Minimizing Retirement Taxes 101
Tim discusses the "retirement tax bomb" - the large tax liability many retirees face from their pre-tax retirement accounts, like 401(k)s.
Today, I'm going to discuss what will typically be your largest expense in retirement: Taxes. I'll talk about what to look out for and be aware of as it relates to taxes in retirement.
One of the main problems we help retirees with at my firm, is lowering lifetime tax liabilities and mitigating a potential tax bomb they might be sitting on.
The Retirement Tax Bomb
After people have built their lives, maybe raised a family or built a career or basically just ascended the proverbial retirement mountain, they have moved from the accumulation phase of life into the ‘how do I turn my nest egg into an income stream’ phase your life. At this point, we often see most people end up with a decent chunk of money in a pre-tax retirement account.
This makes sense because this is what you’ve been told to do for the last few decades. Put your money into a 401(k), or whatever retirement account you have access to. Just keep working and putting money away, and we're going to match a certain percent, and so on.
So everybody has been putting money away for quite some time, and then they get to retirement and they don't realize that they've got this Silent Partner. You’ve got the silent partner in Uncle Sam in your retirement account, and now you have to think: how do I get rid of this partner and pay the lowest taxes possible?
Tax Planning to 'Defuse' the Bomb
Often, whether you’ve been managing your investments yourself or you've been with an investment manager that only looks at investment risk, you have not been thinking: hey, how do I lay the tax code on top of my retirement income situation and make sure I am paying as low a tax rate as possible.
Often people don't realize all along the way they've been making a tax choice. They approach retirement and they're thinking: hey, you know, maybe we should be slightly less aggressive with our investments, a little more conservative because we need to start living on this.
Rarely do people think ‘hey, you know what. I also need to look at this from a tax risk perspective, or risk from the IRS. Our tax code is a code; it's not an opinion or something you can opt out of (legally at least).
Another thing that people often don't realize is that your tax rate in retirement is often determined more by where your income (or spending dollars) comes from, rather than your income itself. This creates a great deal of confusion and frustration.
Why Retirement Taxes are So High
Our tax code is not easy. It’s almost like they make it confusing on purpose so people give up and then pay more taxes than necessary.
When you're in the accumulation phase and you're just putting money away into a 401(k) or an IRA or whatever it might be, you're just working for a paycheck and putting that money away.
Then when you've summited the proverbial peak of the retirement mountain, you’ve got to start coming back down that mountain, and it's totally different because there are so many different confusing things that can happen in retirement that can cause your tax rate to be different and often higher than you think it will be.
Your 'Silent Partner'
My goal today is to make sure that you are at least aware of what is going on and what to look out for.
Your gap years are coming (the gap years are the years between retirement and the required minimum distribution (RMD) age), and there's a ton of good tax planning you can do in those gap years to reduce tax liabilities.
Yes, everybody's situation is a little bit different, but that's what we're here for, to look at situations and determine the best path forward.
So, remember, if you’ve got a large pre-tax retirement account like a 401(k), you have that silent partner in Uncle Sam. Not only do you need to get Uncle Sam out of that partnership, but you also need to think how you’re going to do that in the most tax efficient way possible and limit your lifetime tax liability.
We call it a retirement tax bomb because it can explode what you pay in taxes later in retirement if you do not take steps to mitigate this risk.
What they say is true that you don’t know what you don’t know. People often don’t realize this tax-bomb risk until they get close to retirement and watch a video like this or meet with a tax planning advisor like myself.
The U.S. Tax Code
Now I’m going to cover a bit on how our tax code works and how it's going to pertain to you and your potential tax bomb in retirement. So, why do we want to minimize taxes?
Ordinary Income Tax Brackets
In our country we have 7 different ordinary income tax brackets or 7 buckets (I tend to interchange these two - I might say buckets or brackets, but I mean the same thing). So, we have 7 brackets of ordinary income tax, and then we have 3 buckets of long-term capital gains and preferred dividend rates, which are preferred rates because they are lower than our ordinary income tax rates.
We also have deductions that we want to use properly to mitigate taxes as well. Sidenote - the history of our income tax code started in 1913 when we first implemented an income tax, and we had 7 brackets then, as well. But the rates used to be 1%, 2%, 3%, 4%, 5%, 6%, and 7%. Today they are 10%, 12%, 22%, 24%, 32%, 35% and 37%, so quite a bit different.
These ordinary income tax rates are basically the highest rates in our current tax code, and these rates are what your tax-deferred account will be taxed at when you start taking money from that account, and this is why you might be sitting on a tax-bomb.
The rise and run of each bracket is different too. Intuitively people think maybe all the brackets are similar in size, but that's not true. The jump between 10 and 12% is much smaller than the jump between 12% and 22%.
If you think of it as if you had a carpenter build stairs for a back deck or something, well if your stairs look like the rise and run of our tax brackets, you would definitely fire that carpenter because they're not even close to being symmetrical or the same size of stairs. But, right now, that is how our bracket system works.
Marginal Tax Rates
Now, we also have what is known as a ‘marginal tax rates’ which basically means that only that last dollar was taxed at whatever rate you're in. That's why sometimes your effective, or your average, rate is quite a bit different from your marginal rate.
For example, say you're in the 22% tax bracket, but your average or your effective tax rate might only be 14 or 15%.
The reason for that is that after your deductions, each bracket is only taxed in that respective bracket, so the 10% bracket is charged 10%, the 12% bracket is charged 12%, and then whatever amount might bump into the 22% bracket would be taxed at the 22% rate, but only the amount that crosses that threshold.
So if you had a thousand dollars bump into that 22% bracket, you would pay 22% only on that thousand dollars. So, that's what marginal means.
Long-term Capital Gains Rates
The long-term capital gains and qualified dividend tax rates get better or preferred treatment, because they're basically made to incentivize investment. They’re trying to encourage investments in the economy, and they want to try to help people help themselves by saving or investing for retirement.
The long-term capital gains and qualified dividend brackets are a three-bracket system, as opposed to our 7-bracket ordinary income tax rates. The three brackets are 0%, 15% and 20%. And the rise and run of these 3 three brackets is large, but also not symmetrical.
Standard Deductions
We also have large standard deductions and right now, and they are as big as they've ever been.
Right now, in 2024, if you're married filing jointly, your standard deduction is $29,20. If you're over 65, you get another $1,550 deduction per person. So your deduction is going to be $32,300 if you're both 65+ and filing jointly.
That's a pretty big deduction, over thirty thousand dollars. Because our standard deduction is so high, only about 10 percent of our country is itemizing. This makes things easier for tax preparers, even though they still have to check everything to ensure it makes sense.
Bottom line:
I hope this explanation helps you understand our current tax code and brackets and why you might be sitting on a retirement tax bomb and need to start looking for ways to mitigate this bomb.
A CERTIFIED financial planner™ professional can help you plan for your retirement. Schedule a call today so we can talk about your situation.