Smart Tax Planning for the Gap Years

The following is a guest post from Marotta Wealth Management.

Many families seek financial planning advice specifically for retirement. But if they wait too long, they miss an important tax-planning opportunity. A great strategy is to take advantage of the time between retirement and Social Security at age 70, the so-called gap years. With some planning for this gap, you can move income into the lower tax brackets.

Tax planning is a critical part of comprehensive wealth management. A dollar saved on taxes is worth more than a dollar earned. When you earn a dollar, the government taxes you, taking a portion of your earnings. But if you can choose when and how much you want to pay in taxes, you can apportion your tax burden as beneficially as possible.

Don't think only the very rich need tax planning. Every year you make decisions that delay or accelerate paying taxes. For example, you do nothing and fail to take capital gains. You fund your 401(k) and avoid paying tax. You do not fund your Roth IRA and lose the opportunity to move money where it will never be taxed again. You don't have a Medical Savings Account and miss using pretax dollars for medical expenses. You hold your bonds in a taxable account and pay ordinary income tax rates on your interest.

Thus either by action or inaction, our decisions have a long-term effect on our after-tax situation. Small changes have large effects over time, which is the basis of wealth management. Smart tax planning gives you significant opportunities to boost your after-tax net worth.

Imagine three families, each with wealth they amassed in different ways. The Roths have saved $2 million entirely in Roth accounts. Investments to a Roth account are contributed after having paid taxes. While in the Roth and during withdrawals, no tax is owed. Thus funding a Roth means safeguarding money from taxation.

You might think the Roths are in an enviable position. At age 65 their safe spending rate is about 4.36%, or $87,200 a year. They can withdraw this amount from their Roth account and none of it will be taxed. They have a $2 million portfolio and yet enjoy the lowest tax bracket possible. But they have missed an opportunity to realize some income in the lowest tax brackets. Had they planned they could have delayed paying tax on some of their income until retirement.

The IRAs delayed paying tax on all of their retirement savings. They were able to save more because each dollar of savings only reduced their take-home pay by about 70 cents. They saved over $2.8 million in qualified pretax accounts. At age 65 they retire and must start withdrawals because they have no other money to fund their lifestyle. When they withdraw 4.63%, it will be $124,571. They will pay 30%, or $37,371, in taxes and live off the remaining $87,200.

The Taxables chose not to use any retirement accounts. But their $2.3 million nest egg is now subject to a 15% capital gains tax. Each year they will sell $102,588 (4.63%), paying 15% in tax and leaving them $87,200 to live on.

I've made each family's position as equal as possible at age 65, but these options are rarely equivalent for more than a moment. I've assumed a total state and federal tax of 30% and a capital gains tax of 15%, but these are hardly fixed.

Young families are usually in a much lower tax bracket than they are later in life. For clients younger than 40, I recommend funding a Roth as their first priority. Many families find themselves in the opposite situation. They received a small tax deduction when they were in a low tax bracket only to find that required minimum distributions after age 70 place them in a higher tax bracket.

Senior citizens hold most of the wealth in America. And tax planning should project and minimize the future tax burden as well as the current year.

In 2012 the top capital gains is 15%, but next year it rises to 20% and 23.8%, respectively, for those in the highest brackets. In 2012 the capital gains tax is 0% for couples whose taxable income is under $70,700. This rate rises to 10% next year. All Americans must make capital gains decisions based on the likelihood that the Bush tax cuts will expire for their tax bracket. Doing nothing is equivalent to deciding to pay capital gains in future years at higher rates.

Those in the top tax bracket can choose to convert their traditional IRA accounts to a Roth. If they are already in the 35% tax bracket, they can convert a $2 million traditional IRA to a Roth account and owe $700,000 in federal taxes. Waiting until 2013 to convert would mean they would owe an additional $90,000.

Tax planning is complex with many moving parts to the equation. Roth conversions reduce your future required minimum distributions, which can lower the tax you owe during retirement years. But by inflating one year's income, it can also increase the amount you must pay for Medicare the next year.

This is the general principle for tax planning: move income from high-income years into lower income years and save the difference in marginal rates. If tax rates rise for everyone next year, moving income into this year by doing Roth conversions and realizing capital gains is the best bet.

Imagine a fourth couple, the Planners. They saved in their Roth accounts when they were in the lowest tax brackets. They also saved money in a taxable account. And when their income was at its peak or they could get a match from their employer, they saved in traditional retirement accounts. Now they are retiring at age 65 but not starting Social Security until 70. During those gap years they can convert some of their traditional retirement accounts to Roth accounts while staying in the lowest tax brackets. Expert planning means they have sufficient taxable savings both to pay the tax and continue to fund their lifestyle.

No one wants to pay more federal tax than legally obligated. Small changes in tax planning can have large effects in your after-tax net worth over time. And tax planning over your entire lifetime can have the greatest impact of all.

Comments

[Steve]

So I'm confused. What is the author suggesting is the best path?

[FMF]

Steve --

What I got out of it is this:

1. The issue is complicated.

2. Whether or not you make a decision, you've made a decision (either by action or inaction.)

3. The decisions you make can have big impacts on your finances.

4. You need professional help since every person's situation is different.

[JayB]

I am too young to remember, but I have heard rumors that in the 80's, maybe early 90's there was an opportunity for people to convert a traditional 401k into a Roth with zero penalty. It might have been Reagan from what I remember, but it was all based on what the economy was doing. I believe a lot of it had to do with the recession, and since we are in one, could another opportunity like this arise in the not so distant future?

Anyway, does anybody know how all this went down and if it could happen again? Not really banking on it, but I sure would feel dumb if I get into a Roth, only to find shortly after we have a "duty free" time.

[Apex]

Generally speaking people have the wrong mindset when it comes to tax planning. Most people think I want to pay the least amount of taxes right now. I have watched multiple people make this mistake.

When I was shortly out of college my dad had told me how proud he was that he had gotten his taxable income down to $17,000 for a particular year. (As a farmer there are all kinds of strategies that can be employed to move taxable income around from year to year). I was a little bit rough on him and I am sure he was a bit shocked at how I was basically telling him he had made a large mistake. He was defensive and didn't really want to hear what I was telling him but he sees it now.

He has now been semi retired for almost a decade now and every single year he has had taxable income approaching 6 figures. This is exactly what I had told him would happen because I new as a farmer he had deferred significant amounts of income to avoid taxes that would become taxable later.

By reducing his taxable income to $17K He had wasted $40K of his 15% bracket. Money he could have paid taxes at 15% on during that year is now being taxed at 25% in his higher tax brackets.

There are many complicated situations that might need tax planning but to simplify the situation for most people what you should be shooting for is tax smoothing. You want to keep your taxable income somewhat steady. Peaks and valleys in taxable income will result in higher taxes paid because you will waste parts of your cheaper tax brackets in the valley years and end up paying much higher percentages in the peak years.

[Apex]

@JayB,

I don't know of any ability to convert a 401k but you could convert an IRA to a Roth in 1998 and pay the taxes but not any penalty. Beginning in 2010 anyone can convert any IRA to a Roth at any time with no restrictions as long as you pay the tax in the year you convert. This is actually a great strategy to do some tax smoothing in years where you might have a drop in income.

There has never been a time you could convert to a Roth and not pay the taxes due that I am aware of. There would seem to be no reason for that to be offered and I would be shocked if it ever was.

[JayB]

Thanks for clearing that up Apex, I think the option in 1998 you mentioned is what I misunderstood.

[Matt]

I think the point is no one solution is the best. Each has its pluses and minuses. A suggestion is to have a mix that you can draw upon depending on the many factors that could change in the years.

a crude math example that really does not explain it all other than they all have different answers

(a+b)x t=x or(b)x t+c=y or (a+b)x t+c=z or(a+b)x t=w
a=401k
b=ira
c=roth
t=taxes

[Jim]

Good article. Point I take from this is that you don't want all your retirement in one kind of account. Plus it is a good idea to strategically put money in pre-tax or post-tax accounts based on your current income level.

I'll nitpick one point : "Senior citizens hold most of the wealth in America." Seniors own about 1/3 of the nations wealth if you're looking at family net worth which is not 'most' of the wealth. People age 55-64 actually have higher average net worth than seniors. (reference the latest survey of consumer finances 2010: http://www.federalreserve.gov/econresdata/scf/scf_2010.htm)