down to $20,000 for a period of time, we as their advisor certainly felt that that was okay. Then we just asked Jim and Shelley how do you feel about that. They said they were fine. Certainly Jim did not want to pay a 22% tax rate.

Kevin Kroskey:  Completely well intentioned again. Here’s somebody that’s a smart guy, is reading and saying hey tax rates are lower this year, why don’t I go ahead and pull some more money out of the IRA while we’re in a lower tax rate. Well it looks like they were in a lower tax rate, but when you actually look at it because of the way that the Social Security was taxed they were actually in a much higher rate than what it appeared to be. The same can happen if you have selling investments that are going to produce long-term capital gains. Some of these preferential items, be it a long-term capital gain or if you’re receiving dividends that are called qualified dividends, they all receive a special tax rate. Just the interplay when you start mixing in with some of other tax items that you have on your return, it can look like you’re in a low bracket but you’re actually in a higher bracket than what it appears to be.

Kevin Kroskey:  Again, where we started today was anytime you can pay a lower rate today versus what you would pay in the future, you should do that. In the case of Rick and Mary, they definitely wanted to go ahead and put more money into the 401K and not against the mortgage. In the case of Jim and Shelley who were retired, when you looked at it, we can actually manage them to just be in that 12% tax bracket and only pay a 12% tax rate next year rather than paying a 22% rate this year. It really comes down to that, thinking about hey what is today’s rate versus what are you likely to pay in the future, and then figuring out what’s the smartest way to go ahead and get where you want to be.

Walter Storholt:                Is there a way for somebody Kevin to kind of know what side of the fence they’re going to fall into, or do you really need to analyze the whole situation to be able to get that answer?

Kevin Kroskey:  Today, when I say today in the current year it’s relatively easy to go ahead and look and see what your tax rate is. I say easy, I’m really talking about for us. For most individuals, we have a lot of smart people that we advise on their financial investment and tax planning and frankly a lot of our clients have done pretty well in certain aspects. Taxes are usually the one area that just throws everybody for a loop just because of the complexity that can be involved. Something could look pretty simple, but there’s just some complexity that may be lying below the surface. You can get a quick idea where you’re at, particularly if you know what you’re doing. If you don’t have any of those preference items, if you only had say earned income, if you only had a pension, if you only had taxable IRA distributions, and you had zero Social Security income, you had zero qualified dividends, you had zero capital gains, then it’s going to be a lot easier, even for kind of a non-expert to go ahead and take a look and figure out what their tax rate is going to be.

Kevin Kroskey:  Now in the future, nobody has a crystal ball right. I mean nobody can predict exactly what the tax rates are going to be in the future. However, we were given a gift, it actually came a little bit after Christmas in 2017, but we have this tax reform bill that was passed and is in effect literally only for tax years 2018 through 2025. The current law is that the rates are going to revert back to what they were in 2017 come 2026. Really what’s in effect for these next few years are lower rates and wider brackets really for everybody. We’ve done a lot of tax projections for clients, it’s fourth quarter 2018, we haven’t found one single case where somebody’s worse off this year compared to where they were last year.

Kevin Kroskey:  Just to give a little bit of an example of this, last year, 2017, you were hitting a 25% tax rate at about $75,000 of taxable income. 2018, you’re in a 24% bracket all the way up until $315,000 of taxable income. Not only are the rates lower, but the brackets, particularly in that band that I just exemplified, are a lot wider. It’s really creating a lot of opportunity for people to pay lower taxes today, potentially on more income than what they had before, and avoid higher taxes in the future. I say it’s likely, but anybody that’s listening to this knows our government only gets income from one place and that’s from taxes. A big portion of that is from income taxes. You have a lot of baby boomers retiring every single day, taking Social Security benefits, benefiting from Medicare. All of that stuff comprises a big portion of the government’s budget each and every year. There’s not as many people paying into Social Security.

Kevin Kroskey:  We all know these problems exist, it’s just that our leaders down in Washington haven’t been doing anything about it. The further that they delay, the bigger the change, once it is finally made, which it’s going to have to be made, the bigger the change is going to result. Whether that’s taking away some benefits for certain people, or higher tax rates, or some combination thereof, those are the only solutions on the table. So if you can pay a lower tax rate today compared to what you are likely to pay in the future, again I say likely. Current law is tax rates are going higher in 2026, so we can say that basically greatly. I mean it’s current law. That’s what’s going to happen. But if rates actually go even higher than that, then people that are going to be doing these smart decisions about whether it’s saving today or maybe even moving some money out of their IRA, converting it over to a Roth IRA and paying today’s low tax rate, are playing not only good defense but are ultimately going to pay lower taxes and have more spendable income over their retirement.

Walter Storholt:  All right we teased at the beginning Kevin this would be a two-part podcast, so what haven’t we covered that we’re going to dive into in part number two?

Kevin Kroskey:  Sure, good question. For all the things that we talked about for like Rick and Mary and Jim and Shelley, we kind of divide, and this is kind of a rough divisor, but people that are having roughly about $100,000 or less hitting their tax return. Rick and Mary are making a little bit more than that right now. Jim and Shelley are living on about $7,000 here in retirement, no mortgage, quite a nice lifestyle, but they’re falling in this, I guess part one if you will. As you move up the income scale, some of the strategies are a little bit different. Some new things come into play. I would also say there’s a lot more tax risk for those people. So what we’re going to talk about on part two are some people that just like Rick and Mary and Jim and Shelley worked hard, saved, lived below their means, but they ended up being maybe a little bit more successful, at least in financial terms, grew a little bit more wealth, and have some more complexity, some more planning issues, as well as more tax risk than what we covered here in part one.

Walter Storholt:  All right. All of that will be coming up on part two of this conversation about that retirement rule gone awry that you’re going to plan to be in a lower tax bracket in retirement. True for some, not for others. It depends on your situation. Some of the great examples on today’s program of how that plays out for certain folks.

Walter Storholt:                If you have any questions about your particular financial plan and you haven’t met with Kevin Kroskey and the great team at True Wealth Design yet, we invite you to give them a call, 855-TWDPLAN. Call the office at that number. That’s 855-893-7526, or find us online of course at truewealthdesign.com. You can click the “Are We Right For You” button to schedule your 15 minute call with an experienced financial advisor on the True Wealth team. That’s truewealthdesign.com. Don’t forget to subscribe to the podcast there on the website as well. Lots of different ways you can do that on iTunes, Google, and Spotify. Lots of other options as well there. You can do all of that on the site. And don’t forget if this episode you think would be helpful to someone that you know, please take the link and share it with them. Copy and paste it, email it to them, or share it on Facebook, whatever way you can get it to them so that they can be informed and learn a little bit about the financial world as well.

Walter Storholt:                Kevin, thanks for the help and look forward to talking to you on the next podcast.

Kevin Kroskey:  All right, thank you Walter.

Walter Storholt:                Looking forward to it. It’s going to be a good one, so be sure to join us back for part two of our conversation on another retirement rule gone awry about lower tax brackets in retirement. Thanks for tuning in. We’ll talk to you next time on Retire Smarter.

Speaker 4:           Information provided is for informational purposes only and does not constitute investment, tax or legal advice. Information is obtained from sources that are deemed to be reliable, but their accurateness and completeness cannot be guaranteed. All performance reference is historical and not an indication of future results. Benchmark indexes are hypothetical and do not include any investment fees.