How to Save Potentially $600k in Taxes By Avoiding These Common Mistakes

 

Troy: I’ve yet to meet a client who understands what I’m going to share with you today. It’s one of the more difficult parts of the tax code to communicate as it pertains to planning for your retirement to help you not just pay less tax over time, but to help you pay less tax today.

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Troy: It’s important to understand, in retirement, you have two primary tax systems, the ordinary income tax system and your long-term capital gains and dividend tax system. Now, technically, there’s more than that. You have the estate tax system, you have the gift tax system, you have the generation-skipping transfer tax system, but the two that you have to be most concerned with are ordinary income taxes and long-term capital gains.

What I want to communicate today and what I’m going to show you, and this is very important when it comes to tax planning to help you understand how the decisions that you’re making are impacting your tax return, and therefore, the amount of taxes you pay, the amount of money you keep in your accounts, and the ability to sustain income over long periods of time, to maximize or to optimize, when you take a dollar from one system, what happens is you can cause other dollars that were previously taxed at lower rates to drag into a higher state of taxation. That’s what I want to communicate and try to show you today.

It is a bit complex, but it is extremely important to understand this concept if you’re doing your own retirement income and tax planning.

Long-Term Capital Gains Example

First, I want to start with the long-term capital gains tax system. Now, we’ve done a lot of videos on this. I’m going to talk a little bit about the 0% tax bracket for your dividends and long-term capital gains. I’m not going to go into too much detail on how it works, but I’m just going to show you the numbers and then tie it in to the content of today’s video.

Here we have single, married filing jointly, which are the two most common tax filing statuses. You can have $44,000 of taxable income if you’re single, and up to that level, pay 0% tax on your long-term capital gains and dividends. If you’re married filing jointly, $89,250. These are the tax rates for 2023. Now, on the income tax system, this is a separate system. We see here single, married filing jointly, 10%, 12%, 22%, 24%, 32%, 35%. These are the levels of income or the ranges taxable income. Taxable income is after your deductions. Whether you take the standard deduction or if you itemize, what you’re left with is taxable income.

If let’s say you have $175,000 of taxable income, your top marginal is what we call a tax bracket is 22%. Now, it’s important to understand that not all income is taxed at 22%, and even all of this income isn’t taxed at 22% because it’s a progressive system. I want to show you how the relationship between these two tax systems can impact your retirement planning. I want to set the stage here. You’ve just retired in your early 60s and you have inside your retirement account a 401(k) that’s rolled over to an IRA $1.5 million. Over here, you have a non-qualified account. This is your investments outside of your retirement account.

The fair market value is $750,000. Your basis is $400,000. You’ve bought these stocks for $400,000. They’ve grown to a value today of $750,000, which means you have a $350,000 long-term capital gain. You’ve owned those positions for more than 365 days. The decision now is where do we take our income from, let’s say $75,000 a year, $100,000 a year? You have a couple of decisions to make. One, do you turn on social security? Early 60s, usually not advisable. Do you take it from the retirement account? What is the taxation of that decision?

The Importance of Visibility

What a lot of times we see is someone is going to say, “Okay. I don’t want to pay any tax today.” What they’ll try to do is out of this $400,000 basis, try to go into that investment account and sell the stocks, maybe have a little bit of gain, this one has a loss, and try to net it out to have zero capital gain where they pay zero taxes. That could be the right thing to do, but the piece that’s missing is being able to have the visibility into the future. What does the future look like if I do this today?

If you go that route, what really is happening is you’re boxing yourself into a corner because there’s most likely going to come a point where you can no longer sell anything in that account that has a loss to offset something with a gain, so you’re just left with everything that has gains. Then you have to decide, okay, now do I sell over here and pay the capital gains tax, or do I sell over here and pay income tax? Again, this decision right now is being made in a silo. It’s not being made with respect to any visibility into the future of how this decision is impacting you then. The first thing we need to do is to create visibility.

I’m going to lift the curtain into the future and show you if you don’t handle the retirement account challenge, because all of that money in that tax-infested retirement account, it has to come out at some point, either through required minimum distributions or income later in life once you’ve exhausted the other account. This is just a real quick income analysis, or excuse me, tax analysis. Here is one of the top retirement account tax planning strategies we see over time. If we go this path, this is doing Roth conversions at a strategic amount over a series of years. Obviously, this can change as dynamics change in the economy, the tax environment, and also the account value.

We see $286,000 of potential taxes over the course of retirement versus $870,000. We have, let’s call it $600,000 of taxes on the table that we are either going to pay that we don’t have to just simply by deferring this retirement account tax nightmare kicking that can down the road. That’s the first thing. Now we have some visibility. If we leave the retirement account alone, we only take money from this account, it’s estimated we’re going to pay somewhere around $600,000 of additional taxes that we don’t have to by doing the strategy.

Two Tax Challenges

Now you see you have two tax challenges. One, the retirement account, but two, this built-up gain inside the non-qualified account. What do you do? How much income do you need? When do you need that income? How much income do you need later? This is really the art of tax planning in retirement. Now I want to get into the meat and potatoes of today’s discussion. It’s where the decision that we make to withdraw income from one account that is subject to one income tax system, how that can drag income from this other tax system into higher states of taxation. It’s going to be a bit complex, but I’m going to go through it fairly slowly.

If you have questions or comments, please put them down below. We’ll try to comment if we can. I want to compare 2022 when you were working versus 2023 now retired just to show you how these two income tax systems work, the capital gain system and also the ordinary income tax system. Here we have a 2022 tax analysis. This is actually pulled from a tax return, your hypothetical tax return from 2022.

Now what we do for clients here is we create a 2023 pro forma income column. This allows us to analyze the tax impact of decisions of taking income from either your IRA or your long-term capital gains, turning Social Security on, which is a whole another– not necessarily tax system because Social Security is taxed at ordinary income tax rates, but it has its own calculations which also get complex and ties into everything we’re talking about here.

$100,000 of wages in 2022, We have zero wages in the 2023 pro forma, $20,000 of dividends, $20,000 of dividends. That just carries through. Now what we’re showing here, 2023, $100,000 of long-term capital gains, the income is the same in both years, $120, $120. Standard deduction, a little bit higher in 2023 because they’re indexed for inflation, the standard deduction is. Then we see here the total tax last year was $10,094 because that $100,000 of wages is subject to the ordinary income tax system. Here, our taxes on $120,000 of income are $458. $458, that’s it.

Now is where we’re going to get into this. We see our marginal bracket. Your marginal bracket is the ordinary income tax system. Theoretically, the next dollar you take out of your retirement account should be taxed at your marginal rate, 10%, but we see down here the effective tax on the next $1,000 of ordinary income is actually 15%. How is that? If I’m in the 10% marginal tax bracket, why if I take $1,000 out of my retirement account, is it going to be taxed at 15% effectively? We see it’s the same as the capital gains tax system here. Taking $1,000 of long-term capital gains, we’ll also be taxed at 15%.

How the wrong distribution strategy in retirement can drag you into higher taxation

What’s happening is a $1,000 distribution from your IRA based on all the income that we’ve already structured, it’s not taxed at 10% necessarily. It’s causing long-term capital gains and dividends to be dragged into a state of taxation, whereas previously or before that distribution, a lot of them were taxed at 0%. Remember this chart I showed you here, you can have up to $89,000 of taxable income before your long-term capital gains are even taxed. You’re in this 0% long-term capital gains bracket.

What happens is if we take money out of the IRA, the income tax system is only 10%, but effectively, we’re going to pay 15% because it’s dragging long-term capital gains that were previously taxed at zero into a state of taxation. Now I’m going to show you that same $100,000 of income, except this time $50,000 is going to come out of the IRA and $50,000 is going to come from long-term capital gains. I’m going to show you how it has a completely different impact on your overall tax situation.

We have the same dividends, nothing’s changed there. IRA distributions, $50,000, long-term capital gains, $50,000, income is still $120. Now our taxes have increased from $458 in the previous example where all $100,000 of income came from long-term capital gains to $2,694, but more importantly, we see the effective tax on the next $1,000 of ordinary income, which means if I take one more dollar out of my retirement account or $1,000 more dollars out of my retirement account, then that is going to have an effective tax rate of 27%.

The benefit of tax analysis and planning

Let’s say you come in, you see me, this is what you’ve been doing, and you say, “Troy, I want to buy a boat,” or, “Troy, I want to put a down payment on a vacation home,” or, “Troy, I want to take the family down to the beach. I want to pay for the kids and the grandkids to come. Where should I take this money from?” We simply look at the tax analysis. This is tax planning and retirement. Obviously, once we have visibility into how these decisions are impacting our tax circumstance, we see it makes far more sense to take it out of the long-term capital gains bucket, the non-qualified account, because effectively, we are only going to be paying 15% on that distribution.

How do we get to 27% here? How does that even happen? We’ve only taken $50,000 out of the IRA. We only have $100,000 of income. If we look at the tax brackets, this is the income tax system, we see very clearly that we can have $83,000 to $178,000 of taxable income, and it should only be taxed at 22%. That’s the 22% bracket. How in the world with $120,000 of income, if I take $1,000 more out of my retirement account, am I being taxed at 27%? Hopefully, you’re starting to get where I’m going here. That distribution from the IRA is dragging more of your long-term capital gains. That 50,000 that we have long-term capital gains, it’s dragging it from a state of zero taxation into being taxed at 15%.

I want to show you visually what that looks like. What we’re looking at here, the gray represents the ordinary income tax system. The red equals the capital gains tax system. This is showing us if we take $1,000 of ordinary income, so an IRA distribution, the gray shows us, based on everything that we’ve already distributed or paid long-term capital gains tax on, it’s taxed at 12%. We can take out another $60,000 roughly before we jump up to the 22% tax bracket. I’m just looking at the gray right now. What this is also showing us is if we take $1,000, it is going to be taxed at 12%, that distribution from the IRA, but the red is your long-term capital gains also being brought into a state of taxation.

They’re coming from 0% tax to 15% tax. You’re paying 12% tax on that $1,000 IRA distribution, but then 15% tax on previously distributed long-term capital gains. Effectively, you see up top in the black, 27% is the effective taxation on that $1,000 IRA distribution. I told you that was going to be a bit complex, but it’s important to understand how taking income from one area can drag other parts of your income into a higher state of taxation.

Now, the retirement planning decision, what do we do? If you remember, there’s the situation, we’ve retired, we have this tax problem inside the retirement account, we have to do some Roth conversions. We have to get some money over time out of this retirement account because we see if we head down the path of a strategic IRA distribution and Roth conversion strategy, it’s estimated we’re going to pay about $286,000 in taxes versus the conventional wisdom, let that IRA defer, defer, defer $870,000 over the course of retirement.

We know we have a problem with all of that money inside that tax-infested retirement account. We also have this big long-term capital gain inside the non-qualified account. Now we understand the relationship between making distributions from the IRA, whether it’s a Roth conversion or just a distribution for income, and how that can drag more long-term capital gains into the picture.

The price of retirement portfolios that aren’t optimally structured

Let me pose another concern. Whenever we see an account like this that has big long-term capital gains, typically the investment account is not optimally structured. Because you’ve been avoiding paying taxes on certain positions, they’ve grown to be higher concentrations inside your investment portfolio, which leads to the diversification being out of whack. It leads to a higher concentration risk. It leads to overexposure in usually a particular industry for technology, for example, so the investment account is not optimally structured.

Additionally, you’re heading down a path of having very limited flexibility in regards to where you withdraw your income from because if you keep deferring this to avoid taxes, eventually you’re going to sell everything that has minimal gains or losses. You’re just going to be left with all gains inside this account or substantial portion. Then your choices are going to be here or here, but then you have requirement on distributions turning on at some point fairly soon. You’re going to be forced to distribute from here, and Social Security has to be turned on.

Social Security, whenever you turn that on, it is taxed according to the ordinary income tax system. It is a permanent state of ordinary income, which oftentimes, if you have two Social Security checks, means that you lose all of the preferential treatment that we’ve talked about that’s possible with the non-qualified account, meaning distributions or gains from here will always be taxed either 15% or 18.8% or 23.8& according to the current tax system. There’s more to it than just this when we talk about tax planning with retirement. This is why with the Retirement Success Plan, step one is the investment allocation, step two is income planning, step three is tax planning. All these pieces work together.

Strategies to balance and optimize your portfolio

What would I do in this particular situation? Knowing that I know an account that has gains because they’ve not been sold, I know that this portfolio has typically more risk than someone who comes to see us would want to have inside their account. What I want to show you is $275,000, taking a $275,000 capital gain. We could go all the way up to $350,000, but I just want to show you $275,000 and then wrap this video up.

Everything’s the same. We still have $20,000 of income. I’ve taken out the IRA distributions. We’re only incurring $275,000 of long-term capital gains. Total income is $295,000. We take our standard deduction. Our total tax is $28,000, about 10% of that long-term capital gain. Even though long-term capital gains are taxed at 15%, again, this may be confusing to you, but there’s a phasing in of long-term capital gains. Not everything is just taxed at 15%. When we start to understand, selling off a large chunk of that account, it’s going to have multiple benefits.

One, we’re going to be able to rebalance it, bring it back in line with not just what makes sense from a risk perspective, not being overly concentrated into one sector or a small group of companies, but we’re going to be able to bring it back into something that has appropriate position sizes across multiple sectors, so we have a more balanced portfolio. Also, we can tilt it towards the industries or sectors that we expect to perform well over maybe the next 12 months or so. We’re just bringing the portfolio back in line with today’s economic conditions and also reducing risk for only roughly a 10% tax hit. Let’s say that’s the decision that you make.

Now we no longer have a $350,000 capital gain. We’ve sold off $275,000 of those gains. We brought it back in line for roughly a 10% tax hit. Haven’t addressed the IRA problem yet, but now the portfolio is rebalanced and we just have a $75,000 capital gain. We can carry that forward into the next calendar year, but more importantly, we’ve reduced risk most likely. We have a more optimal portfolio here that has lower risk, higher increased return expectations.

I said in the beginning of this video, you’re in your early 60s, so we still have time to deal with the IRA problem because required minimum distributions probably don’t start until 73 for you. We have about 10 years to deal with the Roth conversion and tax planning strategy with the IRA. Now year two of retirement, we have less risk, a more balanced portfolio, we have more flexibility with regard to where we take our income from, but we’ve also given ourselves the opportunity to address this problem inside the retirement account.

This is not tax advice. I’m not telling you what to do here. It’s just conceptually how we go through these tax challenges and some of the things that we look at to help you understand the decisions that you can make, how they impact you not just today, but over the course of time, and how your income and tax planning also impacts your risk management strategies.

 

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