Wealth Management & Financial Planning

Wealth Management & Financial Planning

The Tax Code and Retirement Planning

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If you work in a kitchen, you better understand how heat works if you want to avoid getting burned. The same principle applies to retirement planning. If you are planning your retirement without understanding long-term taxation issues, expect to feel pain akin to placing your hand on a hot burner. You will not like the pain.

The tax-deferred savings concept originated back in the days when the top marginal tax rate was 70%. Deferring taxes made sense for many savers at that time, but things change.  The historic tax code changes President Reagan introduced in 1986 eliminated all but three marginal tax brackets: 15%, 28% and 31%. Similar to a stairway, each step in the tax bracket has its own tax rate. Even if you reach the top step at 39.6% today, you stepped on smaller steps along the way.

For “married filing jointly” tax returns, the first $18,550 of taxable income found on line 43 of your 1040 is taxed at 10%. The next step in the tax bracket stairway jumps to 15% and remains at that level until taxable income reaches $75,300. From there, the numbers really jump, escalating to 25% on the next step and moving incrementally to the top bracket of 39.6%. 

Alas, there is an elephant in the room that is rarely discussed and often overlooked: the consequences of reaching age 70.5. Individuals often put money into tax-deferred retirement plans with the good intention of letting the funds grow tax-deferred as long as possible, until the individual reaches retirement and begins withdrawing funds at a lower tax rate. Good luck with that, but that’s another column.

Upon reaching age 70.5, you must begin taking Required Minimum Distributions (RMDs). In some situations, it may make sense to delay taking the RMD until the following year, although in that case you must take two distributions. That may not sound so bad at 40 when you are saving for retirement and looking forward to future income. But nobody likes to be “required” to do anything.

It’s been reported that 70% of the money in IRAs and tax-deferred retirement accounts is not accessed before age 70.5! At this “magical age,” individuals are required to begin taking out roughly 3.45% of their retirement assets the first year—whether or not the money is needed. The RMD adds to Social Security taxation, potentially Medicare Part B premiums and even limits some itemized deductions. Sadly it gets worse.

Each year, the percentage you’re required to withdraw rises. If your assets increased, your income followed suit because the account was larger (that’s a good thing.) But your taxable income also went up (not a good thing!)

Eventually one spouse will pass away and the surviving spouse will no longer file jointly. The surviving spouse’s marginal bracket will be cut in half with the same retirement income coming from the asset base. This is called the widow/widower penalty and its potential consequences should be considered as part of the retirement planning journey.

Tax advice provided by CPAs affiliated with Financial Enhancement Group, LLC.

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer.

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