Part 3 – I’m 62 With $1.5 Million How Will My Spending Level Impact My Tax Plan

Troy: Today is part three of our retirement planning case study. The first video, $1.5 million, when should I take Social Security? How much should I spend? How should my portfolio be invested? We looked at all of those different combinations of decisions that can be made and how they impact your probability of success.

Part two, we started to isolate some of those variables and only look at the impact of taking Social Security sooner or later and what impact that had with taxes versus doing your conversions or not doing conversions. Today, we’re going to look at different spending levels and how that impacts the tax plan.

Troy: Hi, I’m Troy Sharpe, CEO of Oak Harvest Financial Group, certified financial planner and professional, host of The Retirement Income Show, and certified tax specialist. Quick refresher on the hypothetical couple that we’ve been talking about in this video series. They’re 62 years old, have a conservative to maybe moderate risk tolerance. We’re assuming a 6% net of fees, average rate of return, they have 1.5 million saved for retirement.

Of that 1.5, 250 is in non-IRA accounts and 1.25 is inside retirement accounts. We have a life expectancy for both spouses running out to age 90. Obviously, these are a lot of variables that could be a lot different from your particular situation, but we’re just trying to convey the different concepts and how all these decisions that you have to make. How much do you spend? Where do you take that income from? What about your taxes if something happens to you? Will your spouse be taken care of?

All of these decisions and planning strategies that we have to look at. We’re just trying to convey the topics to you or at least the concepts, I should say, so you can start to understand whether you’re leaning into retirement or you’ve just retired or wherever you are at on that spectrum, you can start to connect some of these dots and understand the decisions that you have to make in order to optimize your retirement.

Just a quick interruption, if you like the content, our goal is to keep you more connected to your money. In order to do that, you have to stay connected to us. Hit that subscribe button, comment down below and if you liked the video, hit the thumbs up. If you don’t like the video, hit that thumbs down. We’re going to look at three different spending levels. The first one is this couple is spending $75,000 per year. The second scenario is $100,000 per year. The third scenario is 125,000 per year. That 125,000 with 1.5 million saved, that’s a pretty aggressive spend.

Social Security will reduce that portfolio withdrawal needs, so we’re looking at those three spending levels, all in portfolio withdrawal, Social Security, all of those total to one of those three levels. The first one we’re going to look at is the $75,000 spending level. We’re going to look at doing conversions versus not doing conversions. What is the impact? What is the end result?

Just like the last video we watched, no matter when they took Social Security, that was the different variable we were looking at last time versus doing or not doing conversions. Today, we’re going to look at the different spending levels, but just like the last video, 22% bracket for this hypothetical couple with all the variables that we’ve went through, still makes the most sense for them. To give you a sneak peek ahead, it makes the most sense actually no matter what the spending level is. There are some other impactful items that we’ll go through.

First and foremost, spending 75,000 is a small need relative to the portfolio size because Social Security, once that turns on, that’s going to make up a large part of the overall spending need. Doing conversions up to the 22% bracket, we’ll go through the timing of those and the amounts, versus not doing the conversions, almost a million dollars, little less than a million dollars in ending value.
Here’s the cool part, 292,000 in taxes paid over the course of retirement versus 923. Spending less leaves more money in the portfolio, and it actually makes the tax strategy that we’re choosing far more critical because if we keep that money in the portfolio and we don’t have any type of tax plan, it’s going to balloon the IRA, we’re going to be forced to take those big distributions down the road. It becomes more consequential what you’re doing on the tax side of things.

The Roth conversion schedule looks like this for the couple. Again, this is the $75,000 spending level. We have two big conversions in the first couple of years, then another big one, then another big one. Now, under current law, the Trump tax cuts expire after 2025. We see that reflected in the current tax strategy here. Once Social Security turns on, this is actually unique, and I’ll show you a breakdown of where the income is coming from in a minute, but we’re actually getting income from the IRA in these years, instead of doing bigger conversion.

That is keeping the IRA account balances down. Then once Social Security is turned on, we complete the Roth conversion strategy. The reason this is projected this way is because we do get a slight tax benefit with Social Security. Part of the purpose of Roth conversions is to get money out of that IRA. There are really two ways you can do it. You can spend the money or we can do Roth conversions. Now, we’re going to look at where is that income coming from to do Roth conversions, to pay the taxes, and also to live off.

We see here a $204,000 conversion and the yellow is the taxable withdrawal. This is all Roth conversion. Then this yellow, the taxable withdrawal, this is for our living expenses and also to pay the taxes on that Roth conversion. Year two, we’re now knocking out Julie’s IRA here. It’s completely converted. We’re completing our Roth conversion schedule with John’s IRA. We’re still doing a little over 200,000 of conversion and paying the taxes and living expenses from the gold or our taxable.

Now, we get here where the taxable the next year is pretty much exhausted, but we’re doing a $204,000 distribution from John’s IRA. If you remember that last screen, John’s Roth conversion was only 168 for this year, but because we don’t have enough non-qualified dollars to pay the taxes and also live off of, we’re having to still pull $204,000 out of John’s IRA. That’s just how it works to get to that 22% bracket.

Then what is unique here is we’re actually just making IRA withdrawals to meet the living needs and to pay the taxes on that. Then we pick up the Roth conversions here again. From this point forward with this strategy, John has very few distribution needs from the retirement account. We see here is at chart are to the required minimum distributions, very manageable with this Roth conversion strategy.

15,000, 20,000, 25,000 30,000, very manageable that actually helps meet the income need later in life so we don’t have the excess or the surplus of income because of forced distributions above our spending target. Pretty cool little chart here. We’re pulling out more in the beginning because this is reflecting the large Roth conversions, but we see here the amount of money needed later in life. It’s such a small percentage. They’re not in jeopardy at all of running out of income at this spending level.

For those of you who like ledgers better, we see it more clearly here doing the taxable withdrawals. This is living expenses and taxes. This is conversions and also living expenses once we get down here and then that continues. The taxable is exhausted. We’re taking from the retirement account and Social Security at that point. Honestly, everything we’ve converted to Roth, we actually never have to withdraw from so that money just growing and compounding tax-free forever.

Now, we’re going to look at the spending goal of $100,000 a year. For all of these spending levels, we’re just keeping it static. We’re not looking at a go-go spending plan or something that’s more dynamic. That’s something that in real life, we very often develop and create, but they need to be monitored more closely. Honestly, these videos would go hours with all the details that we’d have to go into as far as monitoring those and the different decisions we have to make year to year.

Just static income, but this increases the spending goal to $100,000 per year at retired. We see the ending value is 3 million. The total taxes paid is 258. Interestingly enough, this is less, which makes a lot of sense, we’re spending more, but the taxes are actually a little bit less than spending 75,000 per year. If we compare this spending level to doing conversions versus not doing conversions, we end up with about up 2.3 and 760,000 in taxes paid.

One thing to keep in mind here, and I believe it was the first video that I did, there’s a difference between what’s in our account in the future, this number right here, and this number right here, versus the present value of that future sum or how much purchasing power in today’s dollars, will that amount of money buy. That’s a very, very important number because a lot of people say, “You know what? I’m good if I have 2.3 million, 25, 30 years down the road.”

In purchasing power in today’s dollars, that’s probably somewhere around maybe 800,000, 900,000, maybe a million, depending on what discount rate we used or inflation rate. Still a lot of money. I just want to bring that point back up, because it is an important concept when it comes to these calculations. The optimal tax plan here still went up to the 22% bracket, but because we’re spending more, we’re actually doing less Roth conversions in this instance.

Here is the conversion schedule.

Again, first couple of years, same concept because this couple, they have 250,000 outside of their retirement accounts. This is money that’s used to pay taxes and also live on. Once that exhausts because the spending level is higher now, there’s less money to target Roth conversions because we have to those living funds from the IRA that’s fully taxable that gets us up to the bracket much more quickly.

Four years of conversions and here is the account distribution table. Same concept. Visually what I just went through were knocking Julie’s IRA out first, we’re living off of and paying taxes. The taxable funds, they become exhausted a little bit more rapidly than only spending 75,000 per year. Again, we start to live off John’s IRA here, we’re doing conversions, but we’re also getting our living expenses from there.

The more we spend, the less room, essentially we have for Roth conversions. This is still optimal given that spending level because we’re spending more, we’re taking it out of the IRA. We don’t have any more non-IRA dollars. Our required minimum distributions are a bit smaller and the portfolio withdrawal rate, as we see, it’s still at a comfortable level but we’re still at about 2%, 2.5% here, but it’s definitely higher than spending 75,000.

Ledger style. We’re pulling out from the taxable accounts here, and then this is the tax-deferred distributions. One big change here is, now, we actually are having to withdraw from that Roth IRA, but notice how we’re doing a partial from the IRA, partial from the Roth. What this is doing is this is balancing out our future income needs with respect to the tax plan. This is how much we would take from this account. This is how much we would take from this account. That gets us into the optimal tax balance of distributions.

Now, here’s what those accounts would look like later in life. Obviously, it’s an estimate based on the projected growth rates and the income distribution, but this is one reason why we don’t always have to convert everything inside of our retirement accounts. Based on the conversion schedule, we looked at this $100,000 dollars spending level, we can visually see here the tax-deferred accounts in blue, obviously decreasing over time, the tax-free accounts in yellow, increasing over time.

Once we get here, this is age 75 or so, we still have 335,000 inside that retirement account. That is why we have that required minimum distribution in the table that we just looked at but we can take that RMD plus the Roth withdrawal and still keep us right here. This is targeting an estimated 10% effective tax rate. Again, the computer’s just running a bunch of different algorithms, looking at distributions and running thousands and thousands of calculations to help us optimize what this decision is.

In the real world, this is all going to change, of course, because your account values, some years will earn more, will earn less, you’ll spend more, you’ll spend less, but this is again, giving us an idea of what income planning and tax planning, what that actually means, and why it’s important. We’re trying to find this optimal balance level. If you think about a see-saw, okay, we don’t want to be way over here or way over here. We just want to be balanced and we want to target the optimal tax structure in order to pay the least amount of taxes over time.

Now, we’re going to look at the spending $125,000 level. Then we’re going to look at some things to consider and then some takeaways. As I said earlier, $125,000 a year is pretty aggressive if you have 1.5 million saved. If we look here compared to doing Roth conversions, not doing conversions, we’re still running it– very very close to running out of money here. This going up to the 22% bracket, still is the optimal strategy. We’re not doing any conversions, we run out of money.

It only lasts 26 years. We do theoretically make it 28 years here, taxes paid 248 versus over here almost 800,000 in taxes. In the real world, we wouldn’t spend this much because we would see our account balances reducing, but I want to get through the concepts, again, of how it impacts the Roth and conversion strategy.

Now, I want to show you what we call a glide path, which is the projected account balances, but then it overlay sensitivity analysis. What happens if markets perform really well? What happens if markets don’t perform very well? We see projected account balances, good performance account balances, and then worse performance account balances. This is why I wanted to show you this for this high spending level.

Here’s the projected account balance. If we get to right here, we’re 77, 78 years old. We’re probably not feeling horrible if we started with 1.5 and we’re down to 832. The green band and the light blue band, that’s really good performance, poor performance in the markets but what I want to point out is just how quickly the portfolio values deteriorate from there.

At this point in time, this could lead us into a false sense of security, whereas we really would need to be connected to our money in our accounts and understand if we kept spending that much, maybe it’s out of our control. Maybe it’s medical-related, maybe we’re helping out a kid or a grandkid or whatever it may be. Just understand when are in these scenarios where we’re possibly spending more than we should, the account values can deteriorate pretty quickly.

Now at this higher spending level, again, the tax strategy changes. We’re still doing 204 in the first year, but it deteriorates a little bit more quickly here, at least the amount of conversions we’re doing reduces. Same basic concept we’ve seen here where we exhaust the non-IRA dollars first to live off of, and also pay the taxes on the conversion. We’re just simply doing less conversions.

Then we see here kind of a good point where Julie’s Roth, John’s Roth, we’re making pretty big distributions from the Roth because we need to. The big takeaways from this video is our spending level absolutely impacts how much we pay in taxes, how much we should convert in our accounts to Roth, and also our ending balances, which that one’s common sense if we spend more, we’ll probably have less left, but what is counterintuitive is the more we spend, actually, the less taxes we’ll pay if we don’t do the conversion.

That’s because when we spend more, we pull those IRA balances down, we don’t get into the ballooned IRA situation where the balances are so high. Later, we’re forced to take big distributions and then pay a lot of taxes. I have a summary chart here. Here’s a spending level, 75,125. This is the ending value and the estimated taxes paid over the course of life for the Roth strategy, so 5.7 million, 3 million, $262,000 at life expectancy.

These numbers are all run using the median scenario. If the investment performance is better, these numbers would be higher, if the investment performance is worse, these numbers would be lower. That’s what we’re going to look at in number four of this series, part four of the video series next week, how the different portfolio investments can impact the tax strategy.

Then part five, we’re going to tie it all together because there’s so many different variables and so many choices that we have to make. I want to do one comprehensive case where we look at a real-life spending different levels, go-go, slow-go, maybe one spouse passing away sooner than the other, what that does to taxes. That’s what we’re going to do on part five.

Here’s something kind of neat, the difference between spending 75 and 100 is a difference in estimated $2.7 million in ending value. This is from 62 to age 90, so it’s about 28 years. It just shows you how much spending more and the loss of compound interest on that money can’t have on a plan over time. The taxes as we spend more as I showed you here, are actually less than if we spend less, but we end up with a lot more money in our accounts, and a lot of this money is tax-free.

This is the base case, so this is doing no conversions, spending 75,000, 4.8 versus 2.3. Obviously, we end up with more money over time doing the conversions, and of course, we pay less tax over time but even in this scenario, spending less, we actually pay pretty significant amount more in taxes about 200– Well, I guess not that bad, relatively speaking. Again, look at the difference between estimated ending values. Again, all of these ending portfolio values are in future value, not current purchasing power.

Then the total amount we’ve converted is this last column in the smaller spending level, we’ve converted 865, 560, and then $450,000. Again, we’ve run out of money here not doing the conversions, and we quite possibly run out of money at this high spending level even doing the conversions. Now, I’ve written a few points down here to consider because I don’t want people to, if you’re in this situation, similar age, similar assets saved, similar spending goals, this is still not a blueprint for you to follow.

I’m just trying to provide content to help us start to think about our own situation, but please don’t apply what we’re doing here to your particular situation and these are some of the reasons why. In the real world, we’re not going to spend the same amount of money on an ongoing basis. You may have what we call a go-go plan, where we’re spending 100,000 for the first 5 years or 10 years, then it drops to 80,000 in today’s dollars, then maybe down to 60.

We may have a dynamic spending plan, where in years where the market does really well and our accounts grow more than we expected, maybe we spend some of that money. Maybe we take some gains, lock them in and spend it by selling those securities when the market is up. When the market’s down, maybe we spend less, we tighten the belts a little bit. That’s more of what a dynamic spending plan is.

If you have a go-go plan or a dynamic plan, the tax plan is also going to be different, and that’s really what I tried to illustrate today. Different spending levels alters the tax strategy and the outcome. Both spouses. Do you have the same longevity? Our example today, both spouses made it to 90. One of the most punitive aspects of the tax code is that when one spouse passes away, the surviving spouse goes into the single tax brackets. Your health, that is a consideration with your tax plan.

Legacy plan. What we’re doing today with our tax plan does impact what I call the composition of your accounts later, and that just simply means how much in IRA and how much is in Roth. If it’s important for you to give money to the children, or to the grandchildren, or to keep it in your family, then doing conversions can help benefit that goal. Let me be very clear about this, you get to choose your beneficiaries. It’s either your children, charities, or the IRS.

A lack of planning here, the IRS will be a large beneficiary of your account. Saying you don’t care or one of these things like I hear sometimes, that’s fine but just understand in that scenario, you are choosing the IRS to be your beneficiary. If you’re okay with that, that’s fine with me. I’m actually going to do a video in the future, going through the legacy planning side of things, because if the IRS is the beneficiary due to a lack of planning or a lack of care, then it’s not just income taxes many of you have to worry about for the kids, it’s estate taxes as well. We’ll dig into that. Separate video though, give me a little bit of time.

Long-term care. This is a consideration because the stats are alarming. I haven’t looked at the most recent ones, but I want to say that if both spouses make it to 65, there’s a 90% chance that one of them will need long-term care during their life. When we’re looking at the tax planning, we not only want to make sure we have money left to help pay for those bills, we have to be smart because we can deduct a certain percentage of medical expenses from the IRA.

Maybe we don’t convert everything. Maybe we look for that optimal balance and plan on, “Hey, one of us are probably going to need long-term care. We can get an income tax deduction later in life, possibly for this. That means we can withdraw the money from the IRA and pay no income taxes because we can get a deduction on the tax return.” A little bit more advanced, but just understand those considerations go into the tax planning that we’re doing today.

Then of course charitable. If you are charitable, you have qualified charitable distributions where we send the money directly from your IRA to a charity. It counts towards your RMD but you don’t have to pay income taxes on it. Estate taxes and some of the legacy planning staff isn’t quite as important if we plan on leaving the IRA to charity. Just keep in mind here, there’s a lot more considerations and this is not an exhaustive list, but this is why the financial planning process and working with someone who obviously is competent and educated and understands this situation, but most importantly, understands you and what’s important to you and your family.

Find someone good. If it’s not us, find someone out there that you trust, that is competent, that understands all these different aspects, and get yourself an income plan, a tax plan, an investment strategy. Then have conversations and ask good questions. It’s about a relationship in retirement. I truly believe those that have that relationship with their financial firm, have better retirements, more security, more peace of mind because you know where everything is and why you’re doing what you’re doing.

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