Take advantage of tax planning as we approach the end of 2024! Join us this week as we continue last week's conversion discussing effective tax planning strategies for retirees, focusing on how to manage tax liabilities in retirement.
Key points include:
Tax Planning Before Social Security & RMDs: There is flexibility in managing taxes before Social Security benefits and Required Minimum Distributions (RMDs) begin. In these years, retirees can take advantage of low tax brackets (10% and 12%) by managing their income carefully.
Medicare and Premium Tax Credits: Tax a look at whether or not you qualify, it can be a big money saver!
Roth Conversions and IRA Distributions: Roth conversions are a strategy for moving funds from traditional IRAs to Roth IRAs to avoid future taxes. If you're in a low tax bracket now, it's wise to take some IRA distributions and pay taxes at a low rate (10-12%) rather than wait for higher taxes later.
Capital Gains Tax Harvesting: There are some benefits of capital gains tax harvesting in low-income years, where long-term capital gains may be taxed at 0%.
Planning now and being intentional about tax timing can significantly reduce future tax burdens!
Resources:
- John's firm website: https://www.trinfin.com
-Find us on Facebook: www.facebook.com/friendstalkfinancialplanning
TRANSCRIPT:
Bridget: Hey John, it's that time of year again. Yeah, not Thanksgiving or the rest of the holidays, but time to do tax planning. That's where the action is with taxes. This is how you save money on taxes: by looking at it now at the end of the year. Hi, I'm Bridget Sullivan Mermel. I've got a fee-only financial planning practice in Chicago, Illinois.
John: And I'm John Scherer. I've got a fee-only financial planning practice in Middleton, Wisconsin. And before we jump into tax plan planning, I want to remind everybody to hit that subscribe button. That helps other people find this information on YouTube. I was excited that you mentioned Thanksgiving. I thought there was going to be some fun stuff. But there is meat on the bone. This is where the rubber meets the road from a tax standpoint.
Bridget: Yeah. And this is one of my favorite topics because I'm a nerd and because this can really help people. So once you retire, there's so much more you can do with saving money on taxes than when you've got what I call the W2 train coming into the station every year. This is like you have your own car. You just have so much more freedom, especially in the years before you take both Social Security and required minimum distributions.
You just have a lot more flexibility, and I just love it. So let's talk. The first thing I like to talk to people about is how are they paying for their medical insurance? A lot of people are on Medicare, and they don't retire until they're 65. So I'm not going to belabor this point, but some people are on the marketplace and they get a premium tax credit. And so, when we're talking about these other great ideas that we have, you want to be mindful of your premium tax credit because that is extremely income sensitive and a nice benefit.
So, that I have found takes precedence over everything else. The other thing is that I don't know if premium tax credits are going to stick around for pre-retirees like they are because there will be tax changes towards the end of 2025 or maybe in 2026. And so, take a premium tax credit while you can.
John: Yeah, that's such a great point. We have a similar experience to what you're describing. Before you hit 65 and qualify for Medicare, to the extent that you're paying for your own health insurance, the premium tax credit is critical. We see folks (and I'm sure you do too) who have $500 a month, $1,000 a month, $1,500 a month in credit. Now you see that of course when you do your tax return, but we're talking in the neighborhood of $15,000 to $18,000 a year in lower taxes based on managing your income.
And I don't know the exact numbers (maybe you do) but I know we've got some folks where somewhere in the range of $50,000 of taxable income to the extent we can keep income below that really ramps up those tax credits. And remember we're talking about credits. It's not deductions. Your taxes literally go down by $15,000 because you're paying for health insurance. And your income from a tax standpoint is at a low level. It's just such a great deal.
Bridget: Yeah. So if you're taking that, from what I've seen, it’s pretty much going to override everything else. So that'll be a primary consideration. But after retirement, most people are not in that situation. So let's move on. The first thing let's talk about is IRAs. Well, let's talk first about tax brackets just for a second.
When you look at the tax brackets, first you've got a standard deduction, and then you've got the tax brackets; and you've got a 10% tax bracket and a 12% tax bracket. And those are very friendly tax brackets for the people who are just retired. And you might not be able to be in those tax brackets once you start taking Social Security and you end up taking required minimum distributions. So you want to take full advantage of those tax brackets. Now what are your thoughts there? How do you work this?
John: Yeah, absolutely. It's one of those things where having like having zero tax sounds really good. And we've got somebody whom we've done some work with, and they've got some extra medical expenses, some pretty significant ones. And we took a look at their taxes for the year, and they would owe zero taxes because of these massive deductions that they have for some long-term care issues, those sorts of things, which sounds fantastic except for you go, “Wait a minute.”
Having zero taxes isn't as good as it sounds when you think about how in the future these folks are going to have to take money out of their IRAs and it's going to be whatever. And they have these minimum distributions and those can get pretty substantial. And you go, listen, why don't we take some money out and pay that 10% tax rate at that 12% tax rate. And even though we're intentionally paying some taxes, it actually makes sense in the end. And the question becomes, what are the chances that either you or your heir—somebody who inherits your IRA type money—will pay less than 10% or 12% in taxes?
Not zero. I mean there's a chance. But for many of our folks, you go, oh yeah, when my kids inherit this money, they'll be in their 50s or 60s or something. Shoot, I bet their tax bracket is going to be that level or higher. That's where taking advantage and being intentional about smoothing out the tax brackets is key. We don't want to see 0% now and like 24% when we're in our 80s if we can keep it at that 10% or 12% over time. That's a much better deal.
Bridget: Right. So this is going to mean that you're going to need to make some projections. The other thing is there're two ways to take money out of the IRA right now. You can just take it out if you're going to need it. I saw some people who don't have too much money in taxable accounts, and so they live off their IRAs. That's a lot of people. You might not need any money right now, but you could take it out and be in the 0% or 10% bracket. Why not? Especially if you know you're going to be in a higher tax bracket later.
So you can just take the money out, or if you think, “Well, I'm not going to even need this,” then do a Roth conversion. And you might not even have a Roth account, because a lot of people don't, but a Roth conversion means you put it into a Roth IRA and then once you meet the conditions which are keeping it in there for five years, it's tax free. So it's moving from a pocket that has a hole in it to a pocket that doesn't have a hole in it.
John: Yeah. And just to be clear, when we take money from a regular IRA and put it into Roth, we pay taxes on that money. We pay tax on $20,000, $50,000, $100,000. But then once it's in the Roth, going forward, all the growth is tax free, subject to those rules. So that's the deal. It’s all about controlling the timing. And you described it at the beginning of this episode, Bridget.
When you're working, you get your income, and you don't have a lot of control over when money comes in. Now, in retirement, you've got control and can make some decisions and be intentional about asking, “When do we pay these taxes?” It’s not like we can avoid them for the most part, you can control the timing, which is a really, really powerful tool in your financial planning belt.
Bridget: Right. So if you're going to need the money in five years, I would take it out just as an IRA distribution. If you're not going to need the money for five years, just take a distribution and put it in a Roth.
John: Yep.
Bridget: That's pretty simple. And I would say that there are cases where you can pay zero tax if you have income low enough so that you're still in the 0% bracket if you're just meeting the standard deduction, or your itemized deduction. If that's a possibility, you wouldn't have a huge withdrawal. So that's our first recommendation: Roth conversions and Roth distributions. Number two: capital gains and tax gain harvesting.
Usually, we talk about tax loss harvesting. We didn't really talk about it too much this year because we're not seeing a lot of losses in portfolios. The stock market's been up all year. We didn't even talk about that in our last episode, because we’re both doing these, and we're not seeing a lot of losses, but you can do tax gain harvesting, especially when you're in these brackets. What say you?
John: Yeah, just explain what that means. Tax gain harvesting means intentionally selling things, like an investment that's gone up. For example, we put in $10,000, and now it's worth $15,000. We sell that, and we've got $5,000 in gains, which in most circumstances is unappealing. Geez, I don't want to pay taxes on that. But when your overall income is at a low enough level, the capital gains tax rate is actually zero. It's my favorite tax rate.
So is it taxable income? Yep, it is. And the rate that gets applied when you're in those lower two brackets, the capital gains rate, is zero. So why not take something that in the future will cost me. If I'm in a higher tax bracket, I sell those things, and I pay 15% in capital gains tax. Today I can sell, take those same profits, and pay zero tax. Our favorite tax bracket’s zero.
Bridget: Yeah. And I think most clients agree. So the thing is that for most people, we would prioritize IRA distributions over capital gain harvesting. And it depends on how much they got where and what the positions are in their portfolio. If there's things that we really just don't like, and we want to do some tax gain harvesting because we'd really rather be in different positions, we might do some tax gain harvesting in that situation if they had a large IRA as well.
But usually if somebody's got a big IRA, we just favor that versus the capital gains harvesting. And the biggest reason is that the capital gains rate is lower anyway once you realize capital gains, even if you're in the 22% or 24% bracket, and you get that step up in basis if you pass away, so your heirs don't have to pay tax on it, whereas your heirs will pay tax on receiving an IRA.
John: Yeah. As you said, your mileage may vary. There are unique circumstances. Everybody's different. But in general, I agree with that. When we have low tax years, taking money out of IRAs, because that's going to get taxed to somebody almost certainly, with a few exceptions. But pretty much it’s getting taxed at regular income rates, then the next step is, hey, can we take some capital gains for free? If so, why not take them for free? That's the right way to think about it in my mind.
Bridget: Now I think a lot of people are thinking, “Let's get this party started. How can I do this?” But we're going to put a little bit of a lid on our party. And I've got two lids on the party. The first is if you're taking Social Security, that is not taxable at all when you're at low income and then it gets up to 85% taxable really quickly. Within $10,000 or $20,000, it goes from zero to 85% taxable. So your amount of income goes up fast. When you're doing these calculations, you want to have an idea of if you're taking Social Security, how you're influencing that.
John: Yeah, that's great. But you can't just say, “I'm in this tax bracket,” because that can change the Social Security tax. We had somebody whom we were working with who took, I think, a Roth IRA conversion in the 10% tax bracket. The effective tax on that was 30% because it kicked up the Social Security income amount that was taxable.
Bridget: Right.
John: So just you have to run the numbers, you have to look at the projections, and actually do the return in order to see that.
Bridget: There’s another thing for the party if you're not taking Social Security yet. If you are on Medicare, there's what this IRMAA number. How much you have to pay for Medicare varies based on your income level. And so, you want to double check that chart. I think for a married couple, what comes to mind is that for 2025, it's like over $200,000. But it's something to just consider. It's another thing we look at, just make sure, so we're not doing all this fancy stuff and then tweaking this so that we're paying a lot extra in Medicare premiums.
John: That's right. Pay attention to Social Security taxation. Pay attention to those Medicare premiums as you're looking at these strategies to take advantage of low tax income years. I think it's a great place to wrap things up. Again, I'm John Scherer. I run a fee-only financial planning practice in Middleton, Wisconsin.
Bridget: I am Bridget Sullivan Mermel. I've got a fee-only financial planning practice in Chicago, Illinois. John and I met through a group of nonprofit fee-only financial planners called the Alliance of Comprehensive Planners, or ACP. We're both taking clients, but if you're looking for a planner in your area who does the kind of thing we do, check out acplanners.org.
John: And don't forget, hit that subscribe button.
At Sullivan Mermel, Inc., we are fee-only financial planners located in Chicago, Illinois serving clients in Chicago and throughout the nation. We meet both in-person in our Chicago office and virtually through video conferencing and secure file transfer.
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