Tax season might be over for 2017, but creating a strategy to mitigate taxes is a very important part of retirement planning, which may well stretch across a decade or more. Unfortunately, many people don’t understand it—even some CPAs aren’t knowledgeable about retirement planning. We’d like to present a few of the basic concepts here. If you would rather hear this than read it, listen to our April 18, 2017 podcast on Decker Talk Radio.
Qualified vs. Non-qualified Money
To begin with, it’s important to explain what is meant by qualified versus non-qualified money. Qualified money is your retirement plan money—it’s pre-tax money. It includes accounts like IRAs and 401(k)s. Income taxes are due on the amount of money you withdraw from these accounts in the year that you withdraw it.
Non-qualified money has already been taxed, like your bank accounts, CDs, or Roth IRAs. Taking money out of these accounts does not trigger any taxation, although there are a few rules about Roth IRAs you will need to follow, like having the account for five years before you withdraw any money.
Required Minimum Distributions (RMDs)
The biggest difference between qualified and non-qualified money is that by law you have to take money out of qualified accounts every year on or before December 31st starting at age 70 and a half, following specific formulas that dictate the percentage that must be taken out.
These are called Required Minimum Distributions, or RMDs, and they trigger income taxation. Your yearly income determines what tax bracket you fall in, and that income includes any RMDs you are forced to take. This is why it is extremely important to have a retirement plan in place.
Hypothetically, let’s say that over a period of 20 years, your $250,000 IRA account grew into a million dollars. That sounds great, right? It sounds great until you realize that when you are forced to start withdrawing RMDs, you may be bumped up to the very top income tax bracket. You might be 80 years old and paying 40% of your IRA money out to the IRS!
What Bankers and Brokers Don’t Do
Bankers’ and brokers’ investment recommendations could dramatically affect lines eight and nine of your 1040 form. Those are the lines where you report interest and dividend income to the IRS.
They also don’t care about risky equities investments and how those might hurt you, should the United States experience another market drop like we saw in 2008. Bankers and Brokers only make money when you keep your money at risk in the stock market.
At Decker Retirement Planning, we consider all retirement ramifications, including the huge impact taxation can have. We may analyze your situation and change things to make sure you’re spending the income that you’re getting taxed on. Or, we may advise you to convert or repurchase those same dividend-paying funds, but hold them in a retirement account, like a Roth, so that you’re not taxed on them.
It is important that retirement planning be handled by a qualified financial advisor—preferably a fiduciary—who is legally obligated to put your best interests ahead of all else, and can run all the numbers and help you calculate the best way to handle your assets to minimize taxes.
Conversions
Ask your guy at the bank or girl at the brokerage firm how much you should convert from an IRA to a Roth, and most of them will have no clue. Yet, the Roth IRA offers three advantages to retirees. Number one, it grows tax-free. Number two, it generates income back to you while you’re alive, tax-free. Number three, it passes to your beneficiaries, tax-free. Roth conversion may very well be the biggest tax-saving strategy of your lifetime.
Three years ago, the IRS dropped any limits on conversions, so now you can convert no matter what your tax bracket is. There are even ways you can add more money to IRAs and, subsequently, convert them into Roth accounts even if your income is “too high.”
At Decker Retirement Planning, we have a Roth IRA calculation that allows us to know, to the dollar amount, how much you should convert from a regular IRA to a Roth account. Typically, as a rule of thumb, if you have about a third of your investable funds in a Roth IRA, or around 33 percent, you should stop converting. But, we run the numbers for each retirement plan we design. We’ll even do the calculations for free in our office if anyone is curious.
However, we don’t convert it all at once. We convert it over five to seven years, and we do it in the “Risk Bucket” part of your retirement distribution plan. Read on to find out what that means.
Retirement Distribution Planning
We build individualized retirement distribution plans for each client, reviewing your combination of qualified and non-qualified money and building a custom distribution plan designed to help minimize taxation and maximize your retirement income. There are some general principles we follow in distribution planning, grouping retirement into four stages or buckets:
Bucket One: First Five Years
Bucket Two: Years Six through 10
Bucket Three: Years 11 through 20
Risk Bucket
We put the already-taxed, non-qualified money in the front of your plan—in the first three buckets or first 10 years—meaning that’s what you live on first. By doing that, the taxes that you owe could go way down because your AGI, your Adjusted Gross Income, will put you in a low tax bracket. This may also reduce the taxes you owe on your Social Security.
Principal-guaranteed accounts also go in Buckets One, Two, and Three. They produce immediate income that can be relied upon. Clients who followed this strategy sailed through the stock market fiasco in 2008 unaffected because they were drawing income from principal guaranteed accounts.
The Risk Bucket is where the IRA to Roth conversions actually come into play. We will be doing the conversions in a slow, methodical manner based on the math that gets you the most income for the least tax owed.
Transferring Assets to Beneficiaries
When it comes to estate tax planning, we work with either your, or our, estate tax planning attorneys to help develop strategies designed to transfer as much of your wealth as possible to future generations in the most tax-efficient manner.
Estate plans are complex, and even the best plans can have holes that affect taxation. We look at many variables, including estate tax exemptions that exist in your state, gifting opportunities, life insurance trusts, last-to-die insurance policies, family limited partnerships and Nevada corporations for real estate, foundations, and dynasty trusts.
As you can see, taxes have the potential to be a very dark cloud over retirement, unless you add elements to your retirement plan to help mitigate them. We specialize in helping our clients make smart retirement planning decisions—factoring in risks like taxes—and we welcome the opportunity to help you, too. Call us for your no-cost consultation to see real results for your financial future: 855-425-4566.
At Decker Retirement Planning, we strive to provide comprehensive tax minimization strategies in all areas of our planning.
