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|Rich Best has spent 28 years in the financial services industry, as an advisor, a managing partner, directors of training and marketing, and now as a consultant to the industry. Rich has written extensively on a broad range of personal finance topics and is published on several top financial sites. Recent books include The American Family Survival Bible and Annuity Facts Revealed: What You MUST Know Before You Invest.|
Retirement Planning Mistakes - Not Proactively Planning for Taxes
A very costly mistake many business owners make when planning for retirement is to ignore the impact of taxes on their retirement cash flow. Retirees who have multiple streams of income from pre-tax and post-tax accounts need to be aware of which ones to use at which points in retirement or risk depleting their retirement assets too quickly. The biggest surprise for most retirees is when required minimum distributions (RMDs) kick in at age 70 ½ which can exacerbate their tax problem. Having not even considered the impact of taxes in retirement, many retirees can only cry out, “Why didn’t we plan for this?”
Tax Planning Well Before Retirement
The big opportunity for planning for taxes in retirement actually occurs 10 to 20 years before retirement when choosing among different accumulation vehicles. That is the best opportunity to diversify the taxation of retirement income among pre-tax retirement accounts and post-tax investment accounts (for capital gains). However, most people follow the more conventional planning advice of plowing as much of their income into qualified, pre-tax retirement accounts, such as a 401(k) plan or IRA.
Beware of the Tax Torpedo
While that may be the best way to accumulate capital, because it uses pre-tax contributions and the earnings are not currently taxed, having too much of your assets in tax-deferred accounts can limit the flexibility needed to lower your taxes when you start withdrawing income. That’s because withdrawals from these accounts are taxed as ordinary income. Not only is this income fully taxable, which can push retirees into higher tax brackets, it can also trigger the Social Security “tax torpedo,” which exposes as much as 85 percent of your benefits to ordinary income taxes.
What Exactly is the Social Security “Tax Torpedo?”
The Social Security “tax torpedo” refers to point at which Social Security benefits become taxable because of income received from other sources that exceeds a prescribed threshold. The threshold is breached when all sources of provisional income, including income from tax-free bonds and half of Social Security benefits, exceeds $32,000 for joint filer ($25,000 for individuals). When income is between $32,000 and $44,000 for joint filers ($25,000 to $34,000 for single filers) 50 percent of Social Security income is taxable. When income exceeds those amounts, 85 percent of Social Security is taxable. When Social Security benefits are included as taxable income, it can also push retirees into a higher tax bracket, further compounding the problem.
Most retirees are not likely to experience the tax torpedo because their income is not high enough. However, many retirees unexpectedly experience the tax torpedo at the time required minimum distributions kick in.
Conversely, income from certain post-tax accounts are not taxed (Roth IRA) or taxed at a more favorable rate (capital gains). Utilizing these tax-favored income sources strategically along with taxable pre-tax income sources can alleviate or even eliminate the tax torpedo thereby increasing retiree’s cash flow while preserving their assets for their longer-term income needs.
When Too Much Tax Deferral is Not a Good Thing
The conventional planning advice on the distribution side has been to first tap your post-tax income sources so you can avoid the immediate taxes on your pre-tax investments and keep them growing on a tax-deferred basis. Again, while that strategy makes sense for allowing your assets to accumulate, it can have the unintended consequence of exacerbating your RMD problem, which can increase your taxes and deplete your pre-tax account more quickly.
Many retirees, knowing what they know now in terms of retirement income taxation, would probably have chosen a different strategy that included allocating their more of their retirement contributions among post-tax accounts that generate tax-favored capital gains or a Roth IRA for its tax-free withdrawals (which arenot considered provisional income included in the Social Security tax calculation). However, retirees knocking on retirement’s door still have an opportunity to develop an income strategy that can effectively minimize their taxes and stretch their assets further into the future.
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