Retirement Tax Planning
Posted September 15, 2018
There are three major wealth considerations- accumulation, preservation and transfer. Seems simple, right? It might be. How do you know? Have you written down your retirement objectives beyond the words “Don’t starve to death?” Do you know your retirement tax rate?
As Benjamin Franklin once said, “If you fail to plan, you are planning to fail.” Thanks Ben. Do you ever get the idea that perhaps the lightning bolt hitting the church key did some damage? All kidding aside, the financial planning process is something most people skip or purposely avoid out of fear.
Retirement Tax Planning
The assumption long ago was that your retirement tax rate would be lower than your wage-earning tax rate. And in some cases this remains true for some people. In a lot of situations people’s retirement tax rate is the same. How can that be? Easy, actually.
During your wage-earning years you have kids, tax credits and tax deductions. As you slide into retirement, you kick the kids off the payroll, downsize or pay off your house and start taking your required minimum distributions from your pre-tax retirement accounts. Let’s not forget your robust rental income. So overall income goes down slightly, perhaps, but tax credits and deductions virtually disappear. What is the result without proper retirement tax planning? A possible much higher retirement taxes than you expected.
The Retirement Tax Bomb
You might have a retirement tax rate problem. The not-so-distant cousin to this problem is the tax bomb. Everyone comes into the Watson CPA Group offices and wants to save taxes. Sounds like a great idea, and we’ll do everything we can to help you achieve this goal. However.. and this is a big however… be careful!
Tax savings and tax deferral is not always the same thing. Tax savings are things like deductions and credits. Tax deferrals are IOUs you send to the IRS promising to pay tax on your income at a later date. And the ONLY time a tax deferral become a tax savings is when your marginal retirement tax rate is LOWER than your wage earning rate. Proper retirement tax planning and modeling is critical, and the Watson CPA Group can help.
We recently had a couple with nearly $1.5M in pre-tax retirement savings in their 401k’s. Throughout the years this couple had marginal income tax rates of 15%, 25% and 28%. When they retire their retirement tax rate will be 28% because of strong pension and investment income yet lower tax deductions. So, they break-even on the wage-earning years where they were in the 28% bracket (only about 6 out of 30 years), but will pay more taxes than they saved during the years of 15% and 25% marginal tax rates.
Lastly, consider that it might be easier to recover from a tax bill during your wage-earning years than during retirement. In retirement, you can only rely on savings to pay your retirement taxes. Remember… our job is to build your wealth, and if we can save taxes (not just today but over your lifetime) then that is icing on the wealth building cake. We love cake. We love icing too.
Now that we’ve scared you half to death (and if you read this twice, you’ll die technically), we have another retirement planning page where we show how tax deferrals can actually be a good idea.
Roth Retirement Dollars
What can be done about this retirement tax bomb? The only answer is proper retirement tax planning from your financial advisor AND your tax professional. Do you start contributing to a Roth IRA? And if you are phased out because your income exceeds the limit (about $188,000) do you start siphoning pre-tax dollars away from your IRAs and into Roth IRAs through a backdoor Roth conversion? Perhaps.
Or do we look at the 401k at your current job? Since 2001, many 401k plans have been amended to allow for Roth deferrals into a separate, post-tax account within your 401k. Again, perhaps. The bottom line is that you need proper retirement tax planning, and the Watson CPA Group can model various scenarios for you.