THE FISCAL BLUE PRINT
WITH COACH JEFF MONTGOMERY
Episode 14: Taxes in Retirement & The Power of Zero (continued)
We are picking up on where we left off on last week’s show! Did you do your homework? Did you pull out a piece of paper and draw the 3 tax buckets, label them properly, and start to count your assets? If you didn’t, don’t worry, we’ll do a quick review!
We have a lot to cover today so let’s get right to the disclaimer and start the show.
Disclaimer: Please do not take advice from me on this show. As a licensed Fiduciary I am only allowed to give advice to clients. Unless you’re a client I can’t give you advice because I don’t know you. Think of this as helpful hints and education only! And please, before implementing any information or ideas you hear on this show always consult your legal adviser, your tax adviser, and your financial adviser.
(2:30) Practical Planning Segment: Today we are going to explain how our money is currently taxed by breaking it down into 3 different tax buckets! Here is a quick rundown of the 3 different buckets:
- Bucket 1 is money/accounts that is taxed NOW. Money that you get a 1099 on each year because you have to pay taxes on interest and dividends and capital gains in the year you earned them. Ex savings accounts, personal brokerage accounts.
- Bucket 2 is the “tax later” bucket. This is your tax deferred accounts. IRA , 401k, 403b, 457b, etc
- Bucket 3 is the tax-free bucket. This would be Roth IRA, Roth 401k, and specially design Cash Value life insurance plans.
I think it makes tremendous sense to be proactive in tax planning rather than reactive in tax planning. Most of us are reactive by doing a basic record keeping process, looking for deductions for the previous year and maybe doing some planning for the upcoming year.
What we want to encourage is to start thinking in terms of 5 yr, 10 yrs, 15 years into the future. Proactive tax planning! Think about what could happen in the future with tax rates and develop some very simple planning techniques that may (in certain circumstances) get to a zero percent tax bracket. Getting into the zero percent tax bracket is not something that happens by accident!
First, let’s talk about the TAXED NOW BUCKET! This is the bucket that we get that little gift each year from the custodian called the 1099.
For example, if a $100k CD, grows 2%, you have a taxable event. ($580 off the top.) All of this unfettered taxation, of course, begs the question that “if all these INVESTMENTS ARE 100% TAXABLE WHY HAVE THEM AT ALL?”
(8:30) Whether or not your SS gets taxed depends on your other sources of income. You’ll see that if we have too much in this bucket, earning from dividends or capital gains is part of the calculation to determine whether you will pay federal taxes on your SS. The provisional income calculation, also known as combined income, is as follows:
One-half of your social security
+ Any distributions from the tax-deferred bucket
+ Any 1099 or interest income
+ Any rental income and/or wages
+ Any interest from municipal bonds
If Married: If provisional income is more than $32,000, 50% of SS is taxable. If more than $44,000, 85% is taxable.
If Single: If provisional income is more than $25,000, 50% of SS is taxable. If more than $34,000, 85% is taxable.
This bucket is mainly used for emergency funds and liquidity. However, this bucket can also have some unintended tax consequences. Having too much in this bucket can actually cause and trigger taxes on social security payments, so we have to be careful with how much we have in this bucket.
(12:15) Now, let’s take a look at the TAXED LATER BUCKET. This is the bucket you are probably most familiar with. Chances are you’ve been contributing to this your entire working life!
- IRA’s, SEPs, Simple’s
Money goes into to this pre-tax or tax deductible and when it eventually comes out, it’s all taxable.
The first complicating factor with this bucket is the Required Minimum Distribution. Most of our clients have saved significantly into 401k or IRA plans over the years. Once you reach 70 ½, you are forced to begin taking withdrawals. The process for calculating these withdrawals is relatively straightforward. Each year, you take the ending balance for the prior year and divide it by a factor representing your remaining life expectancy.
No big deal, right? Well, if you’ve done a good job of saving into your IRA, your minimum distributions plus your Social Security may be more than you actually need to sustain the lifestyle you want to live. If that’s the case, it’s likely you will be paying more taxes on the back end than you could be. With the right planning and by being proactive, this may be able to be avoided to some degree.
(17:00) Most people think their tax bracket will be lower in retirement because they are not working any longer! This is a very reasonable assumption. HOWEVER, it’s high time we put that claim under the microscope. We already talked about:
- The government has huge underfunded liabilities
- Tax rates are at all-time lows – Could they go higher? Of course.
- Deductions- mortgage interest, kids, retirement plan contributions, charitable donations, etc. may all be gone in retirement
It all comes down to exemptions and deductions! Even if tax rates stay the same in the future, you could still end up paying higher taxes! If you believe tax rates will be 1% higher in the future it makes sense to limit your contributions to this bucket
(19:30) Is there ever a scenario where you want money in these accounts?
- Yes! First, it’s always good to get free money! If your employer matches your contributions, always maximize that.
- Second, there are legal ways to take money out of your 401k and IRA in retirement without paying ay taxes at all!
Depending on your other income…. If the money that comes out of this bucket, prior to collecting SS is below the standard deduction (currently MFJ standard deduction is $12,200 each or $24,400 total)
(21:30) Now let’s take a look at the TAX-FREE BUCKET. If you’re like most Americans, the lion’s share of your wealth accumulated in the first two buckets! Investments in this bucket must be truly tax free and not counted as provisional income!
A Roth IRA Meets both of the litmus tests: As long as you are 59 ½ and meet the 5 year rule; free from all taxes! Also, it is not counted in the “Nasty Gotcha” provisional income calculation.
So, take note of our country’s fiscal condition, ask yourself where tax rates are going to go when you retire, factor in the reality that you will have very few deductions in retirement. If you have even the slightest notion that tax rates could be higher, then you’ll have more money to spend in retirement if you contribute to a Roth!
(24:00) You must have earned income to contribute to a Roth. However, if you make too much money, you may not be able to contribute to a Roth: Contribution limits 2019: If under age 50 $6,000. If over age 50, $7,000.
There are income restrictions for contributing to a Roth. Yes, there are what is called phase out for Roth contributions based in your Modified Adjusted Gross Income (MAGI) calculation: Take AGI and add IRA contributions, ½ self employment tax, any student loan interest and tuition deductions. These limits are the following:
Married Joint: $193K phaseout, >$203K (MAGI) then you cannot contribute to a Roth
Single, HOH: $122K phaseout, >$137K (MAGI) then you cannot contribute to a Roth
So what if your MAGI is too high and you aren’t allowed to contribute to a Roth. WELL, there is a way, and it is called a back door Roth conversion, not to be confused with a contribution.
There is a difference between a conversion and a contribution. There are income limitations to contributions, but there are no income limitations on a conversion, and you don’t have to be working. Here is an example:
(28:00) Married couple, filing jointly, MAGI is over $203k. Note: You can always contribute to a traditional IRA if you have earned income, but the question is, are these contributions tax deductible? They may or may not be depending on your Adjusted Gross Income. (If your AGI is over $123k, nondeductible) Now, with a backdoor Roth IRA, you can open up a non-deductible traditional IRA and contribute $7,000 into it, assuming you are over the age of 50. You can then immediately convert it into a Roth IRA. As long as the Roth IRA is opened for 5 years and you are over 59 ½ the earnings within the Roth IRA will also be tax-free.
Let’s explain a traditional IRA conversion:
- Any money converted from a traditional IRA if funded with pretax contributions to a Roth IRA will be taxable in the year of the conversion
- Be careful not to convert too much. Tax planning window:
- Low rates now
- Have 5 or 10 years or more before age 70 ½ when RMD are due
- Possibly fill up your tax bracket before going into a higher tax bracket.
Back Door Roth conversion; Be careful about a few gotchas!
- Watch out for the prorata rule!
- Watch out if you are already collecting SS. A conversion could cause SS to be taxable.
Next week, we will discuss the 2nd vehicle that meets both litmus test by creating tax free income and not being counted as provisional income, is commonly referred to as a LIRP. That acronym stands for Life Insurance Retirement Plan.
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