Ready For Retirement
Ready For Retirement
Pre-Retirement Tax Planning: Things to Know to Save Big in Retirement
Retirement tax planning should begin well before retirement. Listener Jodie, with over $2 million in assets in various types of accounts, is concerned about the high tax bracket she anticipates she be in in retirement. Is there a tax strategy that would put her in a lower tax bracket?
James explores some often-overlooked tax strategies that can save retirees thousands in retirement, especially for those like Jodie with diverse portfolios.
Questions answered:
How could my home be part of my tax strategy?
How can understanding different income sources and account types can help minimize tax burdens in retirement?
Timestamps:
0:00 - Jody’s question
3:54 - The home
7:06 - Inflation and tax thresholds
11:04 - Cash flow vs taxable income
15:07 - Withdrawal strategy
19:30 - Summary
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You should begin planning your retirement tax strategy well before you actually retire. Now, this does not mean that you need to know every single meticulous detail about where will tax brackets be, what will your withdrawal strategy look like? What exactly will taxes be, but it does mean that you should have a general understanding about some of those things, and you should have a general understanding about how your current assets and income sources might impact that. That's exactly what we're going to discuss on today's episode of Ready for Retirement, as we unpack a listener's question. Who is planning for retirement but very unsure about how to plan for some of these various items? This is another episode of Ready for Retirement. I'm your host, james Canole, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. This question comes from Jody, and Jody says the following I've been binging on James' podcast and have recently started binging on Ari's. I love your podcast and listen as often as I can, and you both talk about ways to pay lower taxes, and I feel like my net worth breakdown does not allow me to do this. I'm on the high end of the 22% tax bracket, so when I look at tax plays, I never seem to get out of this tax bracket, tax bracket. So when I look at tax plays, I never seem to get out of this tax bracket.
Speaker 1:Here's our current situation. My husband and I are 57 years old and we will retire at age 63. We have $188,000 in a brokerage account, $1.1 million in 401k and IRAs, $860,000 in Roth IRAs, $155,000 in health savings accounts, $69,000 for a total net worth of about $2.37 million, excluding our home. Our home is worth $610,000 and it will be paid off when I turn 61. Our goal is to live out our lives in our current ranch home. I make $165,000 per year and my husband makes $41,000. We put $55,000 into our Roth each year and we max out our HSA each year as well. My husband gets 3% matching, but I do not have a match. I do have $110,000 in medical receipts I have saved for the HSAs because I've never used it. That will allow some flexibility on the HSA's use. I will take Social Security at age 70, which will be $4,713 per month, and my husband will take his benefit at age 67, which is $1,614 per month, and then add his spousal benefit when I turn 70. I also have a pension of $18,800 per month I believe that should say per year, starting at age 60, and that never increases. I plan to keep putting money in the Roth through 2025, when taxes are lower.
Speaker 1:I'm not sure if it makes sense to continue doing this or shift to tax-deferred accounts or even brokerage accounts. I expect a retirement budget of $175,000 per year, which I've already adjusted for inflation for the year we retire, which will go down once Medicare kicks in. I'm assuming no reduction in spending as we age due to some medical conditions that I have that likely will put me in a wheelchair. But despite these health issues, both my husband and I expect long lifespans based on our genetics. When I run the numbers, I can stay in the second tax bracket for the first two years of retirement, but thereafter I'm solidly in the third tax bracket and sometimes even the fourth tax bracket, and my math shows I will spend through all taxable accounts 401ks and IRAs by age 75, and then start hitting my Roth accounts at age 76. This also assumes I'm spending $400,000 to purchase inherited property from other relatives around age 75. Should I be switching to brokerage accounts in 2025? I've done so much number crunching and modeling and still find it difficult to determine the best path forward.
Speaker 1:It would be an honor to make one of your podcasts as one of your examples to help myself and others. Thank you for all the information you provide, and keep doing it. From Jody Jody, thank you very much for that question. I've condensed some of it just for the sake of brevity, because we're going to try to focus on key points, or a few key points, as we go through this, and instead of taking Jody's situation trying to lay out the perfect strategy, what I want to do instead is take some excerpts from what Jody said and maybe reframe the way they're thought about, both for Jody as well as for all of you, because there's some common misconceptions when it comes to tax planning in retirement. So this isn't going to be taking all of Jody's moving pieces and rearrange them in the perfect way, nor should this be construed as advice, but what I will do is give you maybe some different insights from different angles that might help put some of this into perspective.
Speaker 1:The first thing that I want to start thinking through, as we're talking about tax planning in general and how to incorporate some of these things, is the home. Now, this is maybe the least impactful or least important factor of Jodi's tax planning, at least in her tax situation, of course. But I do want to mention it because a lot of people come in and they say, well, here's my home and here's the equity, and here's all this. Your home in some cases does play quite a bit in your tax planning strategy, but in many cases it doesn't. The impact that your home can have on your tax strategy either comes down to the equity in your home or potential write-offs from your home. So let's quickly explore those.
Speaker 1:So equity Now equity does not actually matter unless you plan to do something with your home, meaning it does not matter if you have $500,000 of equity in your home or if you have $5 million of equity in your home. If that home is where you live and it's where you're going to continue to live until you pass, that's really not doing much for you and it's certainly not impacting your tax strategy. Where it would impact your tax strategy is if, at some point, you plan to sell your property or refinance or take some type of reverse mortgage, and the reason for that is because that would likely leave you with some cash. Now that's cash that you could either live on to keep your taxable income lower. Obviously, there's other factors at play here as well. It provides income, but I'm specifically talking about tax strategy. If you have cash, of course, then you could live on that cash and there's no tax hit for taking a loan, so that's cash that you can live on to help keep your taxable income lower. Or maybe you invest it, and if you invest it well, then you need to project out what will the dividends be, the interest be, the capital gains be on that. But that's one way that the equity value of your property or your home could factor into your overall tax strategy.
Speaker 1:The other is with potential write-offs, so any deductions that you have, and this can come in one of two different ways. Obviously, you have property taxes on a home and you could deduct those if you're not taking the standard deduction Now, for current tax law, you cannot deduct any more than $10,000 per year in state and local taxes. Property taxes are a local tax, so even if you're paying 20,000, 30,000, 50,000 per year on property taxes, you cannot deduct any more than 10,000 of that, and that's including any state income taxes you pay as well. Or the other way this can factor into your tax strategy is, of course, with mortgage interest. So if you have a property and you have interest on the mortgage that you have against that property, that interest can be used to write off against your income. So this has to do with tax planning.
Speaker 1:When it comes to what will your itemized deduction be, or your standard deduction? In Jody's case, she says that she and her husband plan to have their mortgage paid off by the time that they retire. A lot of people are in this case as well, and even people who don't have their mortgage fully paid off by the time that they retire. It's very common for them to have it largely paid down, so much so that the interest that they have on their mortgage, even though they're still paying interest and still paying a mortgage, oftentimes that mortgage interest, when you combine it with state and local taxes, when you combine it with charitable giving, when you combine it with any other things that you can itemize, it still comes under the standard deduction amount, which means people tend to take the standard deduction instead. So just wanted to start with that, because Jody did mention her home value in her question and, yes, it absolutely factors into the overall plan, but probably not so much into the tax strategy for this specific situation.
Speaker 1:The next things I want to talk about will apply a lot more, and what I want to go to next is inflation. So inflation doesn't really impact the tax strategy directly, but the way that you calculate numbers into the tax strategy it absolutely does. Here's what I mean by that. I'm going right back to Jody's question. Jody says I expect a retirement budget of $175,000 per year, which is already adjusted for inflation the year that we retire. Okay, so that's good when you're planning for your retirement. It's not how much do I need to have my portfolio and income to support today's living expenses? That's how much do I need to have my portfolio and income to support my retirement expenses, which is going to be higher because of inflation.
Speaker 1:Here's the thing, though what's also higher because of inflation is tax thresholds. So, jody, it's totally fine that you're inflating your income, but if you're taking that $175,000, which I don't know exactly what that is in today's dollars let's say it's 140,000, just to use an arbitrary starting point If you're saying, hey, today I need to live on 140,000, but in retirement I need to live on 175,000. If you're using that 175,000 and then applying it to today's tax thresholds, you're not going to get an accurate assessment. What do I mean by tax threshold? Well, there's tax rates and there's tax thresholds. The rates are the 10%, 12%, 22%, 24%. Those are just the ordinary income tax rates. The tax thresholds, though, says at what dollar amount of taxable income do you cross over into the 10% tax rate? At what dollar amount do you cross over into the 12% tax rate? So the difference between rates and thresholds is that, even though the rates stay the same, at least as long as current tax brackets stay the same, tax thresholds are actually increasing each year with inflation. For example, in 2024, the 12% ordinary income tax bracket ends at $94,300, meaning, if you're under that dollar amount, you're paying taxes at a 12% marginal rate as soon as you exceed $94,300. So the next dollar after that, you're now paying 22% taxes on. So the 12% is the tax rate, the $94,300 is the tax threshold. Well, let's compare that to 2023. In 2023, that 12% tax rate was exactly the same, but the tax threshold was different. $89,450 was the threshold, so below that, you're in the 12% tax rate. Above that, you are at the 22% marginal tax rate. So what you can see is inflation goes up each year, and so to do these tax thresholds from 2023 to 2024, when, looking at this specific tax threshold, that's a 5.4% increase.
Speaker 1:So why do I say all this? I say this because, going back to Jody's question, if you're saying here's my current income, what's this going to look like when I retire? There's certainly good aspects to that, but if you're then looking at the $175,000 and comparing it to today's tax thresholds, you are overstating or you're overestimating, most likely, what your actual tax situation will be, what your actual tax liability will be, and that's because you're keeping lower rates today. You're using today's tax rates and today's tax thresholds, but tomorrow's or I really should say the year in which you retire's actual income. So be very careful about that. Either look at the income that you expect to have in today's dollars and compare that to today's tax rates and tax thresholds, or use your retirement expected income but compare that to today's tax rates and tax thresholds. Or use your retirement expected income but compare that to the retirement tax rates and tax thresholds. And yes, there's some guessing going on with that, because we don't know exactly what's going to happen to tax rates. Obviously, we're in an election year and, with this election, the outcome of that election could very much determine what will tax rates look like for the next number of years, but keep that in mind when you're looking at inflation is tax thresholds. Do go up each year with inflation and make sure that you're incorporating that.
Speaker 1:The next thing that I want to look at here with Jody's tax strategy is the decision between Roth account versus pre-tax IRA account versus brokerage. Jody says the following quote I plan to keep putting money into the Roth through 2025 while taxes are lower. I'm not sure if it makes sense to continue doing this or to shift to tax deferred accounts or even brokerage accounts. I expect a retirement budget of $175,000 per year, all right. Well, we just talked about some of the issues with planning for retirement budget of $175,000 per year, Assuming you're using today's tax thresholds.
Speaker 1:But in retirement, don't look at your retirement cash flow. Look at your retirement taxable income. Even if, hypothetically, jody or you or whoever it is, if your income today and what you plan to live on meaning your actual budget is the exact same as what you plan to live on in retirement, that does not mean that the tax impact of that income will be exactly the same. In fact, in most cases it's not so. Think of cash flow. Cash flow is what income amount are you living on or what are you pulling from accounts or social security or pension. But don't think that automatically is the same as your taxable income. For example, social security. You could receive $1 in social security and that's good for $1 of cash flow, but it's not $1 of taxable income. For example, social security. You could receive $1 in social security and that's good for $1 of cashflow, but it's not $1 of taxable income, because not all of your social security benefit is included in your taxable income. Or you could have money from your Roth IRA $1 of income from your Roth IRA is the equivalent to $1 of cashflow, but it's not taxable at all. It's the equivalent of $0 in taxable income.
Speaker 1:And we can look at a few different income sources or a few other income sources that are similar. So qualified dividends and long-term capital gains well, those are taxed at lower rates than ordinary income rates, so that's cash flow, but it's not taxed the same way. Salary would be the same way. An IRA distribution would be or cash or investment principle. So this is money that you've already paid taxes on. You could live on that to support your cashflow, but not have it impact your taxable income. In addition to this, once you're 65 years old or older, you get an expanded standard deduction, so you get to write off more of your actual income to find out what is actually left as your taxable income.
Speaker 1:So, in looking at Jodi's situation, what I do know is less than half of her assets are actually fully taxable, meaning less than half of her portfolio is in a traditional IRA or 401k. She has a fairly significant Roth IRA account, health savings account, cash accounts, brokerage accounts. So in fact, jody, in looking at this, you have quite a bit of wiggle room to create a really solid tax strategy because of how many different account types you have. Going into retirement, where you wouldn't have maybe the same margin or capacity for tax planning is if everything was in an IRA. There's still absolutely things to look at, but if everything's in an IRA in your income before retirement, in your income after retirement, it's the exact same. There might not be a lot of room to say how can I get my income lower in retirement than it is today, but that's not the case and, like I said, less than half of Jodi's income or less than half of Jodi's assets are actually in an account that is entirely taxable. So there should be a large opportunity here for some good tax planning to make sure that she's doing this right.
Speaker 1:But this is a general principle that doesn't universally apply to everyone, but I would say it's fairly common is that after you retire, the makeup of your income is much different than the makeup of your income in your working years. In your working years, of course, you have a salary which is fully subject to federal taxes and state taxes, depending on what state you live in, but in retirement it's usually a combination of social security, maybe some cash, maybe some dividends, maybe interest, maybe pulling from your Roth IRA. All of those things are taxed differently, and so even if your income is the same income, meaning the dollars you receive in your bank account each month your taxable income is not the same. And that's very important to know, because with tax strategy, you're not looking at your cash flow, you're looking at your taxable income. You're trying to say what can we do to keep our taxable income as low as possible, even while trying to maximize the cash flow coming into us. And then, finally, the last thing that I want to look at here in Jody's case is her withdrawal strategy. Going back to her question, she says quote my math shows I will spend through all the taxable 401ks and IRAs by age 75. Quote my math shows I will spend through all the taxable 401ks and IRAs by age 75. And then I will start hitting my Roth accounts at age 76 end quote.
Speaker 1:So generally speaking again, this is not advice and this is definitely not universally applicable but generally speaking, it's not a good idea to take all from your IRA and then all from your Roth IRA and just to simply divide up your retirement into two phases of. I'm going to start by drawing down the entirety of my IRA and then the entirety of my Roth IRA. There are cases where that makes sense, but for Jody, let's take a look at this and see why that might not be the most smart thing to do. And again, I do not know enough about Jody's situation and make this a recommendation. That should not be construed as advice, but just using some examples here.
Speaker 1:So let's assume that $175,000 is the income coming into Jodi and let's assume that the entirety of that $175,000 is fully taxable. And then let's compare that to what if Jodi was living on $175,000? That all came from her Roth IRA. So first year she takes $175,000 from her traditional IRA and then, year two, she takes $175,000 from her Roth IRA. Let's take a look. Well, if the entirety of that income came from the traditional IRA and we're assuming married finally and jointly for Jodi, that would put her in the 22% marginal tax bracket at an average tax rate, which is simply her total tax divided by her total income of 12.3%. And what it does is it leads to $21,500 of federal taxes. So, to summarize, $175,000 all come from the IRA, all taxable. Of that amount, $21,500 is due in taxes. That's year one, year two. Jodi and her husband then take $175,000 from their Roth IRA. Well, with the Roth IRA, none of that is taxable, so they would be in the 0% tax bracket and no $0 in federal taxes. So over those two years they would pay a total of $21,500 in taxes. All that in year one, nothing in year two. So keep that number in mind real quick.
Speaker 1:Now let's compare that to what if, instead, each year, they took half from the traditional IRA and half from the Roth IRA? So both in years one and in year two, they do that. Well, if that is what they do, then the adjusted gross income each year is $87,500, which is exactly half of $175,000, because that's what comes from the IRA and then what comes from the Roth is not taxable. This would put them in the 12% marginal federal tax bracket and lead to a total tax of $6,160. Now we have to do that for two years. So that was year one, a total tax liability of 6,160, or at least a total federal tax liability, and then they do the very same thing next year for another tax bill of $6,160.
Speaker 1:So let's now compare the two. In the first scenario, where they did all IRA the first year and all Roth IRA the second year, their total tax was $21,500 over those two years. In the second scenario, where they did half IRA and half Roth IRA in year one, ended the same thing in year two. Their total tax liability then was $12,320. So they effectively saved $9,180 in taxes by spreading out how they pulled money out of their IRA and their Roth IRA.
Speaker 1:And that's not to say there's anything magical about half and half. It's just illustrating the point that it's generally not a good idea to go all in from your IRA in one year and then all from your Roth IRA in the following year, and that's simply due to the fact that if you're taking everything from the Roth IRA, you're not taking advantage of your standard deduction or your itemized deduction and you're not taking advantage of some of those lower tax brackets, like the 10% and 12% bracket. That's where smoothing out your withdrawal strategy can be quite effective. I will repeat this again If less than half of Jody's net worth is in tax deferred accounts meaning she should have a pretty good opportunity to say, under certain tax brackets because of her ability to pull from Roth accounts, health savings accounts, brokerage accounts, cash accounts, iras can come up with a good strategic tax plan to where I would be surprised if she couldn't be in a much lower tax bracket in her retirement years than she is currently in her working years. So that is it. That's not to say that's a comprehensive list of all the different things I would look at for Jodi or for anyone else, but as I was reading through her question, those are the things that stuck out to me of where's maybe her thinking starting off in a good place but maybe getting a bit confused. So if we can reframe the way we look at some of these things, we should be able to come up with a much more complete, a much more thorough tax strategy.
Speaker 1:So, jody, I really appreciate you taking the time to submit that question. Really to all of you. We have a lot of questions come in. I read through all of them and try to pick the ones I think are most impactful to the most number of listeners. So thank you to all of you who do that. Thank you to all of you who support the show. Please leave a review If you're enjoying the podcast. You can do so on Spotify or Apple podcasts. If you're watching this on YouTube, would appreciate if you subscribe and hit the like button. And also make sure that you stay tuned, because we're going to be releasing a new format very soon In fact, by the time that you're listening to this episode, we've either already released it or it's something that will be released fairly soon where we want to start inviting you all on the show both to talk about your experiences in retirement what went well, what didn't and also to start doing some actual live case studies, where it's not just case studies that I'm going through on my end, but actually having real people on the show exploring their plan together to show you all what that financial planning, what that strategy, might be able to look like. So I appreciate you all spending some time with me today. Have a great week and I'll see you all next time.
Speaker 1:Hey everyone, it's me again for the disclaimer. Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment, tax, legal or other financial advice. It is for informational purposes only. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember, nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.
