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In this episode, podcast host and author of “Control Your Retirement Destiny” covers Chapter 4 of the 2nd edition of the book titled, “Taxes.” If you want to learn even more than what there is time to cover in the podcast series, you can find the book “Control Your Retirement Destiny” on Amazon. Or, if you are looking for a customized plan for your retirement, visit us at sensiblemoney.com to see how we can help. Chapter 4 – Podcast Script Hi, this is Dana Anspach. I’m the founder and CEO of Sensible Money, a fee-only financial planning firm. I’m also the author of Control Your Retirement Destiny which was initially published in 2013. A 2nd edition was published in 2016, and now, I am working on the 3rd edition. Why a 3rd edition? Well, the tax laws changed - and we want to update Chapter 4, which covers taxes. This podcast covers the material in Chapter 4, and I’ll be discussing both the old tax rules and the new tax rules. We’ll continue to follow the case study of Wally and Sally based on the 2nd edition of the book. The book has incredible 5-stars reviews on Amazon. If you like what you hear today, go to Amazon and search for Control Your Retirement Destiny. You won’t be disappointed. And if you are looking for a customized plan, visit sensiblemoney.com to see how we can help. Ok, let’s get started. In this podcast, I’ll be covering the highlights from Chapter 4 on the topic of “Taxes.” ----- There are very few people I know who enjoy doing their taxes. That includes me. I have actually never done my own tax return. To me, it is worth it to pay someone else to handle this task. Yet, I know a tremendous amount about personal tax rules. So why wouldn’t I do my own tax return? Well, a tax return is a historical account of what happened. Once it is time to file your return, there is nothing you can do to change the outcome. I prefer to use my tax knowledge to figure out how to pay less in taxes. And, to help other people pay less. To me, that is one of the most rewarding parts of my work. To pay less in taxes, you have to plan ahead. How far ahead? The more you want to save, the farther ahead you’ll plan. Think of tax planning in three levels. Level 1 is pretty basic. For example, assume you turn your tax documents in to your tax preparer, and he or she let’s you know you could fund an IRA for the previous year, and thus reduce your tax bill. That wasn’t really planning ahead, but you did learn a step you could take to reduce current year taxes. But is this really the right step to take to lower your taxes in the long run? Not for everyone. Some people are better off funding a Roth IRA instead of a Traditional Deductible IRA. With a Roth, you make after-tax contributions and from that point on, the money grows tax-free. The Roth IRA has several unique advantages for retirees when they enter the phase where they are regularly withdrawing money. For example, Roth withdrawals do not count in the formula that determines how much of your Social Security is taxable. And Roth IRAs do not have what are called Required Minimum Distributions, which begin at age 70 ½ and require you to take out specified amount each year. These unique advantages of Roth IRAs are often missed by traditional tax preparers. The reality of Level 1 planning is that many tax preparers are so focused on what you can do to reduce this year’s tax bill, that the advice they are giving, with the best of intentions, may not be advice that is ideal for you. Next, we have Level 2 tax planning. You must tackle Level 2 planning in the fall, and run a tax projection. The bummer part of doing this is that you have to gather estimates for every item that will be on your upcoming tax return. We do this for most of our clients each year – and I’ll admit, it’s a lot of work. What do we learn from all this work? We can determine what actions need to be taken before the year is over so that people can save money. There are three items we routinely look for. 1) The opportunity to convert a portion of an IRA to a Roth IRA, 2) the ability to realize capital gains if they will fall into the zero percent tax rate, and 3) the ability to realize capital losses that can be used to offset ordinary income. If you aren’t sure what these things mean, keep listening. I promise, I’ll explain most of them in more detail. With Level 2 tax planning you mock up your tax return, and then see what it would look like if you were to take action before the year is over. One of the most memorable results I have from a tax projection was when we told a client that could sell a significant amount of Apple stock and realize $60,000 of capital gains and pay no tax. They were shocked. How were they able to do this? They had just retired, and their taxable income was going to be quite low for the year. When your taxable income is low, any capital gains you realize are likely to fall into what is called the “zero percent tax rate” – which means you can realize those gains and pay no tax. If they had waited even one more year – their taxable income would not have been as low – and they would have paid taxes on the gain at a 15% tax rate, or $9,000 in tax. Planning ahead saved them $9,000. Pretty cool. Then, we have Level 3 tax planning. With level 3 planning, you plan many years ahead. This type of planning can have a big impact on people who are near retirement. Why? Between the age of 55 and 70 there are a lot of moving parts. Retirement usually happens in this age range, which results in a change in taxable income. And various other types of income start– such as Social Security, pensions, deferred compensation payouts and IRA withdrawals – and they often all start at different times. If married, spouses may have different retirement dates and different years where each of their Social Security begins. With all these moving parts, your tax return can look entirely different from year to year – and lots of opportunities exist – if you’re on the lookout for them. In Chapter 4, we follow the case of Wally and Sally. I show you what Level 3 Tax Planning looks like by going through three potential retirement income plans for Wally and Sally. All three plans are designed so that their lifestyle spending is identical. The difference in the three plans is when they begin Social Security, and how they withdraw from various accounts. These changes impact how much in taxes they pay in each scenario. Let’s see how their three scenarios look using the old tax rates. Then we’ll summarize how it might change under the new 2018 rules. In the 2nd Edition of the book, I describe Wally and Sally’s three retirement income plans as Option A, B, and C. With Option A, Wally and Sally take their Social Security early, and at the same time withdraw from their non-retirement accounts. They know at age 70 ½ that by law they are required to begin taking distributions from retirement accounts and they plan to wait and tap IRAs only when these mandatory distributions begin. Their cumulative taxes over a 29-year projected lifetime add up to $452,000. With Option B, they use their suggested Social Security claiming plan, which has them filing a few years later, and they use the same withdrawal order as Option A. Which means they spend non-retirement savings first, while waiting until required distributions begin. Their cumulative taxes total to $487,000. With Option C, they use their suggested Social Security claiming plan while converting IRA assets to a Roth IRA during low tax years, and they withdraw from IRAs before their required distributions begin. Their cumulative taxes add up to only $424,000. That’s a $63,000 difference in taxes paid – depending on how they structure their income plan. There is also a big difference in how much money they have left after 29 years. When looking at the estimated after-tax value of accounts, with Option A they have $816,000 left. With Option B, in 29 years, they have $930,000. And with Option C - $1,153,000. That’s $337,000 more. Now, if I have any economists listening, they will realize that $337,000 sounds like a lot – but that is $337,000 twenty-nine years in the future. You must discount that back to today’s dollars to do a fair comparison. Assuming a 3% inflation rate, in today’s dollars that is worth $143,000. That’s still a decent chunk of money you get to keep by planning ahead. How does this type of planning work? In the early years in retirement, Wally and Sally will be in a lower tax rate. Later in retirement, a higher tax rate will kick in because of their IRA withdrawals. With Option C, they use this to work to their benefit. They withdraw money from their IRA on purpose when their tax rates are low. They are able to put some of it in a Roth IRA where it grows tax-free. This is called a Roth conversion. The result is that later in retirement their Required IRA distributions are lower, and they have less income taxed at the higher rates. What does a similar case study look like under the new 2018 tax laws? I’m working on that right now for the third edition of the book. Starting in 2018, tax rates are lower than they were in 2017 – but they are set to go back to higher rates in the year 2026. This makes planning a bit of a challenge. I ran similar Wally and Sally scenarios using 2018 tax laws, and assuming those rules stay in place and do not revert back to old rates. Under this scenario, Wally and Sally can still save up to $48,000 in federal taxes by building a tax smart withdrawal plan that delays Social Security while withdrawing from IRAs and using Roth conversions. There is up to a $350,000 difference in after-tax assets at the end of their plan. Which is equivalent to $148,000 in today’s dollars. And, if in fact tax laws do revert, the tax planning will save Wally and Sally even more. Under old tax rules, or new ones, there is plenty of money to be found with good planning. Hopefully, I’ve convinced you that tax planning can save you money. Although I can’t cover all the rules in this podcast, with our remaining time I will discuss tax planning triggers that you want to be on the look out for. Then, we’ll talk about a few specific parts of the tax code and how to use these parts to make better planning decisions. First, tax planning triggers. If you have the same salary, the same mortgage, and the same number of dependents this year as you did last year, most likely your tax return this year will look much like it did last year. Where big opportunities show up is when things start to change. I call these items “Triggers.” When a Trigger occurs, it might be a great year to focus extra effort on your tax planning. For example, you change jobs, or you have a year where you are only employed half the year, or you retire. During those years, you are likely to be in a lower tax bracket than you were the year before. Changing jobs, a period of unemployment, and retirement are three major Trigger events. A few others are a change in your number of dependents, a move to a different state, paying off a mortgage, or taking on a new mortgage. Selling a property or investments should also trigger a fresh look at your taxes, as you may have larger capital gains to report in years where these sales occur. Changes in income are likely to have a bigger impact than changes in deductions. To understand why, let’s quickly review how tax rates work. Income is reported on the first page of a 1040 tax return. Although income is reported here, not all of it is taxable. Many line items on your tax form have a column for the full amount of the income, and then a separate entry where you put the taxable portion. You use this income to determine what is called your Total Income on line 22 of the first page of a 1040. Then you get to adjust this income down by what are called “above the line” deductions. Some common ones are contributions to a Health Savings Account or to an IRA. The result is called your AGI, or Adjusted Gross Income, and it is shown on line 37 of a standard 1040 tax form. Next, in 2017 you get to reduce your AGI by taking either the Standard Deduction, or Itemized Deductions. This is one area where things changed between 2017 and 2018. Let’ start with 2017 rules. In 2017, each person got to reduce their AGI by a personal exemption amount of $4,050 and a standard deduction of $6,350. If you were age 65 or older you also got a slightly larger standard deduction. Let’s say you’re married and not yet 65. In 2017, your total standard deduction was $12,700. You would compare this to your itemized deductions, which included things like mortgage interest, state taxes paid, health care expenses up to a limit, and charitable contributions. If your total itemized deductions were more than the standard deduction then you got to use the larger number. In this example I’m using, as long as your itemized deductions were more than $12,700, you would use the itemized. Then you also got to reduce your income by your personal exemptions. In 2017, for a single person, age 65, when you added up your standard deductions and exemptions, without any itemizing, your AGI would be reduced by about almost $12,000 to get to what is called your Taxable Income. For a married couple both age 65, your AGI would be reduced by just over $23,000 to determine your taxable income. In 2018 – it’s different. Now, there is not a personal exemption. Instead, the standard deduction is much larger – at $12,000 each, or a total of $24,000 if married. And, you still get a little more if you’re age 65 or older. In 2018, as a single not yet age 65, you must have more than $12,000 of deductions before you cross the threshold to be able to itemize. For married couples is must be more than $24,000 (If over 65, those numbers change to $13,600 for singles and $26,600 for marrieds.) What all of this means is that many more people will use the standard deduction now instead of itemizing. In addition, what is eligible to be itemized has changed! In 2017, you could deduct state and local taxes, like property taxes and state income taxes paid, with no cap on how much could be deducted. In 2018, you can use a maximum of $10,000 of these types of deductions. This has the biggest impact on folks who live in areas with high property taxes and high state income taxes. There are a few other changes to itemized deductions too, but I can’t go into all of them. The bottom line is that you start with Total Income, then take Above the Line deductions to get to your AGI, then you reduce that by your Standard or Itemized Deductions to get to Taxable Income. Great, you have taxable income. Now what? Now, that income flows into the tax tables. And naturally, that isn’t simple either. Tax rates are tiered. This is something that I find many people do not understand – because under a Tiered system, not all income is taxed at the same rate. In 2018, the rates are 10%, 12%, 22%, 24%, 32% and 35% - these are all slightly less than they were in 2017. To understand how it works, let’s talk through an example of a single person who has Taxable Income of $80,000 (remember, that’s what is left after all their deductions). In 2018, the first $9,525 of that income is taxed at the 10% rate, the next $29,174 is taxed at 12%, and the next $31,775 is taxed at 22%. What if this person were trying to decide if they should contribute more to their 401(k) - and they could either make a deductible contribution to the plan, or an after-tax Roth contribution? Which is better? If they contribute $10,000 it will reduce the taxes they are paying at the 22% rate – which means a $10,000 deduction equals $2,200 saved in taxes. That sounds great! But tax laws are set to revert to the old rates in 2026. What if their retirement projection shows that their income later in retirement will be taxed at the 28% rate. Does it make sense to take a deduction now at 22% - then pay taxes on that same money later when you withdraw it at a 28% rate? Probably not. This is just one example of how Level 3 Tax Planning can help you make better decisions. In addition to looking at the cut off levels between tax rates, you must also consider that all income is not treated the same under the tax code. I think of retirement income in three buckets. There is your: Ordinary income bucket Your Qualified Dividends and LT Cap Gains bucket And then you have Social Security. Ordinary income includes income you earn, interest income, IRA or 401(k) withdrawals, most types of pension income and many other things. This type of income is subject to the ordinary income tax rates that we just went over. Next you have Qualified Dividends and LT Cap gains. Long term capital gains means a gain from the sale of an investment which you owned for at least one year. These two types of income have their own special tax rates which are lower than ordinary income tax rates. The three tiers are 0%, 15% and 20%. Did I say “zero percent”? Yes, I did. There is actually a tax bracket where if your taxable income is less than $38,600 for singles, or $77,200 for married, then your qualified dividends and capital gains are not taxed. There are ways to strategize and intentionally create a tax year where your income will be low so that you can realize capital gains at a lower tax rate. How does all this work together? Well, we have a client that has a $4.5 million taxable portfolio. By taxable, I mean the investments are not inside IRAs or other retirement accounts. In 2017, their Taxable Income was $210,000. How much do you think they paid in taxes? At least 12% right? After all, in 2017 that was the lowest tax rate. At 12% they would pay just over $25,000 in federal taxes. And that would be a pretty good deal. They only paid about $14,000 in federal taxes in 2017. How can this be? A large portion of their income fell into the 0% and 15% capital gain and qualified dividend tax rates. When you structure a portfolio correctly, with taxes in mind, you can create a really great tax efficient outcome. The third type of income we’ll talk about is Social Security. The good news is 15% of the Social Security income you receive is always tax-free. Whoohoo! The bad news, is some people will pay taxes, at the ordinary income tax rate, on up to 85% of their benefits. It is all determined by a formula. If you have no income other than Social Security, you’ll pay no taxes on your benefits. As other types of income begin to flow into the formula, it changes the portion of your benefits subject to taxation. With the right type of planning, many retirees can receive more in benefits, and pay less taxes on what they get. You must engage in Level 3 Tax Planning to spot these opportunities. We’ve now discussed the old and new tax rates, and how the standard deduction has changed. We talked about the special tax rates that apply to qualified dividends and long-term capital gains. We also briefly reviewed how your Social Security benefits are taxed. And, looked at Wally and Sally, and saw a first-hand example of how planning resulted in a better outcome. There are many more items I cover in the tax chapter. There is simply not enough time to cover them all in a single podcast. You can find additional tax-related content on the SensibleMoney.com website in the Learn section. Or to develop a customized tax plan visit us at Sensible Money.com to see how we can help.