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Are You Sitting on a Retirement Tax Bomb - Episode 55 Thumbnail

Are You Sitting on a Retirement Tax Bomb - Episode 55

What does retirement tax bomb mean? I regularly present educational workshops concerning TIR, because TIR can have a major affect on us in our twilight years, certainly if no planning or considerations are made. 

I'm going to use part of what I present at my Taxes in Retirement presentations to answer this question, what is a retirement tax bomb?

  1. I’ll start by talking about what the problem typically is.
  2. Next, I will describe how it creates a large lifetime tax liability if no action is taken.
  3. Then, I will cover how it can not only create an income tax bomb but also a Medicare tax bomb.
  4. After that, I will talk about another concept to plan for: The widow’s or widower’s tax.
  5. And finally, I will describe how your heirs can benefit from your tax planning now. 

Listen to Episode 55 Here:

You can listen online through the direct player above, or a much easier way to listen is by subscribing to the podcast through a free podcast app on your phone.  The podcast is available on iTunes, Spotify, Google Podcasts, iHeartRadio, Stitcher, and several others!

The Problem

Here’s the problem. If you've been saving for retirement over the course of your career, you probably have a large chunk of your nest egg in a pre-tax account.

As you save money through the years, you have to make a decision on where you’re going to put that money from an investment perspective. How are you going to diversify this? What kind of allocation are you going to use and so on...

But whether you knew it or not, you were making tax decisions all along the way too, and there are really only three buckets of money when it comes to taxes: pre-tax money, after-tax money, and tax-free money.

The average person we work with has the majority of their retirement money sitting in a bucket that has never been taxed. This would be your IRA money, 401(k) money, 403(b) money, 457 plans, and plans like that. This is money you chose to put away on a pre-tax basis.The problem is, when you retire, the majority of the money you’ve saved is going to be taxed when you take it out to spend it. Most people forget to account for the silent partner they have until they realize what they're going to have to pay Uncle Sam.

And this is going to cause your income streams in retirement to get taxed in complex ways.

Everyone approaching retirement talks about de-risking their portfolios from an investment perspective, but have you ever de-risked your portfolio from the IRS or from a tax perspective? 

Have you ever laid the tax code over your retirement situation and asked how to optimize and reduce your lifetime tax liability? How do you get Uncle Sam out of that partnership in the most efficient manner possible and pay the least amount of taxes over your lifetime?

Often, your tax rate in retirement will be determined more by where your income comes from, rather than your actual income.

The Income “Tax Bomb”

So how can this create a "tax bomb "? Let's say you have a large pre-tax account, and you don't do any tax planning, and you just push off taking any money (or a minimal amount) out of it until you absolutely have to. And when will you have to? When Required Minimum Distributions (RMDs) kick in. 

You will be required to take money out of your pre-tax account, and the amount will get higher the older you get (assuming your investments continue to grow modestly over time). And you will owe more in taxes and probably get bumped into a higher tax bracket, causing part of the "tax bomb. " 

Now, if we do some tax planning and draw money from the proper accounts at the proper time, and fill up tax brackets each year with Roth Conversions in your "gap years " (the years between retirement and RMD age), we can save our clients tens of thousands and even hundreds of thousands in lifetime taxes. 

And this is just part of the "tax bomb " that can be created by procrastinating or doing nothing.

The Medicare “Tax Bomb”

Not only is there the income "tax bomb, " but there is also a potential Medicare tax bomb. 

Obviously, no one likes paying a higher tax rate than they need to, but what we have found is that when people start taking their RMDs, and it causes their Medicare Parts B+D to cost more, they get really upset with this! And this higher cost is likely to stick around for the rest of their lives.

They say, "Why didn 't my guy/gal tell me this was going to happen?!!"  

Because they don't do real tax planning, I would say around 70-80% of financial advisors still don 't do tax planning. Crazy, in my opinion. 

So, if they haven't done any tax planning in their "gap years," not only do they have to pay a higher tax rate than they should at RMD time, but the cost of Medicare Parts B+D is based on adjusted gross income (AGI), and a higher AGI causes higher Medicare costs.    

In an example I use in my Taxes in Retirement presentations, a couple was happy to pay a very low tax rate the first few years of their retirement, but they did zero tax planning, and now their RMDs are going to kick in next year. 

Not only will they be in the 32% tax bracket, but this will also cause them to bump up 3 levels on the Medicare excess premium threshold chart. So, now they will also be paying $11,503.20 more per year in Medicare premiums. Ouch! And it is likely to be this way for as long as they live.

So, when I say "tax bomb" and "everyone needs tax planning," this is why.

Another Concept: Widow's or Widower's Tax

Another concept to consider is the Widow's or Widower's Tax. Again, I know these aren't exciting concepts for people, but they can certainly move the proverbial needle!

Widow's or Widower's Tax - What do I mean by that? To give you an example, we have a married couple, Spouse A and Spouse B. They have plenty of money - that's not the problem. They worked and saved during their accumulation phase, and they did a great job growing their nest egg.

Let's say they want to live on $8,000 a month of income. Here's how it's going to go:

  • They're going to get $3,000 from Social Security,
  • They’re going to have a $3,000/month pension coming in the door,
  • And they're taking $2,000/month out of their IRAs. 

This gets them to $8,000 a month or $96,000 per year, and after the standard deduction, they’re going to owe the federal government $7,185, an average tax rate of 7.9%.

Now, if you are married or you know somebody who's married, what do you suppose the odds are that they die on the same day? Not good, right? Almost zero.

So, the surviving spouse is going to be a widow or a widower, and now they walk into their CPA or broker that helped them before, and they still have plenty of money. Again, that's not the problem. 

But they weren't working with a retirement specialist, a distribution advisor, or someone that looked at their situation from a tax perspective, and now they say, “Look, I just lost the love of my life. I hope I don't have to worry about money. I just want to maintain the lifestyle that I have.”

And the good news is, they have plenty of money, but…

Now, they have to rework where the income comes from, to get them to that same $8,000/month. Here’s what the new income distribution looks like:

  • $2,000/month from Social Security (highest amount of the couple)
  • $1,500/month from pension (50% survivor benefit)
  • $4,500/month from IRAs

And here's the bad news: they didn't do any tax planning, and the tax bill on that same income, because they're no longer married and they have to file as single now, is $12,711, an average rate of 13.8%.

They used to pay 7.9% on the same income. That's a 75% increase in their tax bill because their spouse died. And the odds of this happening to you are very high if you're married.

So, if you haven’t done any tax planning to take advantage of the beneficial tax treatment of being married, you really need to start, because the tax code is much more advantageous while you're married!

Legacy Planning

Based on everything so far, we can probably agree that tax planning is beneficial for individuals and couples. But it’s also beneficial for legacy planning, because the “tax bomb” will also affect your heirs when they inherit your pre-tax accounts. 

But it could actually be worse for them. If your kids are your heirs, they will most likely inherit your money during their peak earning years, which means they are already in a higher tax bracket. 

And then, thanks to the SECURE Act, they will be forced to draw down those inherited accounts within ten years and pay all ordinary income taxes at the time of the distribution. 

As a result, many tax practitioners are recommending that wealthier individuals look at the possibility of doing partial Roth conversions while they’re still alive, moving some of the traditional IRA assets into Roth IRAs and paying taxes at today’s low rates.

Bottom Line

You have a huge advantage over the IRS. You can plan your taxes over decades instead of just one year at a time. It looks like the IRS would like us to delay taxes as long as possible to get the highest tax payout over your lifetime with the passing of the SECURE Act of 2019 and then SECURE 2.0, passed in 2022.

However, with careful tax planning, you don’t have to fall into that trap.

Delaying Taxes in Retirement Isn’t Always Best, Award-Winning Paper Shows

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