$2 Million, 2 Households, 2 Very Different Tax Bills in Retirement
Tim compares the tax bill of two retired couples with identical Social Security benefits and spending needs. Couple 1 has $2 million in an IRA. Couple 2 has $2 million spread across an IRA, Roth IRA, and taxable brokerage account.
$2 million, 2 households, two very different tax bills in retirement. Now, why is this? Well, it's important to understand that the taxes you owe in retirement aren't determined by how much money you have. They're determined by where that money comes from.
Now that might sound obvious, but if you don’t stay up to date on the tax code or tax planning (and why would you unless you’re in my profession) then you’re not going to know all the nuance of how income streams come together and cause tax bills to be wildly different for retirees.
Most people don't realize this until they start thinking about retirement. And some might say it’s too late to do much about it if you’re retired or close to it, but there is always something to do to optimize and lower your lifetime tax bill. That said, the older you get, the more limited your options become.
That's mostly due to:
- Required Minimum Distributions (RMDs) that will kick in at age 73 or 75, depending on when you were born
- Your Medicare Parts B & D premiums rising along with your adjusted gross income
The Problem
What we often see when people approach retirement is that they have the lion’s share of their nest egg in a tax-deferred account, like a 401(k), 403(b), or a traditional IRA.
This makes sense because that is what you were told to do: get a job, put money into your 401(k), hopefully you get a company match, and let the investments do their thing over the course of a few decades. Then you get to retirement, and with a little good fortune, you might have a million plus in your 401(k).
But, here’s the thing retirees don’t always think about. All that money will be taxed at some point in the future, at our ordinary 7-bracket income tax rates, and these rates are currently the highest in our tax code.
Two Couples
Let’s go over a little comparison to illustrate this:
- Couple one has $2 million — all of it in a traditional IRA.
- Couple two also has $2 million — but split across a traditional IRA, a brokerage account, and a Roth IRA.
Same total. Same Social Security. Same spending needs. Completely different tax picture.
Couple One
Couple one pulls $90,000 from their IRA to cover expenses beyond Social Security. Every dollar is taxed at ordinary income rates.
So, after deductions, but now taking into account the provisional income formula, 85% of their Social Security will be taxed, and their federal tax bill comes to around $10,000.
Couple Two
Now, Couple two pulls the same $90,000, but from three different accounts.
- Some from the IRA,
- Some from the Roth — completely tax free
- Some from the brokerage account — where gains are taxed at preferred long-term capital gains rates, which are 0%, 15%, and 20%. (They are preferred because these are lower than our 7 brackets of ordinary income tax rates.)
Their federal tax bill will be around $3,000. So quite a bit less. Same income (or technically, cash expenditure) for the same lifestyle, but a huge difference in tax bills.
If you compound this over the course of decades, it adds up to a sizeable difference in how much Uncle Sam gets of your money! And he’s going to get that pound of flesh, whether you start taking money now to use for expenses, or by doing surgical Roth conversions, or if you wait until RMDs kick in at age 73 or 75.
It's Not Too Late For Retirement Tax Planning
Now is the time when you want to start thinking about laying the tax code on top of your retirement situation because taxes are generally one of, if not the largest expense in retirement. Managing these taxes properly can save thousands and often millions of dollars over the course of a 20-30 plus-year retirement.
During your working years, or the accumulation phase, you worked and invested your money in your tax deferred 401(k) probably thinking the taxes would be lower in retirement.
But now, tax rates are as low as they’ve been in 100 years, but our national debt certainly isn’t. So, what do you think that means for our future? Well, I’ll just say it’s unlikely our taxes will go lower from here.
So, you worked, probably earned a salary, the IRS took its share, you invested in your retirement plan and there wasn't much to do about it.
Retirement is different. In retirement, if you’ve managed to save some assets, you can decide where your income comes from — which account, in what order, in what amount. That means you have meaningful control over what tax bracket you're actually in. Most people never exercise that control because they never research or understand the way our tax code is built to syphon more of your money to Uncle Sam in retirement.
You’re always making a tax decision
Where your money for your future retirement expenses will come from, is a decision you're making right now, whether you realize it or not. You’re always making a tax decision. And there is generally always something that can be done to lower lifetime tax liabilities, but age, account values, and location of those assets, make a big difference.
The gap years, between retirement and RMD age, are generally a great time to do some real tax planning to lower lifetime tax liabilities. If you would like to see where you are with your retirement situation, take a look at Our Process on our website and book an intro call if you like what you see, and let’s get to it.
A CERTIFIED financial planner™ professional can help you plan for your retirement. Schedule a call today so we can talk about your situation.