Episode: 09-28-2021 | The Role of Taxes in Retirement

Hosted by Kevin J. Zywna, CFP® and Allison K. Dubreuil, CFP®

Unpacking The Impact of Taxes on Retirement

Allison Dubreuil, Wealthway Financial:  Good evening, I thought we would tackle taxes. Everyone loves taxes, right? We will talk about some practical effects that taxes have on retirement. So when you’re a retiree, you have 401k plans, IRAs, retirement, all your retirement accounts, and there are some tax traps that you can fall into. Some situations that might take retirees by surprise, because if you are not completely up to speed on all of the ins and outs of the tax code, I don’t think anyone would be surprised.

Kevin Zywna, Wealthway Financial:  And who really is? Exactly no one, that’s who. Zero people.

Allison Dubreuil, Wealthway Financial:  We’re going to hit some high points of things that you should be on the lookout for when doing your retirement planning. And when in retirement, we can talk about the role of taxes and how they may come into play and impact some of your decisions. But  the first point we want to tackle is what our tax is going to look like in retirement. Many people ask the question, ‘Are my taxes going to be higher or lower?’ And like all good financial planning questions the answer is, it depends. It really depends. First and foremost, it depends on tax rates. So we don’t ever know what tax rates are going to be in the future. And we, as a firm, don’t make a point of trying to predict or forecast that. We work with current tax law to the best of our abilities. So you don’t know what tax rates are going to be in retirement. But typically, you will be in a lower tax rate in retirement than you were when you were working. It might not be as dramatic of a change as you would expect, because you won’t have lots of itemized deductions. Most people now, whether you’re working or retired, take the standard deduction. About 90% do. So you know, don’t bank on having a lot of big tax deductions in retirement.

What do you want to do in retirement? Most people want to finally do all the things that they have put off for a lifetime while they were working and saving. So you want to have fun and use the money that you saved. And there are tax implications when you start using retirement savings. And that’s what we’ll talk about tonight.

Which Financial Vehicles Are Taxed?

Kevin Zywna, Wealthway Financial:  Yes, so if the money’s coming out of pre-tax savings vehicles, like your 401K plan, or your TSP, or your 403B plan, or your simple IRA, then the money that comes out of those traditional large retirement plans is going to come out as ordinary income –  paycheck income. So if you were making $100,000, in salary before retirement, and you need to withdraw $100,000, from your 401K or IRA retirement fund, then you’re going to pay tax on that same $100,000. Just as if you got it through a paycheck.

Allison Dubreuil, Wealthway Financial:  You may have different buckets to pull from. You may have some 401k retirement tax deferred accounts. You may have some regular brokerage savings, that then would just be subject to capital gains tax on any gain that you realize when you decide to sell the investment and use the money for spending. Or you may have Roth money, which as long as done properly would come out tax free. So you may have some options and some ability to strategize from a tax perspective about how to start withdrawing from your nest egg in retirement.

Primary Objective: Maximize Overall Net Worth

Kevin Zywna, Wealthway Financial:  And I should point out some philosophy and strategy here. From our perspective, legally reducing your tax bill is important to your own financial health. And where opportunity presents itself, you should attempt to do that. But that activity should be secondary to the overall activity, the primary objective of trying to maximize your overall net worth – growing your wealth over time.

So many times when we sit down with new clients, one of their primary objective might be to reduce or try to eliminate their tax bill. Well, under the current tax regulation, you just can’t do that without giving away all your money or losing all your money or some other detriment to your net worth. So don’t let the tax tail wag the dog. It’s important to try to lower your taxes, but don’t do that at the expense of the growth of your overall net worth. That’s what’s most important.

And unfortunately, the way the current tax code is, the more you make, the more they’re going to take. The more when you turn a profit on investment, you’re going to have to pay some tax, but where we can move some things around, where we can use some advanced tax planning, then we’re going to try to do that. Because most people’s taxes makeup, if not the largest, one of the top three expense line items in a household.

When Do You Plan For Taxes on Retirement Income?

Allison Dubreuil, Wealthway Financial:  We’re talking about the role of taxes in retirement and retirement planning right now. But your point is a really good one about being proactive. Where you can do a lot of your tax planning for retirement is actually in the accumulation phase. Actually making sure that you’re creating different buckets that have varied tax treatment, so that you have a lot of flexibility and can be very strategic in retirement about where you’re pulling your income from.

Kevin Zywna, Wealthway Financial:  The time to do tax planning is not April 14, the day before taxes.Or on the last day of the year in which your taxes get calculate on. Tax planning for that year starts on January one. And you work it through over the course of the year. Good, proactive tax planning over your lifetime, starts the moment you start getting a paycheck, and looking ahead into the future and finding out what the best tax preferred investment savings vehicles are.

Social Security and Taxes

Allison Dubreuil, Wealthway Financial:  So we’re talking about the role of taxes in retirement and in retirement planning. And something that seems to surprise a lot of people that we talked to is the fact that social security can be, and often is, taxable. Many people don’t realize that if you have a certain amount of income, and we can talk about the specifics, but if you have a certain amount of income, part of your Social Security benefit is taxable. So you look at your adjusted gross income, and you add half of your Social Security benefit to that. And that will give you what they call provisional income. You don’t have to remember any of this, I’m breaking down how they calculate it. So all of your adjusted gross income, and then half of your Social Security benefit. And if it is more than $44,000 a year for married filing joint couples, then 85% of your Social Security benefit will be taxable. If it’s more than $34,000 for single filers, same thing. 85% of your Social Security benefit is taxable. Could they make that more complicated?

Kevin Zywna, Wealthway Financial:  Your takeaway is that your Social Security benefit could be subject to taxes. And here is another key point that many people don’t realize. When you claim Social Security, they don’t withhold taxes, automatically. It’s not even an option when you claim. You actually have to file a separate form to have federal taxes withheld from your Social Security benefit. So you can imagine how many people don’t realize it’s taxable and don’t realize there are no taxes being withheld and that can cause you some problems around tax time. So make sure you elect federal withholding on your Social Security benefit as appropriate.

Allison Dubreuil, Wealthway Financial:  We’ve been talking about the role of taxes in retirement. We’re going through some things to be aware of that might not be commonly known and some pitfalls and traps  to watch out for. So we talked about tax rates in retirement. While you may expect them to be lower, there are situations where your taxes may not be lower because of tax rates, or because of the way your nest egg or your retirement income is structured. The fact that Social Security is taxable for many people, once you have a certain amount of adjusted gross income, that will cause your Social Security benefit to be taxable. So you want to be on the lookout for that. You want to make sure you elect withholding on your Social Security benefits.

Kevin Zywna, Wealthway Financial:  Unless you want to get surprised by a tax bill. Some people pay quarterly estimated taxes because they haven’t withheld enough from the Social Security benefit.

Contributing To Your IRA In Retirement

Allison Dubreuil, Wealthway Financial:  You can do that too. We talked about having different buckets of savings in retirement to have some flexibility for tax purposes. And one of the questions we often get as people are transitioning to retirement or in retirement is, ‘can I still contribute to my IRA?’ They may have been making tax deductible contributions while working or they just may have extra cash flow and they may want to make IRA contributions. Well, up until a couple of years ago, you could not contribute to a traditional IRA after you turned 70 and a half. That was just a solid cut off. But with the Secure Act of 2019 it lifted that age limit. So now anyone of any age can contribute to a traditional IRA as long as you have earned income. That’s the second piece of the equation that many people miss. They think, ‘well I’ve got my pension and I’m, earning my income – I have income, can I contribute?’ No, it has to be earned income and has to be W2 or, it can be business income, but it does have to be earned and not pension or retirement income.

Kevin Zywna, Wealthway Financial:  So for most people, that’s going to be income from wages or profit from a business that you are an owner of. But for pensions, social security, bank interest, dividends from mutual funds, capital gains, distributions, none of that counts.

Allison Dubreuil, Wealthway Financial:  But if you have earned income, you can contribute up to $6,000 a year or anyone over the age of 50 can contribute an extra $1,000 for a total of $7,000 a year. And as long as you meet certain income requirements, you can take a tax deduction for contributions that you put into a traditional IRA. So this is something you can do in your later years. But you have to have the earned income.

Tax Implications on Rolling Over a TSP to an IRA or Roth IRA

Kevin Zywna, Wealthway Financial:  Alright, we have Jim in Newport News. Good evening, Jim. You’re on Dollars & Common sense.

Jim, Caller:  Hey, guys, I’m retired military. I have a military TSP that’s basically traditional, before taxes, contributions. I’m looking to transfer that to a traditional IRA. And then over time converting it. My question is, should I move all of that money out of the TSP into an IRA at one time? Or do you think it’d be better to do a chunk of it a year? Because I’m not going to convert it all in one year? I’ve got to do it over time to keep my tax rates a little in a lower bracket is my idea.

Allison Dubreuil, Wealthway Financial:  How old are you, Jim?

Jim, Caller:  I’m coming up on 60.

Kevin Zywna, Wealthway Financial:  You did say you were retired. Was that correct, Jim?

Jim, Caller:  Yes, retired military.

Kevin Zywna, Wealthway Financial:  The act of transferring the TSP money into a traditional IRA, which is step number one, that is a non-taxable event. You can do that at any time. And there will be no tax implications in that maneuver, done properly, of course. And we generally recommend that most people should make that maneuver. You have more control over the investments in an IRA account than you do in TSP. You have more control over the custodian or the bank or whoever you work with, they’re easy to get access to. So generally, we recommend that people do that when they separate from service from the military or federal government with the TSP.

You could rollover 100% of everything in your TSP to that traditional IRA. And then Step number two is to convert from the traditional IRA to a Roth IRA. What you were describing, looking to do it in segmented amounts, is wise. That would prevent you from getting into too high of a tax bracket. Because everything that comes out of that traditional IRA and converted to Roth IRA is going to be ordinary income. That’s when you’re going to have to pay your taxes. So you do want to manage your tax brackets there. You most likely don’t want to do it all at once. Don’t run yourself all the way up the tax ladder in one particular year. Because then you aren’t doing it as tax efficiently as you otherwise probably could. The strategy is a good one.  You just have to do it in a couple phases.

Jim, Caller:  Okay.

Allison Dubreuil, Wealthway Financial:  Jim, tell me what is your your goal with the Roth conversion? What’s your thought process there?

Jim, Caller:  My thought process is I’m betting that my taxes are going to be higher in retirement than they are right now. Because the tax brackets are lower from now till 25. Again, that’s assuming that it doesn’t get changed. And assuming that the backdoor Roth stays in effect, and I know, Congress is looking at changing that. But my idea is, if I do it now, overall, I will pay less taxes than if I wait till taking it out in retirement because I think I’m going to pay more. Because I think tax rates are going to go

Allison Dubreuil, Wealthway Financial:  Okay. It is a common strategy that that you see being practiced now.

Kevin Zywna, Wealthway Financial:  We want to follow up a little bit on Jim’s question, because it was a good one. And we’re hearing it more and more these days with people concerned about potentially raising tax rates and tax brackets. We’re hearing a lot more people who want to convert traditional IRAs into Roth IRAs, which can be a viable strategy. But that conversion process is a taxable event. So you have to proceed with caution. And we have learned some interesting things through study and analysis about this technique.

Allison Dubreuil, Wealthway Financial:  Yes, we’ve done a lot of research about this recently, because the conventional wisdom out there is if you retire somewhat early, and you have some years where you have no income – nope, no large pension, you haven’t claimed Social Security and you’re required minimum distributions haven’t kicked in yet – then there could be some opportunity to convert some portion of your pre-tax money into tax-free money at low tax rates. But when we try to put this into practice, because you are essentially pre-paying your taxes, it takes you a certain amount of time to break even from from doing that. So you take money out of the traditional IRA, pay your taxes, and then it does grow tax-free going forward. But we’re not seeing that breakeven point until very late 80s, sometimes almost 90. So while it can save you a million, I’ve seen a couple million dollars in taxes over your lifetime, you may not actually really see the benefit of that. And so we might recommend this strategy for clients that feel very strongly about leaving a tax-free asset to their heirs. But if you’re doing it for your benefit, just know that it takes quite a while for you to make up pre-paying those taxes. That is even considering the the tax loss sunsets that are scheduled for 2026.

Kevin Zywna, Wealthway Financial:  So not always a slam dunk strategy. It helps to have a long-time horizon. I guess you could say it would help if future tax rates do jump up considerably. It has to be considerable. It wouldn’t be helpful overall in society but it would help in this wishing. But for this one particular strategy to work, a big jump up in tax brackets and tax rates would then make the numbers more favorable by converting today. 

Paying Taxes On Cash App

Kevin Zywna, Wealthway Financial:  Okay, Brent in Virginia Beach, you are on Dollars & Common Sense.

Brent, Caller:  I have a question about this new Cash App thing, the peer-to-peer sharing. I run two different businesses right now. I only have the two debit cards. And sometimes my guys  need money. I’m cool, you know. There’s a site where they’re picking up like, $500- $600 worth of material. I just send them the money on cash app, because it’s so easy, just do the share to share thing. I know that with the new tax law they’re going to start taxing us on that. So is there a better solution?

Kevin Zywna, Wealthway Financial:  So are we talking about a money transfer technology, like PayPal or Venmo?

Brent, Caller:  Yes.

Kevin Zywna, Wealthway Financial:  And you’re saying that you think that there’s going to be taxation on the transfer?

Brent, Caller:  There is a law that I’ve been hearing about. It’s something like $20,000, or anything more than $600 on transactions is going to get taxed. Well, I’m just worried about that because I’m just a small business owner.

Allison Dubreuil, Wealthway Financial:  It sounds like you’re just trying to find an easy way to facilitate a transaction on your behalf. You’re sending an employee to go purchase supplies on your behalf. And you’ve been doing that using cash app.

Brent, Caller:  Yes, because I only have two business cards. Right. I have one and my business partner has the other.

Allison Dubreuil, Wealthway Financial:  I can see what you’re saying that the IRS would look at that as not you purchasing supplies. They look at that as you sending money to another person to an employee, essentially.

Brent, Caller:  Yes

Kevin Zywna, Wealthway Financial:  Well, I don’t know enough about the proposed law to really give you much guidance there Brent. It is a common practice in business to allow employees to have purchasing power, whether that’s a corporate credit card, whether it’s the company checkbook, whether you give them cash and a voucher system. I can see in today’s modern world where this might look a little like you are paying your employees without withholding federal state taxes, Social Security, taxes, all that. But as long as the documentation in your books were an order, I would, I don’t see how that could be subject to extra taxation.

Brent, Caller:  I was just worried because, while I have all my guys on payroll, I only have two cards, but six employees. I’m running around between two to three different job sites. I can’t always give them the card. So sometimes I have the card, because I’m buying materials. And then my other business partner has his card, because he’s buying materials. Because we’re on two different job sites. I’m just trying to get a little bit of financial advice because I’m new to running two different businesses right now. I’m just trying to not have the IRS say, ‘guess what? I’m getting everything you just made last year. And hey, congratulations. You got $0.’

Allison Dubreuil, Wealthway Financial: I can see how that type of a transaction could be misconstrued. It might be worth talking to your vendors to see if you could set up some other account with them to make it easier for you to facilitate those transactions without you having to be there. Or maybe talking to your bookkeeper or CPA about the best way to handle that. Because without knowing too much about what’s in the current proposals, since it’s all subject to change. I can see how that could be slightly misconstrued and make your bookkeeping more difficult.

Kevin Zywna, Wealthway Financial: But I would expect that as long as the books are in order and you can justify that the money was transferred for payment of materials, that’s a fair and legitimate transaction that, in my mind, shouldn’t pose any additional excise tax.

Brent, Caller: Ok, that makes me feel better. I have a bookkeeper that I pay to do all my stuff. And she’s very good at what she does. I’m just worried because I have a lot of vendors and sometimes I have to pay in cash when an account is maxed out. I just don’t want my employees to have this transfer of funds to count as income.

Kevin Zywna, Wealthway Financial: Brent, when you transfer that money through the Cash App, how does that work?

Brent, Caller:   I have most of my guys set-up on Cash App because it’s the quickest way to transfer money. I gave all my guys Cash App cards because I can transfer the money instantly.

Kevin Zywna, Wealthway Financial: The employee that uses the Cash App card gets a receipt from the vendor, right? And they bring it back to your bookkeeper. They match it back to the Cash App transaction with the receipt for legitimate materials. I don’t know of what extra tax that would provide unless people aren’t doing their books properly.

Thanks for that call. We are going to head to Newport News and speak with Edmond. Good evening, Edmond. You are on Dollars & Common Sense.

How to Plan For Retirement Gap Income

Edmond, Caller: I have a question about asset allocations for short-term money. I know longer term, 7 years, 10 years or more, yes – you want to be in stocks. We have some money set aside for early retirement. My wife and I are 51. We have a good chunk set aside until 60, when we start drawing on our Roth. What’s a good allocation or how should the money be allocated if you have only 1 – 9 years when the money is going to be used?

Kevin Zywna, Wealthway Financial:  First of all, we would say 9 years is not short-term. One year is short-term. We would define short-term as 1-3 years. Medium-term: 3 to 7 or 8 years. Anything longer than 7 or 8 years is long-term. The more money gets pushed to the long-term bucket, the higher the probability that a good investment plan (annuities, stocks) will yield you a higher result. You are kind of spanning the spectrum because you have about 9 years to go. First of all, you do need to have short-term cash on hand. Normally the rule of thumb is 3-6 months for emergency purposes. But one of the strategies that we like to use with our clients who are in the distribution phase of their lives, essentially retirement, is to build-up that bank account even further. Anywhere from upwards of 1 to 2 years in just cash sitting in the bank or money market account. Right now it is not earning anything but it is very accessible, very liquid. There will be no deviation in value. Yes, you could, maybe, squeak out a few more bucks by getting CDs (a 6 month or 12 month CD). We would say that your short-term cash only needs to be up to 2 years if you do the rest of your investment process right. So how does that mesh with what you are thinking right now?

Edmond, Caller: That’s helpful. We would be drawing on that money. We have approximately $500,000 and we are going to draw on that $50,000 a year for 10 years. So I get it. That’s $100K. My issue is what do we do with the remaining $400K?

Kevin Zywna, Wealthway Financial: Here is the suggestion for you. The rest of the $400,000 goes into a well-managed, properly diversified, growth-oriented, investment portfolio. In a brokerage type of account. It’s not in retirement accounts like an IRA. You can access it below age 59.5 without penalty. Each year you roll. You draw out $50,000 from your bank account one year and sell-off $50,000 from that investment account. Then you move it into your bank account. So you are always replenishing that bank account with 1-2 years worth of cash. Yes, it is possible that in some years you could have negative returns and you could be selling some stocks while they are in a down-turn. But because you are only piecemealing the money out of the account, you are buying yourself time by only taking out smaller chunks rather than the whole amount. So that by doing in that way, you maintain the high probability of having more money through equities and being able to have the safety and security of having easy and ready cash flow at the same time. Does that make sense?

Edmond, Caller: Yes, that makes sense. Very helpful. Can you give a range of what might be appropriate amount of stocks versus bonds? What is a range of something that would be appropriate?

Kevin Zywna, Wealthway Financial: I’m not going to give you specific advice as that wouldn’t be proper in this format. I will say that generally, we believe that there is more risk in bonds right now today than there is in stocks. The risk of a lower rate of return in bonds is greater than there is in stocks – over the next 5-10 year period. That is because we are in a rock-bottom interest rate environment. When interest rates start to tick-up, bond values are going to decline. While we haven’t abandoned bonds, we have dramatically underweighted that allocation compared to historical norms.

Edmond, Caller: That is very helpful. Thank you very much

Kevin Zywna, Wealthway Financial: Thanks for the call, Edmond.

Kevin Zywna, Wealthway Financial: A few lastminute thoughts on retirement tax planning.

Allison Dubreuil, Wealthway Financial:  We’ve been talking about the role of taxes in retirement and some things folks may not be aware of. The fact that your Social Security might be taxable and the fact that your different account types in your nest egg might have different tax treatments. Being aware of that. The money that comes out of your 401K and your IRA –  that’s all taxable income and is going to push you up those tax brackets.  If you have Roth money, that will come tax-free. We did have a caller ask about rolling over from a 401K or retirement planning to an IRA – that’s a tax-free movement (if done properly) from trustee to trustee. We do, almost always, recommend consolidating so that you have more control and visibility over those accounts as well as cohesive retirement withdrawal strategy.

Kevin Zywna, Wealthway Financial: You want to simplify your financial affairs as much as possible as you transition into retirement. Very rarely is there any benefit to excess complexity. Consolidate all of those retirement accounts…the TSP, the 401K, the 403B, into an IRA.