April 22, 2022

Why Tax Planning is Meaningful to Your Retirement

As the saying goes, there are two things that will be certain in life… taxes are something we all face and must deal in our lives.

If you’re willing to do a little work, I have good news. By implementing a little forward thinking into your financial plans, your tax bills are more controllable than you may realize. For many, tax day can feel like death. Not many people I talk to enjoy paying taxes and sadly, most believe taxes are what they are. I am here to tell you that with a few well placed and timed strategies you won’t have to dread tax day anymore.

Tax Efficiency Comes From Strategic Planning

There are a few key opportunities during your life that, if taken advantage of, will have tremendous positive impacts on the long term success of your plan. We all know the power of compounding interest and that you should save early and often. What typically flies under the radar and is not as widely discussed is when and where tax planning can have the biggest impact. The precious years just prior to and directly following your retirement is a period of time that presents tremendous opportunity for most retirees.

As with investing, taxes can and should be diversified. The reasons are essentially the same and which tax bucket you hold your assets in will ultimately dictate how efficient you are being with taxes in retirement. A well planned and defined distribution plan will be the key for efficient tax management. By defining your long-term plans and building a plan around those outcomes, you can then work inwards to fill in the micro-details along the way. By having savings spread across tax-differed, tax advantaged, and tax-free accounts to withdraw from and create income, you can literally design how your income interacts with the tax code.

When you really think about it, your tax bill is not dictated by how much you show in income, it depends more on where the income comes from. Tax-free accounts such as Roth IRA, Roth 401(k)s, and Health Savings Accounts (HSA) allow for withdrawals that, under the right circumstances, are 100% tax free! Since these distributions don’t count toward your adjusted gross income, you can essentially have as much income as you want and not see the negative impacts of having a higher income.  

Don’t Forget State Taxes

Not all states tax your retirement benefits. In fact, each state has their own interpretations of the rules. Depending on where you choose to call home in retirement, incomes such as Social Security and pensions could come with tax breaks. There are also a bevy of personal exemptions, deductions, and tax credits to consider in this type of planning. It is very common to not see portions of your income at the state tax level.

Looks Like a Tax, Talks Like a Tax, and Acts Like a Tax, But It’s Not a Tax?

When you look at the setup of today’s tax brackets and how the majority of tax deductions and credits phase-out at different thresholds, it is clear that higher income earners do some heavy lifting when it comes to taxes. The IRS has been clever with it’s language over the years and much of the terminology and definitions that have been adopted to define our tax code look, sound, and feel positive.

In reality, there are cliffs to be aware of. With many of those rules, there are no phase-outs or language that softens the blow. Items such as Medicare premiums, which are dictated by your income levels, will require you to pay additional surcharges if you show just $1 over the threshold! These Income Related Monthly Adjustment Amounts have some interesting rules, including look-back provisions and different definitions of income that need to be accounted for. It is vitally important to know how substantially the surcharges jump with higher income levels.

A Joint Account with Uncle Sam

Tax deferred retirement savings accounts are great vehicles to help you prepare for retirement. In fact, they are the most popular of all the options available to us. What most people don’t realize is that they are making a deal with the IRS… in fact you can think of them as joint accounts with the IRS! The tax deferral feels great on the way in, but if you’re not careful, having too much of your savings in those buckets could lead to some painful experience on the way out. Many of us were told that we should defer so that our taxable income will be lower today. Then, when you retire and plan to withdraw those savings, your baseline income will be lower and so too will be your taxes. A double win!

Tax rates change constantly and that aforementioned strategy only works if your future tax rates are lower than they are today. If they go up,  the lien on our account goes up, and you lose that bet. Having a more diversified savings strategy that incorporates all three tax options (tax deferred, after-tax, and tax-free) allows for greater flexibility in how withdrawals are designed. Ultimately, this will greatly influence your tax bills moving forward.

Provisional Income

Social Security retirement benefits are a huge part of any retirement plan, and like the rest of our income streams, there are taxes to pay. Or are there? The real answer is…it depends.

Social Security plays by its own tax rules and is governed by something called Provisional Income. This is essentially an equation the IRS uses to determine taxes on your Social Security benefits. So, depending on where it came from and how much it is, your income is what will dictate how much of your benefit is taxable.

Everyone gets at least 15% of their Social Security benefit tax free. If you can reverse engineer and design out your income to fall below certain thresholds, you could possibly get 100% of your benefit tax free! Taxation on benefits were first taxed back in 1984 and currently there are no upcoming changes (that I know of). Until these laws change, it will require some thoughtful planning to affect your Social Security benefits in a meaningful way.

Your tax burden is controllable, and with careful planning, you can retain a great deal more of your wealth. For many people, if their tax-diversification is not tended to, they are oblivious about what is coming in their future. Think ahead and start mapping out your taxes! Once you see where you are going and what is in your way, just adding a few key strategies that are aimed at controlling your tax liability can lighten your tax burden!

If you found this blog helpful, check out some of our other ones to learn more!

This page is a publication of Fiat Wealth Management, LLC. The firm is registered as an investment adviser and only conducts business in states where it is properly registered/notice filed or is excluded from registration requirements. Registration is not an endorsement of the firm by securities regulators and does not mean the adviser has achieved a specific level of skill or ability.

Information presented is believed to be current. It should not be viewed as personalized investment advice. All expressions of opinion reflect the judgment of the authors on the date of publication and may change in response to market conditions. You should consult with a professional advisor before implementing any strategies discussed. Content should not be viewed as an offer to buy or sell any of the securities mentioned or as legal or tax advice. You should always consult an attorney or tax professional regarding your specific legal or tax situation.

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