They Almost Paid $3 Million in Taxes. One Change Saved $2 Million.

[00:00:00] Hey, welcome to another episode of Retirement Made Simple. I'm your host, Kevin Lum. I'm a certified financial planner based in Los Angeles, and this podcast is dedicated to helping a million people retire without worry. As a quick reminder, every episode here comes straight from our YouTube channel. So this is just the audio, so you can listen while you're walking, driving, or living your life. Let's dive in.

[00:00:26] Most people facing retirement, particularly those who have saved a significant amount of money, have a silent partner in the retirement. That partner is the IRS. And even if you know the IRS is eventually going to get a share of your retirement savings, very few people understand just how much of the retirement savings might end up going to taxes.

[00:00:50] What people tell me all the time is, look, I don't mind paying my fair share. I just don't want to tip the government. Well, the good news is that the number you owe in taxes isn't set in stone. Because taxes in retirement aren't just about how much money you have saved. Just because you have $3 million saved doesn't mean you have a set tax bill. It's about your retirement tax plan. And if you don't have a tax plan, you're going to pay more in taxes in retirement.

[00:01:18] So today I want to show you exactly why. Because for many retirees, there is a window of opportunity that can literally save you hundreds of thousands of dollars in taxes over your lifetime and sometimes millions of dollars. And you want to be able to use that tax window effectively. So before we jump into numbers, and in fact, I'm going to walk through a scenario and some software that I use with clients. I want to make sure that we are speaking the same language.

[00:01:47] If you don't like videos that get a little bit in depth, this is not going to be the video for you. Because retirement taxes work very differently than the taxes did while you were still working. And once you understand the rules, everything in this video is going to make a lot more sense. So let's start with one simple idea. Not all retirement income is taxed the same. Go ahead and underline that. Not all retirement income is taxed the same.

[00:02:15] In fact, retirement income really comes from four different buckets. And each one is taxed differently. First, you have your traditional accounts. The first bucket is your traditional 401k or your traditional IRA. And this is the bucket that most people have the majority of their money in. You've been saving your 401k during your working year. You had a deduction when that money went in. But now when that money comes out, every dollar that comes out of those accounts is generally taxed as ordinary income,

[00:02:44] which is the same way your W-2 income is taxed. And the IRS doesn't care whether you're withdrawing money you contributed 30 years ago or the investment growth that has accumulated over the decades. It felt great getting a tax deduction as the money went into that account. But now that account has been growing over 30 years and every dollar that you pull from that account is treated just like your paycheck.

[00:03:10] The original money that you put in and then all of the investment growth. And so if you have $3 million sitting in that account, you are going to pay tax on $3 million. Now, the amount of money in taxes you pay on that $3 million, that is not fixed. But someone is going to have to pay tax on that $3 million. The second type of account is a Roth account. Roth 401k or Roth IRA.

[00:03:34] Most people today know that money goes into a Roth IRA is not tax deductible, but all the future growth is completely tax free. And qualified withdrawals from a Roth IRA or Roth 401k are generally tax free, which means that those withdrawals usually don't increase your taxable income.

[00:03:56] And that's really valuable because they don't create the same ripple effects throughout your tax return that withdrawals from a traditional account will do. So money taken out of a Roth IRA is typically completely tax free. The third bucket is your taxable brokerage account. And this works a bit differently. You already paid taxes on the money you invested. So, you know, you earned $100,000 a year and you save $10,000 a year.

[00:04:22] And so you put $10,000 a year into the stock market. So when you withdraw your original principal, there's generally no additional tax. If you put in $300,000 throughout the years in this account, you know, put $10,000 a year in over 30 year period of time, you put in $30,000. The initial amount of money you put in that account, the $300,000, there's no tax on that money. Instead, you're taxed on things like dividends.

[00:04:49] So if the stocks you purchased or the index funds that you purchased have dividends or if there's any interest, you're going to pay tax on the dividends and interest. And you're also going to pay tax on realized capital gains. And long-term capital gains have their own tax rate, which is often much lower than ordinary income tax rates. Are you confused yet? And I haven't even got into it and I'm not going to get into the ways that dividends are taxed. Some dividends are taxed as ordinary income.

[00:05:19] Some dividends are taxed like long-term capital gains. Interest is taxed as ordinary income unless it's interest coming from a municipal bond. There's so many different roads we can go down, but I want to kind of keep us going forward. So I'm not going to get too far down any of those paths.

[00:05:36] But what you need to know is that money that you have in a taxable brokerage account, any gains as long as you've held it over a year, typically will be taxed as long-term capital gains, which will normally have a much more favorable tax rate than income that you pull from, say, your traditional IRA or your W-2 job. The next bucket is the fourth bucket is Social Security. And this is where a lot of retirees get surprised.

[00:06:04] You probably heard someone say something like up to 85% of your Social Security is taxable. And this is where a lot of retirees get surprised. Some people hear that and they think, wait, the government's going to take 85% of my Social Security income? I had someone say that to me once. That's not what it means. It means that up to 85% of your benefit can be taxable. And then that taxable income is taxed at whatever your ordinary income tax bracket happens to be.

[00:06:33] Some people, depending on their income or their provisional income, which is a whole other conversation, are going to be taxed at 0%. They're not going to pay any tax on their Social Security. Some people are going to have to pay tax on 50% of their Social Security benefit. And other people are going to have to pay tax on 85% of their Social Security benefit. So how does the IRS decide? It's all based on something called provisional income. And you don't need to memorize the formula, but you do need to understand the concept.

[00:07:02] The IRS starts through other income. So let's say you've taken $100,000 out of your IRA. So the IRS writes that down, $100,000. And then they add in any tax-exempt interest. So you bought some of those municipal bonds, and you're getting $10,000 a year in interest from those. So they add that to the $100,000 you took out of the IRA. So now you have $110,000 in income. And then they add back in one half of your Social Security benefit. This is how they get the provisional income.

[00:07:32] So if you have $40,000 in Social Security benefit, they're going to take $20,000 of that, and they're going to add it in. So we have the $100,000 from the IRA. We have the $10,000 of interest from the immunity bonds. So now we're at $110,000. And then we're going to take your $40,000 Social Security benefit, cut that in half, take $20,000. So now we have $130,000. And that is your provisional income. If that number is relatively low, very little of your Social Security benefit will be taxable.

[00:08:01] But as that number increases, more and more of your Social Security benefit is pulled onto your tax return. And eventually, and for many of you watching, about 85% of your benefit is going to be included as taxable income. And here's why all of this matters. Some people think, why do I care? Imagine you take $40,000 from your IRA. Most people think, well, I'll just pay tax and not $40,000.

[00:08:29] But that's not necessarily what happens because that withdrawal can also cause more of your Social Security income to be taxable, which means that the true tax cost of that withdrawal may be much higher than you expected. And I think this takes a lot of people in retirement by surprise. Why? Because it's so incredibly complicated and there's so many moving pieces. But what it means is that by taking more money out of a particular account, you end up raising your marginal tax rate.

[00:08:58] So you take $40,000 out and you're like, you know, that's fine. I'm only going to be in the 10% of the 12% tax bracket. But now it causes more of your Social Security benefit to get added back in. That ends up raising the marginal tax bracket or the amount of tax you're going to pay on each additional dollar. Now, here's what's important to remember. If you don't remember anything else from this video, remember this. Your goal isn't to pay the least amount of tax this year.

[00:09:23] Your goal is to pay the least amount of tax over your lifetime. And those are two very different goals. Because what I see happen all the time is when you retire, you have this window before Social Security starts, before RMDs start, right? Social Security, you could push all the way off to age 70. So RMDs start as late as age 75. So you retire at age 62. You have this window where you pay almost zero dollars in taxes.

[00:09:50] It's, let's say, you have some money in the CD or a taxable brokerage account or someplace else, you know, in your bank account that you're living off of. You're not pulling money out of your IRA. You're not taking Social Security. You know, you can pay almost zero dollars in taxes for a long period of time. But what you're doing by trying to pay the least amount of taxes in this particular year is you are creating a much larger tax bill down the road.

[00:10:13] So let's try to just put all this together because the IRS does not look at each source of retirement income separately. And this is important to understand. It stacks everything together, right? The traditional IRA withdrawals, the pension incomes, the interest income, the dividends, the capital gains, the taxable portion of your Social Security. They all interact with one another. And that's why retirement taxes are so complicated, right?

[00:10:42] One decision like taking an extra withdrawal from your IRA can create three separate consequences. First, it can increase your federal tax bill, which is not that surprising. But then it can cause more of your Social Security benefit to be taxed. And then finally, it can also increase your Medicare premiums if it pushes you over one of the IRMA thresholds.

[00:11:05] And this is why retirement tax planning is different from tax planning when you were still working because there are a number of variables that are all kind of interconnected. And it's also why proactive tax planning is so important, which is why you want to reuse the golden window or the retirement tax window to your advantage. Some of you are saying, what is he talking about? So imagine you retire at age 62. You don't claim Social Security until your full retirement age or maybe age 70.

[00:11:33] So there's eight years potentially before Social Security income kicks in. And then your required minimum distributions don't begin until, say, age 75. Those years in between are going to be some of the lowest income years of your entire life. And you have a choice. You can just pay basically no money in taxes during that period of time, right? The IRS isn't forcing money out of your retirement accounts yet. Why?

[00:12:00] Because they want that account to continue to grow so it'll push you into a higher and higher marginal tax rate and increase your lifetime tax bill. That's why they keep pushing your RMD age out, right? The IRS wants that money to keep growing. They want you to have to pull it out at some point, but they want it to grow as long as possible. So you have to pay a higher tax bill. And Social Security, like I said, Social Security may not start yet.

[00:12:25] And so now during this window, during this period, you get to decide how much of your taxable income you're going to recognize each year. And that is an incredible opportunity because once required minimum distributions begin, that flexibility is going to disappear. And then the IRS is going to begin deciding how much income comes out this year. And you really, you have very little control at that point. And so those of you watching are like, oh, this sounds really interesting. What does this look like in practice? Well, I'm glad you asked.

[00:12:53] I'm going to pull up some software I use with clients and kind of walk you through this and kind of help you get an understanding of what this looks like. So here we have Jim and Pam Halpert. They live in Scranton, Pennsylvania. Jim is 61. Pam is 60. They're about a year and a half apart in age. And I want to kind of use this to illustrate that golden window or that tax planning window that I talked about earlier. So you can see here that Jim is not going to begin claiming Social Security until 2031. In fact, that's his full retirement age.

[00:13:23] He could push it out a few years longer, but I'm just going to leave it at 2031 for now. And then Pam is going to start claiming Social Security in 2033. So there's a window here about five years before Jim collects Social Security and about seven years before Pam collects Social Security. And then we can scroll out here for RMDs. It's about 13 years before Jim collects or has to start taking RMDs. And it's about 15 years before Pam has to start taking RMDs. So this is that golden window or that tax planning window that I'm talking about.

[00:13:51] So in their situation, they don't spend a lot of money. They live in Scranton, Pennsylvania. It's pretty inexpensive to live there. They spend about $120,000 a year. They have $3.5 million in assets, not including their home. $500,000 in a taxable brokerage account, about $250,000 in gains. And then $2 million in Jim's IRA. And then they've got a million in Pam's IRA. The software I'm using today is not the typical software I use in this channel, which is Right Capital. But this is Income Lab.

[00:14:19] And I'm using Income Lab because I think it illustrates kind of this tax planning window a bit better. But in this situation, Jim and Pam have decided they're not going to take advantage of this window. And so I want to look at their tax situation if they don't do anything other than just having a proper withdrawal strategy. Pulling from the taxable first, tax deferred, and tax free, although they don't have any tax free in this situation. So we can kind of look at their situation here. And we can click on taxes.

[00:14:48] And we can see exactly what I talked about earlier, that early in their retirement, they basically have $0 in taxes. They have a small amount of state tax, but zero in federal tax. Once you take into account their standard deduction and all the different pieces of their plan and a lot of long-term capital gains, and the long-term capital gains amount that you can pull out is 0%.

[00:15:12] And so early in their retirement, outside a little bit of state income tax, they basically have a no-tax bill. And for the first 10 years of their 12 years of retirement, they pay almost no money in taxes. And then what you see is RMDs kick in and that tax bill just skyrockets. It goes from no money to almost $300,000 a year. Some people ask, well, is this in today's dollars or is it real dollars or nominal dollars? This is in today's dollars. So this is assuming inflation in the future.

[00:15:42] If you were actually put in nominal dollars, the amounts that you'd see here would be significantly higher, right? The tax bill would be half a million dollars. But those numbers get crazy because they take into account inflation. So let's go back to real dollars using today's dollars. But Jim and Pam watched one of our videos and they thought, you know what? Maybe we should consider doing something more proactive. And so what I want to show you is kind of what this looks like a little more in depth. So here we can kind of see their income a little more detail.

[00:16:11] So we can see here they have $61,000 in other non-taxable income, the basis they pulled out of this account. And then they have this long-term capital gains, which is $63,000. But if you remember that you can pull up as a couple that's married filing jointly, you can take up to $98,000 in long-term capital gains completely tax-free. So you can see here they're not paying any taxes, right? Because that long-term capital gain is 0% all the way up to here.

[00:16:39] And then the ordinary income, they're underneath the threshold here. So they have $0 in taxes. And then you come all the way over to 2031. You can see they're taking money out of their IRA now to live, right? So that other tax will qualify distribution along with a little bit of long-term capital gains. And then a little bit of their Social Security benefits being taxed. But still pretty minor, right? They're squarely in the 12% tax bracket. They don't have any IRMA issues. But then we scroll over here.

[00:17:08] And once you see the pink RMDs that kicked in. When RMDs first kick in, it's not that big of a deal. So 2039, this is what people say to me all the time. They're like, look, I calculated my RMDs. It's not that big a deal. When I turn 75, it's going to be $150,000 a year or whatever it might be. And they're like, that's nothing. But what's important to understand is often your account is growing faster than you are spending it. If the market is doing well.

[00:17:32] But also for every year you age, the amount of the RMD, even if the account value is the same, the amount of the RMD actually increases, right? There's a whole formula that I'm not going to go into here. So it's $157,000 a year. It's a little more than they need, but it's not that big a deal. But then, you know, that's 2039. But if we jump ahead till 2049, so 10 years in to RMDs, now it's $412,000 a year. And they don't need all this money.

[00:18:00] You know, one of the things, I don't remember I said this early, but in this plan, Jim passes about 10 years earlier than Pam. And so, you know, now you've got Pam in 2059 taking out half million dollars in RMD. And she's in the 35% tax bracket here and the top armadier. So she's got the highest tax bill of her entire life at the end of a retirement. So someone shows us to Jim and Pam, they're like, we need to do something different.

[00:18:27] So they go to see a financial advisor and the financial advisor shows them this tax strategy heat map. And, you know, their current strategy, their average tax rate is 23%. They're going to pay about $3 million in taxes. And so they start looking, is there a better strategy? And what they find out is that the sweet spot for them is probably doing pretty aggressive Roth conversions early in retirement, maybe going all the way up to the 24% tax bracket.

[00:18:54] And what happens is that their average tax rate over the course of retirement drops in 23% all the way down to 12%. And their total tax bill goes from $3 million all the way down to $841,000. So let's go ahead and see what this looks like in the plan. So now we can see that their tax bill early in retirement is massive, right? They're paying $100,000 a year. They went from paying $0 in taxes to $100,000 a year in taxes,

[00:19:22] which is a lot easier said than done. I've helped a lot of people do Roth conversions. And everyone loves the idea in theory of saving money on taxes until they have to write that first check the IRS. And they could be paying $0 in taxes. And instead, they're going to be paying $100,000 a year in taxes. But what you see is for the first, you know, eight, nine years of their plan, they have a fairly large tax bill. But then they never pay another penny in tax for the next rest of their plan.

[00:19:51] So let's go all the way out to 2053, which is where the tax bill before was the highest. And what we see is that basically very little of the Social Security benefit is subject to tax. There's no IRMA. And they are able to greatly reduce their lifetime tax bill by almost $2 million through using that golden window, through using these years here, where typically they can avoid paying tax at all, frontloading that tax bill, controlling the tax bill.

[00:20:18] And the other piece that I haven't really talked about, let's go back to the other strategy. Let's say they don't do anything here. And so they're not going to do any, they're not going to do any tax strategy. So we're going to go back and look at this tax plan. And you see it just skyrockets up into the right. This does not account for any increases in taxes in the future. And one of the things that's happening currently is we have a debt that's skyrocketing really rapidly. And at some point that debt is going to have to be paid off. And we are at record low tax rates right now.

[00:20:48] And so the possibility of there being tax heights in the future is pretty high. This does not take that into account. So this is just assuming the current tax rate stay into the future. And you can see you just end up with this massive tax bill at the end of the retirement plan by not using this golden window here to do some tax strategy. Now, I'm not telling you to do a Roth conversion of the 24% tax bracket and pay a large tax bill early in your retirement plan.

[00:21:17] That may not make sense for you. What I am saying is you want to be strategic. I am a planner at heart. I plan everything. And when I approach my tax bill, I also want to take that same strategic approach. And so I want to say, how can I go about creating a situation where I can use the tax code to my advantage? Instead of being forced to take a tax bill out later in life and I'm paying the highest bill.

[00:21:41] Instead of being forced into a tax bracket that I don't control and up in the 35% tax bracket with proper tax planning and tax strategy, you can often reduce your lifetime tax bill. You can reduce your earnest surcharges. You can lower your average tax rate and hopefully save a significant amount of money in taxes over the course of your life. But you need to decide what your tax strategy is going to be, your tax plan.

[00:22:09] Maybe you just convert up to the top the 12% tax bracket or the 10% tax bracket or whatever makes sense in your situation. But you need a tax plan. But if you're retiring early, you want to be sure to use that tax planning window to your advantage and not squander it and just pay 0% tax for a few years and end up causing a much bigger tax bill later on down the road. Hey, thanks for listening. If you enjoyed this content, if you'd do me a favor and just leave a review on whatever podcast app you're using,

[00:22:39] Apple or Google or Spotify. And also you can find us on YouTube. Just search Foundry Financial or Retirement Made Simple. You should be able to find us by searching both. And then you can find our website at foundryfinancial.org. Thanks for listening.