Worried About Taxes Increasing? Here's a Solution.
Updated: Sep 27, 2020
Did you know it’s possible to retire in the zero percent tax bracket? You might be thinking, it’s too good to be true. But as long as you know how to put your money into different “buckets,” you could retire and pay no income tax on your 401(k) distribution, your Social Security payments, and several other available streams of income.
Here’s an overview of how it works:
In the past, we’ve talked about planning for retirement. But now I want to ask you a question about taxes. Do you think taxes are likely to be higher or lower in the future?
If you said higher, you’re right. The national debt is increasing faster than normal, thanks to the coronavirus. And the government’s best chance of getting that money back is to raise taxes on its citizens.
This is going to cause big problems for people who are depending on pre-tax retirement accounts like 401(k)s and traditional IRAs. If tax rates go up, how much of that money can you actually keep?
If you don’t like the idea of paying more tax, you’re not alone. In fact, it raises a good question: if you could pay taxes now, while they’re lower, would you do it? That’s what a lot of my clients have been asking me lately.
And yes, there is a way to make sure you’re not paying more hard-earned money to the IRS than is absolutely necessary. Let's examine how.
There are several strategies we can use to keep as much of your retirement income tax-free as possible. For some, they’ll even be able to get into that 0% tax bracket. But let’s back up a bit first and explain the trouble with relying on traditional retirement accounts and Social Security.
The Problem with Traditional Retirement Accounts
How many of you think you're set for retirement because you max out you yearly contributions to a 401(k) or IRA? The selling point for these traditional accounts is the tax break you get right now. You fund your account pre-tax and let both the principal and the gains grow tax-free.
Essentially, the government is giving you a tax break now, during a time when taxes are low. In return, you will pay taxes later, when taxes will likely be higher.
THAT FUTURE TAX RATE IS EXACTLY WHAT’S WORRYING MANY AMERICANS THESE DAYS.
What’s the point in growing a tax-free account if the government can take it all back in the future with higher taxes? While it’s highly unlikely the government will take all of it back, we don’t know exactly what they will take back.
We know they have a massive funding shortfall. And we know higher taxes are an easy way to start making up that difference. But that’s not all.
The Problem with Social Security
Social Security benefits are taxable at the federal level based on your income. Depending on that taxable income, up to 85% of your Social Security benefits can be taxed.
• If you are single and your income exceeds $25,000, up to 50% of your Social Security could be taxable. • If you are single and your income exceeds $32,000, up to 85% of your Social Security could be taxable. • If you are married filing jointly and your income exceeds $32,000, up to 50% of your Social Security could be taxable. • If you are married filing jointly and your income exceeds $44,000, up to 85% of your Social Security could be taxable. In this situation, that income is calculated as modified adjusted gross income + 50% of Social Security benefits + any of the common streams of income listed below. • Rental income: yes • Interest: yes • Dividends: yes • Pensions: yes • Tax-exempt muni bond interest: yes • Traditional IRA distributions: yes • Capital gains: it depends (we’ll get to that in a sec) Now, how many of your retirement plans are based on two or more of the above income streams? Now you see the problem we’re leading up to.
THE MORE YOU HAVE IN YOUR 401(K) OR IRA, THE MORE YOU'LL LOSE TO TAXES. AND THE MORE MONEY YOU RECEIVE FROM YOUR 401(K) OR IRA, THE MORE OF YOUR SOCIAL SECURITY YOU'LL LOSE TO TAXES.
The Solution: Reduce Taxable Income
If too much tax is the problem, there’s one clear solution: reduce the amount of taxable income.
So what doesn’t count as taxable income?
• Roth IRA distributions (assuming you are over age 59.5 and had the account for at least 5 years) • Life insurance policy loans (which do incur a bit of interest) • Immediate annuity payments (up to the initial investment amount) • Some capital gains, depending on length of time held and taxable income You want to have as much money as possible in these tax-free vehicles. And you only want to withdraw as much money from taxable vehicles as enables you to stay in the 0% tax bracket. This keeps your Social Security 100% tax-free. Combining all these strategies, it’s possible to have a 0% tax bracket in retirement.
• Rely heavily on tax-free sources of income.
Policy loans are not taxable. They may, however, incur a small interest fee. This works best if you grow that cash value for 10+ years. The longer the money grows, the more you benefit from compounding interest!
Think of cash value policies as a replacement for bonds in your portfolios, since bond returns are nowhere near the percentage typically projected (5-7%).
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o Roth 401(k) or IRA
All withdrawals, including interest, are 100% tax-free since they were funded with after-tax dollars.
Calculate the cost of a traditional-to-Roth 401(k) or IRA conversion. Your will pay tax now, but have tax-free withdrawals later. A possible silver lining? If the value of your IRA is lower thanks to a general market drop, that also helps lessen the tax burden.
• Keep taxable income below the standard deduction.
o Have to take an RMD? Set it so that it doesn’t exceed the standard deduction. That deduction essentially wipes out the same amount in taxable income.
Tax year 2020, single: $14,050 Tax year 2020, married: $27,400
• Factor in Social Security.
o The average person collects about $15,000/year. Taking Social Security earlier can result in smaller payments, which may actually help in terms of reducing taxable income, depending on your needs.
• Remember the 0% capital gains tax rate. o The IRS taxes long-term capital gains (those held for at least a year) at 0%, 15% or 20%. The 0% rate applies to long-term capital gains as long as your 2020 taxable income doesn’t exceed $39,375 (for single filers) and $78,750 ( for married, filing jointly).
o Capital gains are taxed differently than ordinary income. If your income is $10,000 under the 22% tax bracket and you have a $20,000 long-term capital gain, you pay 0% tax on the first $10,000 of the gain. The second $10,000, which bumps you into the 22% bracket, will be taxed at 15% - but your ordinary income remains in the 12% bracket.
Given the ever-increasing national debt, recent government bailouts and the funding issues surrounding Social Security and Medicare, the wealthy are anticipating that tax rates are likely to go up and are implementing strategies that reduce, or completely eliminate taxes all together while in retirement.
To Learn More, See Our Frequently Asked Questions
Note: If you reached the age of 70½ in 2019 the prior rule applies, and you must take your first RMD by April 1, 2020. If you reach age 70 ½ in 2020 or later you must take your first RMD by April 1 of the year after you reach 72.
401(k), 403(b), 457, and other qualified retirement plans are tax-advantaged plans established by the IRS to help Americans save for their retirement years. Many organizations that offer these plans provide their employees with self-service options to access the savings and investment components within these plans. Working with a professional to review your options, as well as the impact of those selections on your savings and retirement income potential, can prove to be invaluable advice for the future.
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