Step 3 of Retirement Success Plan: Tax Planning
Troy: You’ll hear me talk about visibility a lot when it comes to retirement planning and to put very simply, that means being able to see the impact of the decisions you make today and how that affects your future in regards to financial security, your account balances, the taxes you pay now versus the taxes you’ll have to pay later. None of us would get in the car in a thunderstorm, not put the seatbelt on, not turn the windshield wipers on, no headlights, and just drive down the freeway. We wouldn’t do that. We need visibility so we can make good decisions, we can react when needed. When we’re planning for retirement and taking distributions from the various accounts that we have, you simply need to understand how the decisions you make today are impacting your financial security in the future.
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Step 3 in the retirement success plan is tax planning. This is something that’s done in the beginning of the plan but more importantly, it’s something that’s done throughout the relationship. Remember, step 1, allocation. We need the allocation to make sure that you’re comfortable with your investment plan. If you have too much risk, you’re probably not going to stay invested. When the markets go down, you get out, plan blows up, everything else is pointless. Allocation is step one. Have to make sure we’re in that comfort zone there but also in a position to achieve expected returns that help you draw income, reach your goals, everything we’ve talked about so far.
Once we’ve had that allocation, we can start to develop the income plan, which is step 2. Now that we have income, we can really start the tax planning discussion. When we’re building these plans behind the scenes and between typically your first and second or second and third visit, we’re doing all three of these at the same time. We come up with a base recommendation or a base idea of what makes sense for you, and then we start to have discussions getting feedback from you as to the benefits and considerations of some of the different paths that we can go.
The third step, the tax planning step, is something that is very, very important in the beginning but also on an ongoing basis. What I’m going to show you today are some of the tools that we use with our clients to have conversations about tax planning. It’s important to understand a couple of things. First and foremost, tax planning, even though there’s science and math behind it, it is very much an art. The easiest way to explain this is if we take money out of this account and let’s say, we decide to pay more taxes today to pay less taxes over the course of time, well, how does that make you feel? You have to write a check to the IRS. That’s less money in your account that you’ll have to earn interest on. Even though the math may tell us one thing, we need to make sure that the decisions we’re making today also make sense for you in context of your overall plan.
The difference between tax advice and tax planning
The second distinction I want to make here is the difference between tax advice and tax planning. When you need tax advice, you go to your CPA. Typically, that’s going to be, can I take this deduction for my small business, or I just had a newborn child, what type of tax credit do I get? They’re looking at everything that’s happened over the past year and reporting it to the IRS and hopefully, creating some type of strategy to help you pay less tax on that year’s basis.
What we do from a tax planning perspective is we have access as the financial planner to far more information about your specific circumstances, your health, your longevity, your total assets, your spending goals, how you may want to spend more in the early years of retirement, spend less later. We’re building a financial plan and then taking into consideration the decisions that we could make and how that impacts not just your taxes today but your taxes in the future. As planners, we’re looking forward. Typically, your CPA is looking in the past, so very, very big distinction there.
A lot of people think they can go to their CPA and get forward tax planning. Well, you may be able to pay for that as an extra service but typically, your CPA is not going to have an intimate understanding of all the subjective items of your retirement plan in order to really do that proper planning. The first thing I like to do is look at the status quo. What happens if you follow conventional wisdom, which means you continue to defer your retirement accounts as long as possible and live off your non-IRA accounts when those paychecks stop and you enter into retirement. For a lot of you, that’s the exact wrong way to go about things, but we have to have that base understanding because, for some of you, it does make a lot of sense.
Going beyond conventional wisdom with tax planning
What we have here is this is the conventional wisdom. Now, this is a hypothetical case study. This is very common to what we see. If you’re single or married, if you have $4 million or $1 million or $500,000, whatever you have, we always want to look at this base scenario and then compare it to one of the top-ranked Roth conversion strategies. Usually, the Roth conversion strategy is one of the top-ranked as opposed to simply withdrawing from multiple different accounts and avoiding Roth conversions but, again, everyone’s circumstance is a bit different. High-level, all we see here is two diverging paths. One, we do absolutely nothing. We let those retirement accounts defer and we pull from them once we’ve exhausted all of our non-IRA funds. This one over here, we take a more strategic approach targeting specific tax brackets and areas of the tax code to where we can withdraw either simultaneously from both of those different types of accounts or do Roth conversions. We see high-level taxes paid. This is one of the top-rank strategies. A lot of times, number 1 through number 10, not a huge difference but it’s really about the ongoing maintenance and management because things change so dramatically from year to year typically when it comes to tax planning.
As we look at the base scenario over here, the conventional wisdom path, we see it’s estimated. We’re going to going to pay about a million dollars in taxes if we follow that strategy, but over here, we have one of the top rank strategies. What this particular software does is it runs hundreds of thousands of different possible distribution and Roth conversion scenarios, and then it starts to rank them typically the top 30, the top 50, just depending on how many there are for your particular situation.
We see over here, it’s an estimated $566,000 in taxes paid with this going down this path. We clearly see there are some potential tax savings here and that’s not a little bit of money. That’s a pretty significant amount of money. When we start to talk about those big questions that you have in retirement, do I have enough? Will I run out of money? If something happens to me, will my spouse be okay? How do I pay less tax, medical expenses, long-term care, assisted living. When we can develop a tax planning strategy that has the potential to save us hundreds of thousands of dollars, well, that essentially is found money. That’s more money that you have in your accounts to help address some of those retirement concerns down the road.
We see an estimated ending value here of 4.8 versus 4.2, so about $600,000, let’s call it, maybe $650,000 and additional ending value. Now we know that there is a potential tax savings here that’s pretty significant. We also know that it’s projected if we follow that path that you should have higher ending balances later in life. Does that mean that we should absolutely go down that path? No, it does not. It’s time to get a bit more granular and first understand what challenges do we have if we choose to go down more of the conventional wisdom path or the one that was initially recommended, or we try to find a happy medium somewhere in between there. Again, this can change from year to year because the market performs differently, economic conditions, health things can pop up as well as just your simple willingness to take on various risks when it comes to future taxes can all change what the plan is.
First thing I like to do is, green is conventional wisdom. Here it’s just simply showing us if we do nothing, based on the amount of money we have in our retirement accounts, what is it projected that our required minimum distributions will be in the future? We see here we’re at 120, 150, and it’s going all the way up to $200,000, $250,000. That’s just money that is forced to be distributed out of your retirement account. Understanding that, you’ll have that distribution plus Social Security plus any dividends or interest or pension or rental income or any of your other income from your various streams on top of these required minimum distributions.
Things to consider when tax planning for the future
I ask you, what do you think taxes will be in the future? None of us really know, but I’m of the belief that taxes will most likely be higher, but at some point, they will probably also swing back. That political pendulum, it swings, taxes go up. Those in party typically get replaced. New politicians come in, tax rates change for a little bit, then they typically go back the other direction. This is the art. We know this is a problem most likely though to have substantial required minimum distributions and minimally, we know that it’s a risk. In case taxes do go up in the future, if we all of a sudden are 84 and we have $300,000, $350,000 of income, well, what if half of that is going to taxes? 60%, 40%? That’s a risk we don’t know, so the question to you becomes, do you want to carry that tax risk? Something else to keep in mind.
When one spouse predeceases the other, you go from the married filing jointly brackets to the single brackets. The rates change, and I say brackets because they get compressed. You can have substantially less income and pay the same or possibly even more in taxes. That’s a very, very important distinction here or something to understand. That’s a risk. Do you want to carry it or do you want to start to address it today? Remember, in the beginning of this video, I said you will pay taxes. The only question is, when will you pay those taxes and how much will you pay in tax? I’d like you to see the visual composition of your accounts based on different paths that you can take. Here, what we see in the blue, it’s all tax deferred. We’re starting at about 2 million. We’re not spending as much to where we’re creating drawdowns in this particular hypothetical case study but we see all the money that we have, it’s just growing in these tax-infested accounts, so a couple of things. One, you want a second home, you want to buy a boat, you want to spend $50,000 going on a vacation, you just want to go to the grocery store, all of that money that you have to take out, it’s going to be subject to income taxes because they’re in these tax-deferred accounts and you’re subject to whatever your partner in that account, which is Uncle Sam, whatever they say tax rates are. That’s the first thing to be aware of.
Considering Taxes when Estate Planning
The second thing, if it’s important to you at all when you pass this money on to your kids and grandkids, if you care how much they actually get to keep. The law says when you pass retirement accounts on, they have to be fully distributed within 10 years of the day to death. Let’s say you have two children and let’s say they’re married and working. Both spouses maybe have jobs, and they’re making pretty good income. If they inherit this account, they have to start distributing. This income will go on top of their income, and what will taxes be in 15, 20, 30 years? We don’t know but that’s a tax risk. I want you to understand the estate planning component of the tax decisions that we make today.
Estate planning, by the way, is step 5 of the retirement success plan. All of this blends together but it’s also a guide path for decisions that we have on an ongoing basis in this relationship. Up here, we see now the composition of the accounts if we start to address the tax infestation we have in these accounts. The yellow is now tax-free. This plan does not have us completely eliminating the tax-deferred accounts as part of our overall retirement plan, but we do clearly see over the first few years here, we’re really addressing it and over time, this actually has a multiple-account distribution strategy later.
We are taking income from the IRAs along with Social Security to target a specific tax bracket in the future while allowing these Roth IRAs, the tax-free accounts, to build and compound. Those also have to be distributed within 10 years of the date of death but there are no requirement on distributions annually for your beneficiaries. Again, they are 100% income tax-free whenever your kids inherit them. Those are some of the benefits and considerations that you should be aware of and are part of the conversation when we’re building a tax plan.
Roth Conversions
As we see here, something else we should know is that the blue line represents your account balances projected when we take money out of the account, convert it over to a Roth IRA, which creates a taxable event that you have to write a check to the government and pay those taxes. Because you are paying taxes, you have less money in your account to earn interest on over time. We can clearly see the divergence between two hypothetical scenarios here. The green is doing no tax conversions, keeping it all in the retirement accounts, letting it balloon and defer and defer and defer. The blue simply shows we’re doing those conversions because we want to take that tax risk off the table, either taxes being high in the future, one spouse predeceased and the other, and numerous others, but we see the divergence of these accounts.
Now one thing to keep in mind as well, the green is a higher balance but you have a partner in that account, Uncle Sam. Uncle Sam can come into that relationship at any time and change the rules of that partnership. Just being aware of, even though, yes, you do have more money on paper, all that money is not yours, so some of the conversations that we have regarding the pros and cons of making these tax planning decisions. One last thing here before I jump into the next software that we use with you to help have these tax planning conversations, I also like to see the numbers.
In this column, we have the Roth conversion scenario. Taking Social Security later in life, deferring it because those two go together. The income plan and the tax plan, they work together and you’ll see in a second. Over here, we have deferring those retirement accounts, taking Social Security early, and how these two interact with one another. The total taxes column, very clearly, we see that this particular tax plan is taking advantage of the Trump tax cut. We do have a limited window of time here to take advantage of not just lower tax rates but much higher brackets.
When we talk about brackets, I want you to think of a tax bracket as a bucket. You can fill that bucket up with a whole bunch of different income before you go into the next bucket and that next bucket taxes the next dollar at a higher rate. This is called a progressive tax system. With the Trump tax cuts, what they’ve done is they’ve created much bigger buckets so you can put more income into that bucket before you go to the next one. In 2026, the law sunsets. Those buckets are getting smaller. The rates are going up and the buckets are getting smaller. There is a limited window of opportunity here to take advantage of some of these tax planning techniques and find the optimal structure that takes into consideration your future security versus what you’re willing to do and pay today in regards to taxes. I want to look at a few different ages here and just show you the comparison. Here we see, at 75, doing the tax conversion strategy, we have 80 in deferring Social Security. We have $87,000 of Social Security. We’re only paying $4,000 in taxes. Over here, same age, 75, we have $50,000 in Social Security but we’re paying $30,000 in taxes. Fast-forward five years, up-to $94,000, only paying $6800. $53,000, paying $43,000. The taxes takes into consideration all of the income in this particular financial plan, both sides, but the income chart here is only showing the Social Security. There’s a lot more, obviously, if this was a one-on-one meeting that we will go through and start to look at this in detail, but I just want to convey the power of having a tax plan and an income plan working together because Social Security is a major part of your retirement income plan.
Again, the art. Do you feel more comfortable paying less taxes today, taking Social Security sooner, having more money in your account balances, but because we’re taking Social Security and not doing conversions to preserve those account balances, we will have to take more money out of our accounts later because our guaranteed lifetime income from Social Security is significantly less but also because we have to take a lot more out to account for the taxes that we will owe. I sat with clients, they say, “Troy, this is the way I want to go. I feel much more comfortable with this.” A lot of people that we sit with, “You know, this is the way we want to go.”
I’m not here to tell you one is right and one is wrong. I’m here to identify the risks of going with this plan versus this plan and have those conversations and then start to find what makes sense for you. We want to build this box around you, not fit you into some preset or pre-made retirement planning box. Once you have a clear understanding of how different decisions that you can make today impact your future, and let me be very clear here, you don’t have to decide what you’re going to do for the next five years. You just have to decide what are you going to do this year, but when you have that visibility into how those decisions or that decision impacts your future, you start to create more visibility. You start to create more clarity but you also have confidence because you understand when you write the check to the government, if you’re doing Roth conversions, you understand the benefit today and also down the road.
Tax Planning: An Ongoing Necessity
For clients, when we have this relationship where we’re talking about tax planning on an ongoing basis, we’re going to go a bit deeper. When we start to look at possible decisions that we can make today, we want to be able to model them out but on a much more short-term basis. We’ve already decided that, hey, we want to go in this direction. We understand the positive impact that can have on the long term. Now let’s start to get, again, a bit more granular but do so over a much shorter timeframe. Here’s an example of– This is a essentially a proforma tax analysis for a client that, let’s say, we had a plan together, been with us for some time. They come in and they say, “Troy, I’m done with work. My boss really made me upset. I want to spend time with the kids and grandkids. It’s just time for me to retire.”
We have 2023. They come in. This was their wages for 2023. Maybe they had some dividends. Maybe they had some other income. Now what we’re doing is we’re creating a proforma, so let’s say 2022, and now this is 2023. We need to look to see what income from the previous year is carrying forward to this year. We start to build out this proforma tax statement and then we can even go one at a scenario, go out to 2024 here if we want to look at this over a 2-year timeframe, but what we’re doing is we’re starting to fill in these blanks, so based on information that we gathered from that longer term plan, let’s say, it’s $100,000 Roth conversion. Let’s actually go in and look to see how is that going to impact your taxes today, how is that going to impact your modified adjusted gross income, how is that going to impact your taxable income?
Now, we’re starting to create visibility into the short-term from information that we’ve gathered or gleaned from the long-term analysis. Let me show you a quick example. Let’s just assume this was December. The client came in and said, “Troy, I’m no longer going to have my wages.” We don’t have to transfer any wages over to 2023. We have the dividends. Let’s say we decided from the other longer-term analysis that a $75,000 Roth conversion is a possible way to go. We input that over here. We don’t have this capital gain, which was on their tax return from last year. We may have some though later in the year, just depends. Now we can open up a couple of these other modules here and let’s say, we want to solve for max. We can go $36,000 in ordinary income before we hit the next change in their effective rate. We have a Medicare breakpoint at $1500 more. This is how much we can have in long-term capital gains or dividends before that gets us to a change in the overall effective tax rate. It’s starting to get a little bit in the weeds here but it’s just important to to point out some of the different things that we have from a planning perspective on a short-term basis, because even if you’re not going to become a client like many of you’re watching this video never will, but you still need to understand that when you’re looking at the long-term of your tax plan, how you should plug some of that data into the short-term analysis and start to get an idea of where you’re at.
Then you come to the art point of this process where you’ve done the math, now let’s start to look at this subjectively, let’s start to look at this emotionally, let’s start to look at this with respect to our spending goals, the fact that, hey, we just retire, we don’t have paychecks coming in. Maybe we want to be a bit more cautious but also, we have a limited window of time here because the Trump tax cuts are going away. You see how all these different things are coming in to be a factor into the decision and the path that you ultimately choose.
Understanding the Impact of the decisions you make today
This is step 3 of the retirement success plan. It’s tax planning, which is creating visibility into the future of your accounts and taxes based on understanding the impact of the decisions that you make today and then the relationship. I can’t stress enough how important the relationship is moving forward because having this expertise on an ongoing basis to have these types of discussions around the choices that you can make really is what creates good value over time because you can compound good decision after good decision after good decision. I feel that gives you a much better chance to pay less tax over the course of your retirement.
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