Sadly, most people don’t thoughtfully consider their taxes when planning for retirement. Taxes are complex, but proper planning may reliably add tens or even hundreds of thousands of dollars to your family’s net worth over time.
I believe because of the complexity and a catch 22 I’ll describe, most default to another retirement rule gone awry – that you’ll be in a lower tax bracket once you retire. This is often false for a surprisingly wide range of retirees.
Here’s the catch: CPA’s generally do not perform proactive income tax planning for individuals unless you are a key client with a big business. Regardless, your CPA cannot advise on your investments, which are certainly related to your tax planning. They’re also not privy to your retirement goals nor the portfolio distributions required to meet those goals. Missing the longer-term view of things doesn’t allow a multi-year approach to your tax planning.
How about your average financial advisor? Well he doesn’t even fully understand your various marginal tax rates let alone how to execute tax planning strategies to save you money. Even if he was enlightened, his firm likely precludes him from providing any tax advice. Instead he’s instructed to say, “Consult your tax advisor.”
Either you never made aware of the tax planning opportunities you have, or if you are, around and around you go in trying to get help to capitalize on them … the dreaded catch 22.
A short story can illustrate a common scenario and planning opportunities.
The Modest Millers
Jim and Sue Miller lived below their means, worked hard, saved, and ended up with more money than they thought possible. Jim worked as an engineer and Sue worked at home taking care of their three kids and ran their household. They accumulated $1M at retirement — $800K in their 401k/IRA, $100K in Roth IRAs, and $100K – some of which they inherited – in a joint account.
Now that the mortgage is paid off and their kids are self-sufficient, they plan to live on about $6K per month in retirement. Jim will have $2.5K per month in Social Security, and Sue is pleased to learn she’ll have half of this from her Social Security spousal benefit. Thus, they figure they’ll need another $2.25K per month from their investments.
The Miller’s advisor, who helps them integrate their retirement, tax, and investment planning together in a coordinated strategy, shows them this retirement scenario, and how they’ll appear to be in a 15% tax bracket in retirement. He explains they’ll get about $23K deducted from their adjusted gross income from the standard deduction and two personal exemptions alone before arriving at their taxable income. Since the top of the 15% bracket is about $76K of taxable income, you can nearly have $100K of gross income, given the $23K in deductions and exemptions.
Assuming income comes from Social Security ($45K) and taxable IRA withdrawals ($30K), only about 30% of their Social Security benefit is taxable. Thus, they pay only about $2K in federal income taxes as they enjoy their retirement and spend their $6K per month.
Despite paying only $2K in taxes, which is a lot less than they paid while working, they are surprised to learn that their marginal tax rate – the tax rate paid on the last dollar – is 27.5% due to the way Social Security is taxed. At most they were in a 25% bracket while working.
When they want another $10,000 IRA distribution for their 40th wedding anniversary trip, the tax owed would now nearly be an additional $3K more even though it seems they’re in the 15% tax bracket and thus should theoretically pay $1.5K more. Yet, now nearly half (not 30%) of their Social Security benefit is being taxed.
They are happy after their advisor suggests they consider an alternate distribution strategy. This strategy not only helps to better optimize their Social Security benefits but also integrates a more tax-efficient distribution strategy and Roth IRA conversions, smoothing the taxes they pay over a multi-year period and helping them have even more after-tax wealth.
Their advisor even references a robust 2013 Journal of Financial Planning study where a married couple with $2M at retirement ends up with more than $400K more over time by following a tax-efficient distribution strategy compared to following common rules.
While Jim and Sue say they’re not likely to splurge on themselves too much, they are happy to do so on their grandkids and plan to help with their college. They also agree to give more to their church and a few causes they support. The Miller’s said, “Much better used here than leaving a tip to the IRS.”
You have more flexibility in retirement over how you are taxed. You may have a Roth IRA, traditional IRA, and joint account that have different tax implications as you create a tax-efficient withdrawal strategy. Plus, you have discretion over timing decisions involving Social Security, pensions, deferred compensation, stock options, etc.
Everyone is different and your tax situation can vary greatly from year to year. And no doubt tax rates will change over time. Yet, tax planning done right is a yearly activity that can reliably add value. You just need an enlightened advisor to guide that process and integrate it with your retirement and investment planning.
Kevin Kroskey, CFP®, MBA is President & Sr. Wealth Advisor with True Wealth Design, an independent registered investment advisory and wealth management firm specializing in retirement, tax, and investment planning for successful familes at or near retirement.