Assets and Taxes - The Implications of Taxes in Retirement | Episode #1

Starting point is 00:00:00 Welcome to the first episode of Assets and Taxes. I'm Kent Fitzpatrick. I'm the Managing Director here at Asset Strategy and a Senior Financial Consultant for over three decades. That's a lot of time and a lot of experience we want to share with you. Before we start this first episode, I wanted to give you a brief overview of our firm, a little bit about what you can expect from our podcast, and what we'll be discussing today. So Asset Strategy, we provide wealth management solutions to individuals and families, as well as retirement plans and business financial solutions for corporate and non-profits. We're a trusted advisor to investment stewards and fiduciaries, utilizing prudent process, transparency, and a collective approach to strengthening your financial future. Asset Strategy provides wealth management solutions to individuals and families,

Starting point is 00:00:48 as well as retirement plans and business financial solutions to corporations and non-profits. We're a trusted advisor to investment stewards and fiduciaries, utilizing prudent process, transparency, and a consultative approach to strengthening the financial future for America's workforce. Our mission, helping you create, manage, protect, and distribute wealth. How do we do this? Well, we help families define, plan, and work to achieve their financial goals and objectives, whether that's risk protection, accumulating wealth, minimizing taxes, or legacy planning. For our corporate and nonprofit clients, we help build retirement plans that protect fiduciaries and truly change participant behaviors to drive meaningful outcomes.

Starting point is 00:01:30 We also work with entrepreneurs on tax and risk management strategies. Now that you've learned a little bit about us, let's talk about what you can expect from our podcast. This podcast will dive into the dynamic world of financial planning, tax strategies, investment, and retirement ideas. Think of our podcast, Assets and Taxes, as the yin and yang of your financial journey. You want your assets to grow and your taxes to shrink. Whether you're an individual looking to maximize your wealth or a small mid-sized business owner navigating complex financial landscapes, our podcast brings you timely discussions, expert interviews, and actionable ideas and strategies. Join us as we explore how to make your money work harder,

Starting point is 00:02:11 keep more of what you earn, and have a little fun along the way. In this podcast, I sat down with Asset Strategy Senior Financial Consultant David O'Brien, who is a CFP, or a Certified Financial Planner, and a Chartered Alternative Investment Analyst to talk about everything you need to know about how taxes have an impact on your retirement. We discuss ERISA and your 401k plan, IRAs, Social Security, Medicare, Roth IRA conversion strategies, smart tax distribution strategies, legacy and estate planning, and qualified charitable distributions. If you're someone who may be retired or you're thinking about doing so soon,

Starting point is 00:02:48 you need to listen and learn some serious implications that could affect your retirement income. If you have more questions, consider booking a free 15-minute discovery call with one of our advisors so we can begin to discuss your situation and help you kick taxes to the curb. A link will be in the description at the end of this episode. So without further ado, here's the first episode of Assets and Taxes. Thank you for joining us for our next podcast. I'm Kent Fitzpatrick at Asset Strategy, and as we've shared with you before, we create, manage, protect, and distribute wealth. With me today is my colleague David O'Brien. David, thank you for

Starting point is 00:03:25 joining. Thanks for having me. David is a CFP, Certified Financial Planner, and also a CAIA, Chartered Alternative Investment Analyst, with over two decades of experience in financial advisory space. Today, we're going to talk about a three-letter word that a lot of people just don't want to talk about, taxes, or tax, T-A-X, right? And I think before Dave and I came into the studio, we were talking offline a little bit about, you know, folks do a great job on the accumulation phase, but they don't think about when I get to retirement, what happens with taxes? What's the impact that has? And since the Tax Cuts and Jobs Act, we have seven different tax brackets. And I don't think a lot of people understand kind of managing those tax brackets. But just maybe expand on our earlier conversation, Dave, the point you made about the focus on accumulation. Yeah, Kent, thanks. It's been interesting because things have really

Starting point is 00:04:19 changed from generation to generation. And we're seeing now the folks retiring today have very different financial pictures than even folks that were retiring just 10 years ago. Most people don't have traditional pensions anymore. They've accumulated all of their assets generally in qualified plans through their employer or through their small business or SEP plans, IRAs. The 401k became the new pension. Exactly. So we don't really think about this, but 401ks weren't really a thing before really the late 80s, early 90s. But pretty much my generation, that's all we know, is we assume everyone had 401ks. But that wasn't the case.

Starting point is 00:05:07 Actually, IRAs only became into existence in 1978. And the initial contribution limit was only $1,500. Well, and you think about the timing when mutual funds really became popular. I mean, there's probably a battle between MFS and maybe American funds, what the original date was. But I think it wasn't until the 80s that mutual funds really came into vogue as well as a vehicle to invest those assets. Yeah, absolutely. It wasn't very common for individuals to have a lot of stock market exposure in, you know, the prior generations. It was really only the wealthy that had exposure to

Starting point is 00:05:40 the markets, and that would be in a taxable brokerage account. So IRAs, tax-deferred accounts weren't really that big of a deal. Most people had their pension, Social Security, and other, you know, maybe rental income or different sources of income. Now we have a generation of folks that are retiring with, you know, seven-figure balances in qualified retirement accounts, and we're starting to realize that can actually have some serious tax implications. Well, and also with the introduction of Roth not too many years ago, and now with Secure 2.0, bringing the Roth 401k into vogue, that's another interesting tax dilemma. Do I fund pre-tax? Do I fund post-tax? What's the requirements for RMD on one side or not on the other. So there's a lot of

Starting point is 00:06:26 complexity. I guess to kind of maybe rapid fire with you, a couple of the ideas or topics we were going to cover today, and this is going to seem like an overwhelming list, but between ERISA and IRAs, we already talked about 401ks, we'll touch on Social Security, Medicare, maybe IRMA, Roth IRAs. And people, do they know about conversions? Everyone says, I make too much money, I can't contribute to a Roth. Well, that's not true. I mean, everyone can make a Roth contribution. It's maybe through a backdoor Roth, or maybe Dave and I will talk about the mega backdoor Roth. But what are tax smart distribution strategies? QCD, the Qualified Charitable Distribution, legacy estate planning. So there's a myriad of things that come out of this conversation about understanding tax in retirement.

Starting point is 00:07:16 So, Dave, maybe let's let's let's dive in and let's let's just talk about maybe on the surface, what is a retiree, what do they need to be thinking about when they've worked for 30, 40 years? It used to be you get the watch and like you said, your pension, that was maybe our grandparents' generation. But now they've got accounts all over the place. The tax people are going to tell them what they need to do with their RMDs or required minimum distribution. But what are some of the things that they should be thinking about in terms of getting organized or getting their arms around their stuff? That's a good point, Kent. It's gotten much more complicated for today's accumulators to get ready for retirement. And then you throw on top of that, it gets even more complicated once

Starting point is 00:08:06 you're spending down your assets, understanding taxes in retirement. A lot of people don't realize taxes and healthcare are likely your biggest expenses in retirement. So how do you get in front of that? And I think, unfortunately, our industry has done a very poor job of educating clients on tax smart strategies, making a plan. Most folks are just trying to save as much as they can and accumulate it as much as they can and assuming the rest will work out down the road. And most financial advisors are happy to just focus on managing the assets for the client. They don't really get into tax planning. Most firms, they don't allow their advisors to talk about tax planning. So there's a big gap out there for people that have problems that they don't even know about. But let's back up. Maybe we'll talk a little bit about just the differences between a Roth IRA and a traditional

Starting point is 00:09:05 good place to start in her retirement account Roth IRAs haven't been around that long they're relatively new I think it was 2007 when they were initially came into existence and have slowly gained popularity and you mentioned the secure Act which was only a few years ago, created a Roth 401k option, which some folks have now through their employee-sponsored retirement plans or employer-sponsored retirement plans. So Roths are becoming more available. But really, initially, I'll be the first to admit, I didn't really think it was that big of a deal. You can either, the difference between a Roth account is you pay taxes today, the assets grow tax deferred, but when you withdraw those assets, you pay zero tax. So it's prepaying your taxes opposed to a traditional IRA account, whereas we get a

Starting point is 00:10:02 deduction today, but when those assets come out, they're fully taxable as income. So it can have a really big impact on your retirement income. Well, and just to add to that too, so I know the requirement is you've got to hold it in there for five years and at least age 59 and a half. You can always take out your corpus, your principal, without additional tax because that's already taxed dollars, and all that accumulation. Now, in our notes that we were talking about earlier, a lot of people just ignore that because they said, what can I put in there? I can put in seven grand. That's not going to grow to much. But I think you've got a great example here about just how much that little contribution can compound to. Because I think, as you said, regular IRAs started in 1974 at $1,500. Today,

Starting point is 00:10:48 there's $7,000 in 2024 with $1,000 catch-up, so $8,000. But walk us through that example because I think it's a real good one. Yeah, I think what we realize is that some IRA accounts have grown to be pretty significant, even though the contribution limits are relatively small, to your point. So if you just started out back when the IRA account came into existence and fully funded your account $1,500 back in 1978, and every year the contributions have increased over time, and you just got a 6% return. This is a simple return. We're not talking about any particular investment, but you just got 6% compounded over that length of time. You'd have over $1.2 million in that lowly IRA account

Starting point is 00:11:33 that we don't really give a lot of credit to. Now you look today at 401ks, with much, much higher contribution limits and employer match potential. We're seeing 401k balances in the millions of dollars, right? And those are potential tax time bombs for future retirees. So let's go back to a point we made earlier about people's misconception that, oh, I make too much money, I can't contribute to a Roth. Can you just walk us through the basics of what the industry refers to as a backdoor Roth? Yeah, so you can contribute, any individual,

Starting point is 00:12:11 regardless of income, can contribute to an IRA and have it be a non-deductible contribution. Regardless of income limit. Regardless of income limit. You are limited on who can contribute to a Roth. Married filing jointly, I believe, is $90,000. Directly. Directly. To a Roth account directly, not a Roth 401k. There's no limits on those. So a lot of folks just don't think about it as an option because they're either making too much money or it's just, you know, they're funding all their retirement through their corporate plan. But you can make a non-deductible IRA contribution and then immediately do what's called a conversion. So you change that from a traditional IRA account to a Roth account. Now, normally, if you had a deductible account, you'd

Starting point is 00:12:59 pay taxes on that converted amount. But since we made a non-deductible contribution, that's not taxable. So you just recharacterize that non-deductible IRA into a Roth. Yeah. And you mentioned about the Roth K. And let's just talk about what the 401k limits are and walk the audience through, again, pre- and post-ta tax options within a 401k structure. Yeah, that's a good point. So you can make, if your employer offers it, which has become more common now, you can elect to make Roth 401k contributions. And the difference is I'm going to pay tax on that money today at whatever your tax rate is. It's not a deductible contribution, but when it comes out down the road, it's tax-free. But why does that matter? That's really the bigger issue.

Starting point is 00:13:50 There are a couple of other differences with Roth versus traditional IRA accounts or traditional qualified accounts, exactly. The other is there's no required minimum distributions for a Roth account. A lot of folks don't think about that because they think that's way off into the future. And actually recently the IRS or the, I'm sorry, the government made a change to when you have to start taking required minimum distributions. Now it's up to 72. It's going to become 73. But at 72, you have to take out at least a portion of your IRA account. The government wants to get their tax money. So you can't defer it indefinitely. Most people will be spending that money down anyways. So it may not be a factor, but somebody that has accumulated a

Starting point is 00:14:40 very large balance in a qualified plan, that could really boost the amount that they have to start taking out of their IRA accounts. So it doesn't start out as a big number, but when you get into your 80s, your life expectancy is shorter. That percentage that you have to take out every year climbs to a pretty high number. So what you find, and this is where the problem is becoming more evident today, is we're finding retirees that are in very, very high tax brackets and they have no options because they have to take out those required minimum distributions. To pay for that health care expense that gets larger and larger. Exactly. So then that also triggers sometimes your Social

Starting point is 00:15:25 Security Part B and Part D premiums are impacted by your income. So most people don't think about this. Again, this is something that's way off into the future. But there's something called income-related Medicare adjustment amount. IRMA. IRMA, exactly. So much easier to say. But Irma is not your friend. And if you make a lot of money in retirement, which again, if you've been a good saver and you've accumulated a fair amount of wealth, you could be paying a significantly higher Medicare premium as a result of that.

Starting point is 00:16:00 So technically, it's not a tax. But it sure feels like a tax to me. What walks like a duck, talks like a duck. me. What walks like a duck talks like a duck. Exactly. It doesn't show up on your tax return. It just gets deducted from the amount you receive in Social Security. Well, I think a lot of our listeners probably are not familiar that IRMA is a backwards-looking assessment.

Starting point is 00:16:19 So if I'm going to apply for Medicare at 65, they're going to look back to see what your earnings were at age 63 to determine what that surcharge is going to be on your Part B. We have it in our notes. So you can range from as low as $174 up to almost $600. So it is a big delta, especially for someone who's retired. They don't have earned income anymore, and they're reliant on drawing their income or Social Security benefits. So that's a big penalty. Yeah. And for a married couple, it's times two. You each have your own Medicare premiums that you're going to pay. So it doubles. So it can really add up to a pretty big number. And again, sometimes people just aren't aware, and they get caught off guard. That's the worst is that they're just no

Starting point is 00:17:05 one told them. So if they can manage what that income is at age 63, at least for that look back, that's going to set them up for a more successful or less painful tax potentially with IRMA. Yeah. If you have some Roth assets and traditional IRA assets and Social Security, you have different tax buckets that you're able to draw on in retirement. So we can take a certain amount from our IRA accounts, that's going to be taxed as ordinary income, that's going to impact how much our Social Security is taxed. But then that tax-free bucket, the Roth bucket, allows us to manage our tax brackets in retirement, which can be very, very powerful. The problem, as we mentioned before, is if you have all of your assets or substantially all of your assets in fully tax

Starting point is 00:17:59 deferred accounts, and those RMDs keep ticking up over time, you have no control over that. And what you find is you have, you know, retirees, as I said, in their 80s that are paying much higher taxes than they ever thought they would be. Their Medicare is taxed. And also, we haven't touched on it yet, but those assets can be terrible for beneficiaries to inherit. Yeah, correct, correct. And I think you said it, but I think it's managing that tax distribution strategy. So you talked about tax deductions. There's also tax credits.

Starting point is 00:18:38 There's tax-free. So I think it's kind of aligning those strategies and having a projection into what that tax impact is going to be if I don't make some plans before I get to these trigger dates. Absolutely. And we can run those analysis for folks and actually take a look at where they are today, what their current tax bracket is. And you can actually do what's called a partial conversion. So if you do have a significantly large IRA, 401k balance, you don't have to convert everything all at once.

Starting point is 00:19:08 So what we often will recommend is you have somebody that's in their pre-retirement phase, or maybe they take a step back from their full-time job or have lower earnings for a period of time, or recent retirees, one spouse may be working, the other not. There's a lot of scenarios that may artificially lower your tax bracket one year. You can make a conversion up to a certain level, so we call it filling the bracket, and convert only that amount, and then you can do that over multiple years. So it keeps you in a lower tax bracket, but will chip away at the tax problem in the future.

Starting point is 00:19:48 And so you don't have to do it all at once is my point. So having a tax smart strategy, you may implement over three to five years to significantly convert a significant amount of your traditional IRA assets to Roth that gives you that flexibility in the future. So it's really bracket management. I think I alluded to that there's seven brackets, maybe just for our audience. Those brackets are 10, 12, 22, 24, 32, 35, and 37. But as Dave said, there's an income gap, if you will, or a stepping stone before I'm going to pierce into the next higher bracket. So it's that bracket management, I think, is what you're suggesting, that you can really do some smart tax strategies or conversions if that applies. Absolutely.

Starting point is 00:20:37 It's what you pay on that marginal dollar of tax. So your effective rate may be lower because, as as people know our tax brackets are blend or progressive. So you want to just avoid triggering that next higher bracket. But you may have some room in there that we can tell people how much is a smart amount to convert in any given year based on their current income. And as I said, if they go through a transition year, or for one reason or another, they have a lower income year, you may be more aggressive with your conversions. And we can... Or they triggered some losses or whatnot, right?

Starting point is 00:21:13 Yeah, you could have carry forward losses and other things like that. So there's a lot of scenarios where you may be a little bit more aggressive with the conversions, but we want to be smart about it. You don't want to pay more taxes than you need to. Sure. And no one likes to prepay taxes, but in some cases that could lifetime, lower your lifetime tax bill. We may prepay a little bit today, but longer term when you see that that saves you a significant amount of money over time, it can be a very smart strategy. So, you know, my takeaway is a little planning, a little foresight, a little strategy can go quite a long way. Absolutely. And as we, let's kind of wind down here because, you know, we certainly can answer anybody's individual

Starting point is 00:21:57 questions and we're available for consultations. Everybody's situation is different, so it may not make sense for everybody. But for a lot of folks out there that have been very diligent and good savers, having too much money in a qualified plan can cause a lot of other unforeseen problems. And we touched very briefly on some of the changes of the SECURE 2.0 Act that's a couple years ago, they eliminated the ability for beneficiaries of IRA accounts to what we call stretch them. Prior to the SECURE Act, they used to be able to take withdrawals based on your life expectancy. So most beneficiaries are going to be in their hopefully high-income years. They could just take out a smaller amount every year and have that tax deferral for their life expectancy. So inheriting an IRA wasn't that big of a tax hit.

Starting point is 00:22:51 They don't get a step-up in basis, so that's another thing. So they're fully taxable on distribution. Now, post-Secure 2.0, the beneficiaries have to take out all of those assets within 10 years. Whether it's Roth or IRA. That's correct. Roth isn't going to trigger any taxes to the beneficiary, though. It's really those traditional IRA accounts. Those can be really tax bombs for the beneficiaries. But here's a point I want to stress that you brought up earlier, the estate tax. I think a lot of people say, well, gee, I've named my kids or grandkids as my beneficiaries, so it's out of my estate, right? Well,

Starting point is 00:23:29 no. The Roth, they're going to inherit tax-free. They've got to take it out over those 10 years. The IRA, the kids are going to inherit as taxable income. They've got to drain it out over 10 years. But what mom or dad didn't realize is that's includable assets in terms of their estate, so it's subject to estate tax. Correct. And now federal estate taxes are fairly high, so it's not going to impact that many folks. But if we're sitting here in Massachusetts, the state estate tax is only $2 million. And 16% is the tipping fee. Is the high, is the marginal rate. And what also people don't realize is once you trigger $2 million, it's the whole $2 million that's subject to tax. It's not just the assets above that.

Starting point is 00:24:11 It's retro. It's retro. There is an exclusion amount, so you do get a credit. But that's a pretty big hit. So IRA assets that hit a taxable estate, which nowadays, as I said, if these are folks with large balances, they own their home, you know what housing prices are these days, they've got a reasonable amount of assets, you die as a Massachusetts resident, it's a very high possibility that those IRA assets are not only going to be subject to an estate tax, then those distributions are fully taxable to the beneficiary. So it's really a double whammy. So it's become really not a great asset to inherit. So you really want to, you know,

Starting point is 00:24:55 Roth actually, on the other hand, you flip that on its head. Roth asset is a great asset to inherit. They come tax-free to the beneficiary. They can hold them tax-deferred for 10 years, and when they take it out, it's fully tax-free. So it really changed the dynamics of the value to the beneficiaries, Roth versus traditional. So one point I want to talk about before we wrap up here related to estate planning and legacy planning is the QCD or qualified charitable distribution. Can you talk to the audience about that? Yeah, absolutely. A lot of folks don't realize that that is an option if you are charitably inclined.

Starting point is 00:25:38 Right. now is with the unified credit, most charitable deductions, especially as a retiree, are likely not going to be deductible. So you're saying about the standard deduction or the personal exemption? Correct. They're not going to itemize. Most retirees these days aren't going to be itemizing. It depends. Everyone's situation is different. But more often than not, that's a $5,000 charitable contribution that they're going to make to their church or school or what have you, isn't deductible. And don't you want to be giving away tax inefficient assets? Yeah. So that's a great point. You can do what's called a charitable QCD, Charitable Qualified Charitable Deduction. So you can take assets up to $100,000 directly out of your IRA and make that donation.

Starting point is 00:26:36 Does that satisfy my RMD that year? It does. So that's a good way. And it doesn't hit your 1040 so you don't have taxable income on that. So it is effectively getting that tax deduction that you missed out on. So it's not taxable income to you. It satisfies your RMD, and the charity gets the full benefit.

Starting point is 00:26:59 Fantastic, fantastic. Well, Dave, this is really a great conversation. There's obviously a lot of complexity when you're not just in the accumulation years, but you're thinking about the drawdown years. So I would recommend, you know, everyone's situation is different or unique. Don't go it alone. You probably need to talk with an experienced planner. And I want to thank you for some of these ideas you shared with the audience today. Yeah, thanks a lot, Ken. I think it's become, you know, more and more complicated with all these different rules changes over time. And I think just there is a gap out there and there's a lot of folks that just aren't getting this advice. And it's, you know, it can really sneak

Starting point is 00:27:40 up on you. So pre-planning is really important. So if you're in that kind of retirement red zone, we call it, you know, 60-ish years and older, and you haven't sat down and put together a retirement income plan, you really should. And this is just one facet to it, but having a, you know, a plan in place to manage your taxes in retirement can really make a huge difference to your overall lifetime income. Fantastic. Well, thanks again for this conversation. Yeah, it was great. Thanks for having me. Thank you.

Assets and Taxes - The Implications of Taxes in Retirement | Episode #1

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