After reading about this retirement tax opportunity. you will discover why retirees might want to pay more taxes today!
We’ve all heard from well-meaning people that “eating broccoli is good for you” and that “you’ll thank me later”. Well the same logic could apply to you if you pay your taxes today.
Let me set up a common scenario that many multi-millionaires often find themselves facing.
Multi-millionaires – it means you are worth two million or more dollars. Most multi-millionaires I know don’t think of themselves as multi-millionaires – thus I needed to be clear on the definition.
Mr. and Mrs. Multi-Millionaire has recently wrapped up a long and financially rewarding career(s). The bank, investment, and retirement accounts are stuffed with multiple millions. By every financial measure they are rich, well-to-do, wealthy — whichever adjective you want to use, but there is one measure where they are no longer classified as rich.
The big salaries and bonuses are no more; and thus, their taxable income has plummeted from the top marginal brackets to some of the lower brackets – possibly even the lowest bracket. During the first few years of retirement, retirees could find themselves in a situation where they have very little “taxable” income. The pension doesn’t start until 65 — if there is one. For numerous reasons, social security is being delayed or has not yet started. And there isn’t a need to draw from retirement plan assets because there is plenty of cash or liquid after-tax investments.
Why Retirees Might Want to Pay MORE Taxes – Retirement Planning Paradox
As a Financial Planner, I love this paradox! The IRS thinks that multi-millionaires are poor because they have no taxable income that has to be reported! They are still millionaires. They are living and spending like millionaires, yet the IRS is taxing them at the lowest rates because they don’t have much in the way of “reportable” income.
If you’re one of those multi-millionaires, unfortunately the IRS probably won’t always tax you as though you are poor. They will come knocking at your door requesting bigger tax payments because at some point, the pension and social security income will start, and the IRS will want its share. Plus, at the magic age of 70.5, the IRS is going to force you to take a required taxable distribution from your retirement accounts. For many multi-millionaires, a large portion of your wealth is invested in “qualified” retirement plans such as: IRA’s, 401(k)s or 403(b)s. Guess what? At 70.5 the IRS mandates you take a Required Minimum Distribution (RMD). This required distribution is fully taxable to you as ordinary income and could push you into higher and higher tax brackets.
Imagine, you are standing on one side of the Grand Canyon soaking in the beauty of nature. Immediately in front of you there is a shear drop to the canyon floor which stretches several hundred yards then there is another cliff rising straight up from the canyon floor on the other side.
This is often the trajectory the tax brackets of multi-millionaires follow. High on the side of pre-retirement, a dramatic drop for a few years after retirement followed by higher rates as various income streams start later in retirement.
Why Retirees Might Want to pay MORE Taxes – Think of it another way.
When you are still working you probably have little control over your taxes – you are making what you are making and you are taking advantage of every tax break you can. Yet you still have very little control over your tax rate. Later in retirement, when pensions, social security, and required distributions have started you can’t control the amounts or timing of those sources of taxable income.
The Opportunity exists in the chasm between high tax brackets
In this chasm you have control over your taxable income.
What do you mean? I’m no longer working and my other income hasn’t started.
True. But you can control how much and when you take money out of your IRA or other retirement accounts. If you choose, you can dial up your taxable income by either taking withdrawals from your IRA and paying tax on the dollars withdrawn or better yet by transacting a Roth Conversion and positioning dollars into an account with no future tax liability.
Why would I want to do this?
I can think of several reasons.
You are in the chasm of low rates. Here are 4 reasons why retirees might want to pay MORE taxes. Jump across the chasm and enhance your comfortable retirement.
- You can “fill up” a lower bracket
Let’s assume you are married and file jointly and your 2019 taxable income at the moment is $15,000. This means you are in the 12% marginal tax rate. You could “fill up” the 12% marginal tax band which has a limit of $78,950 in 2019 by realizing ($78,950 – $15,000) = $63,950 of additional income by either taking an IRA withdrawal in that amount or converting that amount to a Roth IRA. When is the last time you had the gift of a 12% top tax bracket? How long will you remain this bracket?
- Pay today’s tax rate
Do you think rates are going up or down in the future? Think about the national budget deficit. If nothing else, the current rates are set to sunset to higher rates automatically in 2026.
- Reduce your future tax liability
Realizing income by taking retirement plan withdraws or converting to a Roth IRA both reduce the amount that you have in retirement plans subject to future required minimum distributions. And if you do the Roth Conversion you get all future growth on the converted dollars TAX-FREE! (If those dollars stayed in a Traditional IRA or 401k or another pre-tax retirement plan, the required distributions on that growth would be taxed at ordinary income rates.) The benefits of being in the chasm of low rates are abounding.
- Bonus Reasons for the Roth Conversion
(a) The Roth Conversion can give you potential future tax flexibility by having money in three different tax structures: after-tax, tax deferred and tax-free (Roth). This gives you some control to possibly affect your future tax rates by controlling which bucket you pull from.
(b) The Roth Conversion allows you to pass money free of income tax liability to family members because you’ve already paid the taxes.
Retirement Tax Opportunity Next Steps
This is an involved financial strategy that requires financial foresight by your Financial Advisor and coordination with your tax advisor. The Financial Advisors at Salomon and Ludwin regularly coordinate these types of value-added conversations with clients and their CPAs…strategies that have the potential to enhance your wealth and make a meaningful impact on the next generation.
Disclosure: This information is intended for educational purposes only and should not be construed as advice. You should discuss your circumstances with a qualified financial professional prior to making any decisions.