Pay less tax with better planning

Nobody wants to pay more tax then they have to, unfortunately very few people take the time to figure out the best legal ways to lower their life time tax bill. Most people have very little control over the timing of their earned income (pay check) so they think there is little they can do about their taxes. Everybody, however, has considerable control over what accounts they can put money into, and when they can take money out of those accounts. Doing it correctly can save you hundreds of thousands of dollars in taxes over your lifetime.

In some of my earlier articles I talked about retirement and other accounts and the importance of investing in them to shelter or delay taxes on as much money as possible. But here is a quick refresher on what these are. There are individual accounts otherwise known as IRAs and there are employer sponsored plans, generically referred to as 401Ks. Your employer sponsored plan may be called something different such as a 403B if you work for a nonprofit or a simple IRA if you work for a small company.  For the sake of this article all employer sponsored accounts will be treated the same and referred to as 401Ks. If you have a high deductible insurance program you can also contribute to an HSA It is the greatest legal tax dodge ever invented! If you have a family and are not contributing to an HSA you are probably paying at least $2,500 more a year in taxes then you have to. Please refer to my post on Retirements accounts were I describe these accounts in greater detail.

There are two types of IRAs, Traditional and Roth.

With a traditional IRA you usually get a tax deduction (subject to income limitations) when you make your contribution. Both your contribution and any earnings you make grow tax differed, meaning you pay no taxes until you withdraw the money. When you withdraw the money it is all taxed as ordinary income according to the tax bracket explained below. With a few exceptions any money you draw before the year in which you reach 59 and a half years old will be subject to an excise penalty on top of the tax. You must start taking minimum required distributions (RMD) once you turn 72. If you turned 70 and a half before 2020 you must continue to comply with the old rules that required RMDs at that age. Other than the RMD you can control when you take money out of the account either through withdraws or conversions. Timing when to remove money from these accounts is the best way to manage your lifetime tax bill.

With a Roth IRA you do not receive a tax deduction when you make your contribution but all the money is withdrawn tax free including all the money you earn on the investments as long as you wait until you are 59 and a half to take it out. There are no RMD requirements.

401Ks used to all be traditional, now many employers offer a Roth option. Most employer plans can be rolled over into IRAs when you leave an employer or when you turn 59 and a half. The withdrawal, and taxing rules and RMDs are essentially the same as described above for IRAs whether you leave them at your employer or roll them into IRAs. When it comes to making RMDs and planning your withdrawals for tax purposes all your traditional accounts should be added together regardless of how many accounts and whether they are still with former employers or not. Going forward in this article I will use the term IRA to refer to all traditional accounts added together (including 401Ks) and I will use the term Roth for all Roth accounts added together (including Roth 401ks).

In an earlier article I talked about earning tax free money and the importance of contributing to tax free and tax deferred accounts. If you are not sure why you should be doing this, please review that article by following the hyperlink.  If you have not started your retirement planning please review that article. If you are not sure how much you should be saving please read my article on that.

Our tax code is way too complicated, most people including some financial planners, don’t fully understand how it affects your investments. I even head a financial planner the other night come up with a cute (but incorrect) phrase, “Your IRA is simply and IOU to the IRS.” While it is true you owe taxes on your traditional IRA only a portion of it will go to the IRS. How much goes to the IRS depends on how well you plan the distributions from your various accounts.  While you need to realize any stream of income from a traditional IRA is taxable income you also need to understand you have some control over when you take that income and with careful planning you can minimize the amount of money you pay in taxes.

Everyone should be looking at ways to legitimately reduce their life time tax bill but particularly those people at, or who are likely in retirement to be at the higher tax rates. It is also important to do, if you believe, like I do, that taxes are more likely to go up than down in the future.  The current tax rates are set to expire and go to the older higher rates at the end of 2025.

This article gives you some basic strategies for minimizing your lifetime taxes. This can become quite complicated and my examples in this article are an over simplification just to get you to start thinking about this. They should not be construed as advice or a plan for your individual situation. Putting together an individualized plan early can help you save a lot of money.  For many people putting together an actual plan can be quite difficult but it is essential to map this out early and not wait until withdrawals are forced on you either by need or RMD requirements.  Besides affecting your tax rate, drawing too much income at one time can also increase your Medicare premiums which are based on your adjusted gross income as well as subject you to an additional net investment tax of 3.8%. If your income is high enough you could also see your long term capital gains tax rate increase from 15% to 20%.

Getting this wrong can be quite costly. The difference between paying an average 32% tax rate and paying an average 15% tax rate is $170,000 on a millions dollars. That is a considerable amount of money to be left on the table due to lack of planning.   Whether you have more or less than a million dollars saved for retirement the point is, with careful planning you can minimize the taxes you pay and maximize the amount of money left for you and your family.  If you cannot figure this out on your own reach out for help, even if you have to pay a qualified financial planner it will probably be money well spent. Just make sure they are qualified to help you with this specialized area.

There are lots of factors to consider, including but not limited to; the size of your accounts and other sources of income, when you plan to retire, if you have a pension, and when you plan to take Social Security. If you are married the plan has to include all of the above for your spouse also, in addition to considering scenarios for what happens if one spouse passes away before the other. Death of a spouse affects your plan because sources of income may go away or be diminished, i.e. the deceased spouse’s social security and pension if they had one. Your expenses will go down but won’t be cut in half. While income streams may be diminished the surviving spouse will likely be pushed into the higher single tax bracket causing income to be taxed at a higher rate. Finally you also have to factor in your estate plan if you want to minimize taxes for your heirs should something happen to you before you spend all the money.

There are four categories of tax payer, single, head of household, married filing jointly, or Married Filing separately. The tax rate brackets are slightly different for each category and change each year. They can be found by Googling Federal income tax brackets or following the hyperlink. For simplicity I will use the Single brackets in my explanation. That is the bracket in which you hit the break points the soonest, with the exception of married filing separately that is identical to the single until the highest bracket which it reaches earlier)

The brackets only affect taxable income, so that is basically the amount of all your wages and investment income, any withdrawals from your traditional IRA, less your standard or itemized deduction. Certain investment income such as dividends, interest, and long term capital gains, are entitled to a lower rate than your bracket, and may become part of your plan for minimizing taxes.

The table below gives you and illustration of how tax rates work.

bracket	break  point	Start When income reaches	End when income reaches	range	rate
Income up to $9,875	$0.00	$12,400	$22,275	$9,875	10.00%
Over $9,876 to $40,125	$22,276	$22,276	$52,525	$30,249	12.00%
Over $40,126 to $85,525	$52,526	$52,526	$97,925	$45,399	22.00%
Over $85,526 to $163.300	$97,926	$97,926	$175,700	$77,774	24.00%
Over $163,301 to $207,350	$175,701	$175,701	$220,050	$44,349	32.00%
Over $207,351 to $518,400	$220,051	$220,051	$530,800	$310,749	35.00%
over 518,401	$518,401.00	$530,801			37.00%

If you assume a standard deduction (If you itemize you simply would start paying taxes at the amount of your itemized deduction) A single person pays no income tax of the first $12,400 they earn. They then pay 10% federal income tax on the next $9,875 they earn. When their income reaches $22,276 they pay federal tax at a 12% rate until their income reaches $52,525 and so on. So your affective tax rate (divide your total tax by total income) is never anywhere near your top marginal rate, and that top marginal rate is only applied to any dollars you earn above the break point.

So if you are currently earning $97,925 dollars you’re highest, or last earned dollars, are being taxed at 22% by the federal government meaning you are keeping 78 cents of every one of the last $45,399 dollars that you earned.

Let’s look at how this would be applied to withdrawals from your IRA. Most older people I talk to are heavily over weighted in their traditional IRAs, most younger people are heavily over weighted in their Roth’s. Who is right? On the one had they are both right for at least seeing the importance of putting money into a tax free or tax deferred account . As far as tax management goes however they are probably both wrong even when considering all the other factors previously listed. You need to strike a balance that fits your personal situation, but likely includes some money in each type of account if you are interested in minimizing your lifetime tax bill.

Older people grew up with Traditional IRAs long before the Roth ever came about. Some stuck with the traditional because it was comfortable and they understood it so they never saw a need to educate themselves on or look at the advantages of a Roth. Many younger people are scared to death of rising taxes and when they hear tax free forever that is the easy out for them with no planning required and a Roth is all they know.

Here is where some tax planning comes into play and having options really makes it easier to minimize your life time tax bill. Everyone should be looking at ways to legitimately reduce their life time tax bill but particularly those people at, or who are likely to be at the higher tax rates. It is also important if you believe that taxes are more likely to go up than down in the future.  The biggest percentage jump that most people need to worry about currently is from 24% to 32% so ideally you want to time and manage your income wherever possible to keep below that 32% breakpoint.  That break point is $175,701 for single filers with a standard deduction. For a lot people that means they have room to play with when managing withdrawals or conversions from traditional IRAs.

For people that have a millions dollars or more in their IRA (which is a good target for anyone wanting to retire comfortably in the next couple of years) this planning is crucial. If that is their main source of income in retirement and they have to draw out large chunks of that in any particular year, when added to their social security and pension and other sources of income, it could easily push them into a higher tax bracket then they were at when they were taking all those deductions in their younger years. The worst thing to do would be to take out the full amount in any one year, or even in as few as ten years. Unfortunately if you pass away before taking it all out your beneficiaries (with the exceptions of a spouse) have to take all the money our within ten years under the new rules. If you set up a stretch IRA through a pass through trust the new law may require all the funds to be taken out in the tenth year! This could lead to the vast majority of your account being taxed at the highest tax rate in affect at the time! If you are in that scenario please consult your estate planner immediately. Even if your heirs spread the distribution out over the ten years, and there are no additional gains, that is still $100,000 a year which will likely push your adult children into a much higher tax bracket (especially if you only have one). You could end up leaving them far less than you might have otherwise if you simply had a plan in place to minimize your taxes.

If you are nearing retirement with a large traditional IRA there are steps you can take at this late stage of the game. For starters start contributing to a Roth IRA and Roth 401k if available to you and stop all contributions to traditional 401ks unless it is the only way to get a company match. Having some money in a Roth is important because you want to have an account that you can draw from tax free in retirement to manage your future tax rates. Even if you do not have access to contribute to a Roth 401K and you don’t have earned income, or your earned income is too high to make a Roth IRA contribution, if you are nearing retirement you should stop contributing to a traditional IRA/401K if your account is already over a Million dollars.

While the general rules is to put as much into your tax deferred accounts as possible, as you get older there may be more tax efficient ways of investing your money. By contributing to traditional accounts you are deferring taxes and essentially getting an interest free loan which you can invest until you take the money out. That is great when you’re in you 20’s and that interest free loan will last for 40 or 50 years. It looses some of its charm in your sixties because the interest free loan will only be around to grow for ten to twenty years. If you have a million dollars or more already in the account it is likely that most of any new money you put it will be taxed at the 24% or higher tax rate when you take it out so you lose the tax advantage of a lower rate on your immediate deduction and you also loose the favorable treatment of dividends, interest and long term capital gains for any money invested in a traditional IRA.  Everything that comes out of an IRA is considered ordinary income and taxed at your full rate.  Instead of investing the money in an IRA later in life, if you can’t put the money in a Roth you are better off investing in stocks or a good mutual funds held in a taxable brokerage account. If you hold them for at least one year your long term gains will be taxed at the 15% tax rate as will any dividends you earn.  This is a savings of at least 9% on your taxes! If you hold those stocks until you die your heirs will get what is called a stepped up basis and all tax on the gains will be avoided!

As an example if you had another $100,000 to invest and it doubled over 10 years let’s looked at how the $100,000 gain would be taxed in different scenarios. If you take that gain out of your traditional IRA and you’re already in the millionaire club and/or have other sources of income, you tax at a minimum will likely be 24% or $24,000 leaving you $76,000 to spend.  If you withdraw that money from a Roth your tax will be $0.00. Leaving you with the full $100,000 to spend. If you can’t put it in a Roth but instead put in in a taxable account, and hold the stock for 10 year you would pay a 15% capital gains tax leaving you with $85,000 to spend. If you die before selling the stock you heirs would get a stepped up basis, pay no taxes and get the full $100,000 to spend.

So hopefully this is now making some sense. If it is you should also consider converting some of your IRA to a Roth each year. You want to avoid a scenario of pushing yourself or your heirs into the 32% or higher tax bracket because you wait to take all the money out of your traditional IRA in a condensed time frame. The hard thing to accept is that you need to pay taxes when you make the conversion, but by strategically converting small amounts overtime you can control the tax rate and avoid taking out large lump sums when you need money or your RMD’s kick in. You need to understand even though you may be paying taxes earlier than planned on some of this money it is better to pay 24% or lower now, than it is pay 31% higher on a larger amount latter. That's right, a larger amount, over time your investment value should go up so it just increases the amount that will be taxed and the amount you will be forced to take out through RMDs whether you need it or not.

An example of how this might look is if you’re single and making $90,000 a year you have up to $70,000 you can convert without hitting the 32% tax bracket.  Of course $70,000 might be a bit much to do in one year because you have to pay the taxes on that extra income, and if you can’t do that without withdrawing funds from your IRA it could be counterproductive, especially if you are not old enough to withdraw funds penalty free. But you should not start converting as much as you can afford to convert each year.

A good time to do conversion is when you retire early, especially if you are able to postpone your social security until you are 70. If you have no other income, you can essentially withdrawal or convert $12,400 a year tax free (higher if you itemize your deductions and/or are married), and another $40,000 a year at the 10% and 12% tax rate. Another good time to do a conversion is during a Market correction, that way you pay taxes when the value of your stock is low, convert it to a Roth so when the stock market comes back the increase in value back to its old value and beyond will all be tax free.

For tax purposes a withdrawal or a conversion are treated the same as long as you are old enough for to avoid the penalty for early withdrawal. There is no age limitation for conversions, they can be done at any age. If you don’t need the money immediately a conversion is always better than a withdrawal because in a Roth the money will grow tax free.

Strategically converting the money to a Roth over time is important not only to manage your taxes but to help control when you take funds out. If an emergency comes up and you need to take a large chunk of money out of your retirement accounts, taking it from a Roth does not affect you taxes, as it is a tax free withdrawal. Taking a large chunk from your traditional IRA may push you into a higher tax bracket and increase the amount you have to withdraw because you have to withdraw enough to cover your needs and the taxes on the money you withdraw.  On the other hand, even if you don’t need money you still have to take your RMD from the IRA every year starting at age 72. You have to pay taxes on the withdrawal whether you need the money or not. There are no RMD requirements for the Roth. An RMD cannot be converted to a Roth, so once taken out that money can only be spent or placed in a taxable account.

The younger people that have no traditional IRA holdings may also be missing an opportunity. They have more time to play with and many things can change so it is always nice to have options. Many young people that are already investing for retirement in their 20s are doing everything right to allow themselves to retire early if they wish to do so. If that is part of their goal or plan, why pay a 24% or 31% tax on your highest dollars now when, if you retire at age 50 or 60 you may have several years ahead of you with no income, since withdrawing from your Roth is not taxable. Wouldn’t it be nice to take some tax benefit from deductions now knowing that there may be periods in your future where you will have little to no income and could be withdrawing or converting $12,400 a year completely tax free from a traditional IRA?  And then only pay 10 to 12% tax rate on the next $40,000?  That clearly beats the 22, 24 or 32% you are likely paying now on your last dollars if you aren’t taking a deduction. Besides early retirement you may have periods of reduced income because of layoffs, going back to school, or taking a year off to raise kids or go on a sabbatical. By having money in both types of accounts it gives you options for minimizing your life time tax bill.

I am a big Fan of the Roth and think all things being equal it is a safer bet than a traditional IRA as there is no uncertainty. That being said I think having some money you can convert should you find occasions when your income is low, and avoiding a known 32% tax bracket now are reasons enough for putting some money in a traditional IRA or 401K. How much depends on your own situation and projections. Remember if your company has a match all matching funds go into a traditional even if your contributions are going to a Roth. Also if your company has a defined contribution program instead of, or in addition to a match that also goes into a traditional account.

Whether young or old, once accounting for tax planning flexibility, every spare penny you have intended for long term investing should be going into a Roth if you have access and are legible. If you are already 60 every penny extra penny you can put into a Roth should go there even short term money. It doesn’t ‘matter if you have to take some out tomorrow, you already meet the age requirement! A lot of people stop contributing to these accounts because they are retired, semi-retired or think they already have enough money saved for retirement. But if you can already take it out penalty free, you can use it as a savings account and earn interest tax free. You should put every penny you can to tax free accounts and keep it tax free as long as you can.  If you are retired but have a part time job or your spouse works you can still and should continue to maximize your Roth contributions every year.

See my recent post on retirement accounts for a better explanation, who is eligible and why this should be done. If you really want to grow family wealth convince your children to start contributing to Roth IRAs from the time of their first summer job or earned income. If you are in a position to do so, consider helping them contribute the max they are eligible to contribute. It doesn’t matter how young they are it is great family planning to shelter as much money from taxes as possible. If they have earned income they can max out the Roth up to $6,000 a year or their earned income, whichever is lower. Many part time jobs now allow 401K contributions, have you children take advantage of those particularly if there is a match available. Set your children up for a life time habit of saving and help the family avoid taxes something everyone can agree on. If you want to see, or show them how important starting early is refer them to these post. The early Bird Gets the worm and Real life examples of letting your money work for you.  Also watch for an upcoming post on educating your children about money.

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