034: Taxes in Retirement: Part 2
Oct 22, 2020
In the previous episode of this podcast, we explored what taxes currently mean for retirees – and why taxes are the most expensive thing in almost every retirement plan.
If you save the wrong way, you’ll be penalized for it. If you were so lucky as to live to be 115 years old, you’d be required to withdraw 50% of your pre-tax retirement accounts each year – and no matter what age you are, your required minimum distributions can lead to massive tax spikes.
Today, we get at the heart of why your pre-tax investments are so expensive when compared to Roth investments, how to effectively prep your taxes regardless of what happens in this year’s election, and why the health of your investments won’t tell you anything about your spending when it comes to your taxes.
Here are just a handful of the things that we'll discuss:
- Why 59 ½, 70 ½, and 72 are the magic ages when it comes to taxes – and what tax penalties you face when you withdraw from your retirement plan at each age.
- How retirees can use qualified charitable distributions to minimize Social Security taxes.
- Tax opportunities created by the CARES Act that may be worth considering
- “Investments are very important but that’s not going to tell you what your spending is going to look like if taxes go up.” – Ed Siddell
LeAnne Siddell: It’s The Retirement Trainer with Ed Siddell, a podcast about finding ways to help you become financially fit for your future no matter what shape you’re in now. Planning for taxes and retirement taxes, are they going up? Are they going down? Are they staying the same? This is Part 2. This is LeAnne Siddell and here to help us with all of our questions and to get some guidance to help us stay in the best financial shape possible, the retirement trainer, Ed Siddell. Hi, Ed.
Ed Siddell: Part 2 of the party, right?
LeAnne Siddell: Yeah, exactly. If you didn’t have enough, again, we’re going to hit you again.
Ed Siddell: Yeah. Glutton for punishment. Put your party hats on because this is fun. You know, it is. It’s not fun but it’s a necessary evil to understand where your money’s going.
LeAnne Siddell: Well, and again, the taxes are such as we talked about in the last podcast, what’s the most expensive thing that you have in your retirement plan and it is taxes. So. where do we get started?
Ed Siddell: All right. Well, we kind of laid the groundwork in our last podcast. It kind of got a little long-winded and thank goodness you cut me off because I do get in the weeds real like, I’ll hop in a rabbit hole in the first heartbeat. You know, last time we talked on required minimum distributions and the CARES Act and planning for taxes in retirement. And let’s start there. So, when we’re doing the class, when I’m taking questions, we always write on their taxes and then we talk about the sweet spot, the magical ages for planning for taxes and retirement. You know, and those two ages are 59 ½ and like we said last time, what I always ask people, all right, what are the two magical ages? Well, half the group says 70 ½. The other one says 72. And I’m like, “Okay, you’re both right.” Because prior to the SECURE Act, which was passed and effective January 1 of this year, and we’ll get into more details in why that’s so important for tax planning. Prior to January 1 of this year, if you turn 70 ½, you had to start taking your required minimum distributions and you cannot stop. If you turn 70 ½ after our January 1 of this year or later, you do not have to start taking required minimum distributions until the age of 72.
LeAnne Siddell: Got it.
Ed Siddell: So, the first magical age is 59 ½ and the reason that that’s a magical age is that’s the youngest that you can be and start taking withdrawals or distributions out of your IRA and 401(k) if the plan administrator allows it, the plan sponsor, and not have the 10% early withdrawal penalty called an excise tax. Now, you still have to pay ordinary income on it but you don’t have to pay that early withdrawal penalty. So, that’s 59 ½ and then we have 70 ½ and 72. So, we call that the sweet spot because there are so many planning opportunities that can be done. Now, once you hit 70 ½ or 72, with the exception of this year because there is a moratorium because of the CARES Act, you do not have to take an RMD, required minimum distribution this year, you have to start taking it at 70 ½ or 72 as we talked about. So, a required minimum distribution as Uncle is saying, “You have deferred your taxes long enough. I want my money.” And in the words of Jerry Maguire, show me the what?
LeAnne Siddell: Show me the money.
Ed Siddell: Show me the money and that’s exactly they want their money. And you know what? You got to pay it. There’s no way around it but what we do is we help families. Most of the families that we’re working with, we’re showing them they’re deciding when they’re going to pay the taxes and how much they’re going to pay because they’re taking advantage of the current tax code right now. So, we’re going to get into that advanced planning after the election, between the election and the end of the year and why that’s going to be so important. So, let’s talk about these two sweet spots, these two ages when it comes to taxes. When you have to start taking your required minimum distribution, you have to start taking a withdrawal percentage and the IRS they’ve shown their hand. It’s on at least I know three places on the IRS website. They have a table. So, based on your age, you have to withdraw a certain amount of your pre-tax retirement and as I said before, it’s the most expensive money that you can buy. And I think I use that in the last episode too is pre-tax retirement, it’s the single biggest asset that most people have besides their homes. So, very, very expensive. So, let’s just say I think it’s 70 ½, it’s 3.65% is the percentage that you have to withdraw and it’s based on December 31 of the previous year.
LeAnne Siddell: And it continues to grow the older…
Ed Siddell: Each and every year. Yeah. So, if you’re lucky and blessed enough to live a long and healthy and fruitful active life until the age of 115 then you have to withdraw over 50%. I don’t want to live that long. So, I’m just going to use an example here and just round up that that percentage to 4%, just to make the math easy. And so, we started working with a young lady who turned 70 ½ last year, and I’m just going to call her Joe. Okay. And so, Joe had about $500,000 in her pre-tax IRA retirement account and she didn’t want the money. She didn’t need the money but she had to take it because Uncle Sam said, “Show me the money.” And so, if you take 4% of that 500,000, so she has to withdraw about $20,000 and like I said, she didn’t need it and she didn’t want it. Now, we were talking about this current tax code, and even with this being as low as it is, taking that 20,000 out is a huge spike in taxes because now that she’s taking this out, now her Social Security, 85% of her Social Security is now going to be taxed because she’s over that provisional income limit and she’s on the border, on the cusp of the Medicare premium adjustment charge, which is really just a tax. It’s called the means-based testing. You’re being penalized because you save the wrong way. And it’s the same thing with Social Security.
So, now she has to pay extra for Medicare B, C, and D and she has to do that for two years, even if we knock it down. So, that’s a huge spike. And as we’re talking to her, we found out that what she likes, what she doesn’t like, what are her interests. She has a charitable inclination so she gives money to her church as well as to a local community-based charity. That’s a big deal. Especially with everything that’s going on right now, a lot of charities have lost an awful lot of money, not just this year, but because of the current tax code, because the standard deduction went up so high. A lot of charities, a lot of people were putting more into these charities to drop them below different tax levels and get a lower tax rate but because the standard deduction more than doubled in most cases, they no longer have to do that. And so, a lot of charitable donations dropped anywhere, you know, I think the estimate for this year was going to be close to about $14 billion in loss, but I think it’s going to wind up being larger than that because of COVID-19 for sure.
LeAnne Siddell: Yeah. For sure.
Ed Siddell: So, as we found out, she had that charitable inclination. What we decided to do was do a QCD, a qualified charitable distribution. And what that means is the money’s coming directly out of her IRA. She is not touching it. Part of it is going directly to the church. The other part is going directly to the charity so it never ever touches her hands. And so, we took 15,000 of that to fund those charities and she kept the other 5,000. However, as far as Uncle Sam was concerned because it left her IRA, she got full credit for the required minimum distribution and yet at the same time, it didn’t affect her taxes. So, because we got rid of that 15,000, 85% of her Social Security is no longer being taxed. That’s number one. And number two, the means-based testing, she’s not paying that surcharge or premium adjustment charge on our Medicare B, C, and D.
LeAnne Siddell: Huge savings, yeah.
Ed Siddell: It is. So, understanding that part is so important because now when we look at why pre-tax investments are so expensive as compared to Roth investments, if this money were on the Roth, she wouldn’t have to worry about it because she had already paid her taxes early on as she was putting that money, I think in the example that I used in the last show was the seed versus the harvest, right? You know, using a $10,000 bag of seeds, think of that as the Roth. So, you purchase a $10,000 bag of seed that plants 100 acres. So, would you rather pay taxes on $10,000 or 100 acres that yields $100,000 in income? Well, obviously the $10,000. It’s not a trick question. All right. I just got an eye roll there.
LeAnne Siddell: Yeah. It’s the downfall of hearing it over and over again.
Ed Siddell: It’s like Novocain. Just give it time. It works.
LeAnne Siddell: Exactly. Sadly enough, I think for people like me, I need to hear it over and over again in order to get it.
Ed Siddell: And so, doing the Roth conversions and participating in Roths, I mean, most people don’t even know that the Roth option has been around since the late 90s. It’s been around for over 20 years but yet most of us haven’t had access to it. And again, conventional financial wisdom always told us that, hey, taxes are going to be lower in the future, we’re going to spend less, and go ahead and get the deduction now. Well, now we know that that’s not exactly true in most cases. So, doing the Roth conversions now, as we’re meeting with families, and we’re looking at their current income where the money’s coming from, what their cash flow is, and converting those assets, those pre-tax assets over into a Roth, what that long-term tax savings is, for a lot of people, it’s huge. I mean, we were doing one for a family and that tax savings was well into the six figures. I mean, that’s bottom dollar right into the pocket and that is based on this current tax code going away in 2025. So, depending on the outcome of the election, this current tax code could go away even sooner. And so, making sure that we’re planning for that and like I said we’ll know after the election what makes sense and what people are comfortable with and what the positive or negative impact in doing those Roth conversions are going to be for each family in that cash flow because, again, retirement is all about cash flow.
LeAnne Siddell: So, if they’re in that sweet spot and they’re right now trying to figure out what it’s going to look like for them in retirement, getting that plan done is imperative, getting that plan done to understand where you are now and where you want to be, and how the details are going to come together.
Ed Siddell: Yeah. And it’s not just in that sweet spot. So, if you look at it, unfortunately, there’s a lot of people furloughed. A lot of people have lost their job. Because the CARES Act, there are some other planning opportunities that people can take advantage of and you no longer have to be 59 ½. If your money is in an IRA, you can convert it over into a Roth without that early withdrawal penalty. So, you’ve got a lot of options to do things then you want to decide, “Do I want to do it all in one year? Or do I want to spread it over the next couple of years?” And that’s why the outcome of the election is so important because you’re going to know how to plan. So, do I have four more years? Is this the last year? Or am I going to have a couple of years? Am I willing to do some this year and hedge my bets just to be on the safe side?
LeAnne Siddell: I think regardless of the election this year or who ends up in the White House, I do believe that the planning component of this is imperative no matter where you are or what the election looks like it. The planning will put your mind at ease that you’ve done what you needed to do in order to make sure that you’re taking advantage of every opportunity that’s in front of you right now.
Ed Siddell: Yeah. And everyone gets caught up in investments, investments, investments, and investments are very important but that’s not going to tell you what your spending is going to look like if taxes go up.
LeAnne Siddell: Cash flow, cash flow, cash flow.
Ed Siddell: It’s not going to tell you what it’s going to look like if Social Security gets cut. It’s inflation, interest rates, all these things, but what will is an income plan, which is really spending plan, cash flow, and that probability of success, right? Being able to look out 5, 10, 15, 20, 25 years down the road and give you the comfort to say, “You know what, yeah, you’re going to be okay,” or we need to kind of do some tweaking because we’re below the line or we’re at the line and we want to make sure that we’re going to have not just an okay retirement but we’re going to have the ideal retirement.
LeAnne Siddell: So, now’s the time. So, what we’re talking about is get your questions answered and find out what you need to do to save on your taxes. So, Ed, how can we do that?
Ed Siddell: Give me a call. Come on in. No cost. No obligation. We’ll go ahead and use our tax and financial planning software and we’ll put together a plan. Like I said, that plan is the roadmap for you to make sure that you’re in the best shape possible when you retire and we don’t charge a penny for the families that we’re helping. We just do it.
LeAnne Siddell: So, there you go. Give us a call at 614-526-4118 or email us at firstname.lastname@example.org or you can reach Ed through our website, which is www.EGSIFinancial.com. Thanks, Ed.
Ed Siddell: Thanks, LeAnne.