There typically comes a time when your income sources drastically change from one source to another, or from one to multiple sources.
For most, this will be shifting from earning income from a career, to then living off your own savings, potential pensions, or even passive income from real estate or businesses.
During this phase of life is when you have the opportunity to capitalize on tax planning and reduce your lifetime tax bill substantially!
More specifically, I discuss:
- Planning early enough to be able to implement tax savings strategies.
- Getting strategic about when you claim Social Security for lifetime tax savings.
- Tax planning strategies for retirement accounts.
- Preserving your capital gains from taxation.
- Roth conversions during your “gap years”.
Resources From This Episode:
The Key Moments In This Episode Are:
00:01:15 - The Art of Paying Less Taxes
00:03:15 - Importance of Early Retirement Planning
00:05:54 - Differentiating Tax Preparers and Tax Planners
00:08:31 - Strategic Social Security Benefits and Tax Planning
00:14:37 - Tax Planning Strategies for Retirement Accounts
00:15:48 - Shielding Capital Gains from Taxation
00:17:13 - The Importance of Long-Term Planning
00:18:55 - Delaying Social Security and Tax Implications
00:24:01 - Roth Conversions and Tax Savings
00:30:13 - Investment Strategies and Services
00:30:44 - Considerations for Roth IRA Conversion
00:31:16 - Risks and Considerations for Bonds
00:32:03 - Tax and Legal Advice Disclaimer
Although retirement means different things to different people, and not everyone simply drops everything and stops working in their 50s or 60s, there typically comes a time period where your income sources drastically change from one source to another or from one to multiple sources. For most, this will be shifting from earning income from a career to then living off your own savings or potential pensions, or even passive income from real estate or businesses. During this phase of life, you have the opportunity to capitalize on tax planning and reduce your lifetime tax bill substantially.
Welcome, listeners, to the Retired-ish podcast. I am recording for you today from the lovely Hawaiian islands. And today, you're in for a holiday treat because we are talking taxes and not like boring number crunching, but how to legally pay less than you need to. Because, more often than not, most people overpay, whether they know it or not. This is my favorite stuff. I geek out on this. I think taxes are fun. I know I'm weird, but hey, someone's got to do it. Might as well be me.
I'm your host, Cameron Valadez, certified financial planner, and today I want to help you understand how you can do a little preparing ahead of time to make a huge impact on the amount of taxes that you'll pay. And not just today but over the rest of your life. If you haven't noticed by now, this show is about planning. I know most of you have probably planned ahead for major events throughout your life, whether it's deciding what career path you want to take or what education you'll need.
Maybe you plan for your wedding or your child's wedding, plan to move to another state, or even plan a vacation. Whatever the case is, and typically it's a lot of work, but well worth it in the end. Flying by the seat of your pants typically doesn't end up being very efficient and often costs you more money and stress as well. I've got news for you. Planning for a full-blown retirement, semiretirement, or even exiting your business is no walk in the park either. But the benefits of doing so far outweigh most of the other major life events that you'll plan for, like I mentioned.
Retirement planning is a major necessity. Yet so many people don't plan enough, or they simply don't start early enough. Think about when you were younger, trying to figure out what you were going to do with your life; how much time, money, and effort was wasted because you didn't know exactly how you would pursue your career or your profession and had to make up a plan B or change course entirely. Maybe you started a business venture early on as an entrepreneur, and you had to dive right in and figure things out on your own.
It likely took several years for it to start working out for you and your family financially. Or maybe you relied on a partner or a spouse to support you while you finished something like higher education. When it comes to retiring in some shape or form, you likely won't have the same resources or opportunities that you had when you were younger. There aren't as many options when it comes to plan B. You need to be ready.
After all, you don't want to retire and then find yourself having to go back into the workforce doing something that you don't enjoy one day since that would defeat the purpose of a fulfilling retirement, right? That's the root of what I'm getting at in today's episode.
But I want to dive a little deeper into one of the components of holistic retirement planning, which is tax planning. Now, I'm sure taxes aren't your favorite topic, so I'll try to make it a little bit more interesting by sharing with you how to pay less than you need to, which sounds a little bit more fun. The first thing I want you to understand is that the tax code is massive, and it's constantly changing.
In fact, since about the year 2017, we've had numerous bills and acts passed through Congress that have had major impacts, especially for retirees. The good news is that you don't need to become a tax attorney, enrolled agent, or CPA to learn how to save more in taxes. You just need to be aware and be a good planner and implementer, or simply delegate those duties to somebody else. While the Internet and technology have put nearly every piece of information in existence in the palm of our hand, it's still very frustrating and confusing trying to figure out what exactly you can apply to your specific situation since everyone is a bit different and unique. Google a tax strategy your friend told you about, and you'll get hundreds of thousands of results, likely more.
Therefore, many people decide to defer anything and everything that has to do with taxes to their accountant or their tax professional. While these professionals are very important, I caution you against assuming that they will handle everything and be able to see what tax traps lie on the horizon. As I've mentioned in previous episodes, the vast majority of tax professionals simply prepare taxes, which is far different from tax planning. Tax planning is planning for what's to come while preparing your taxes is reporting what recently happened already. More often than not, tax professionals are taking meticulous care in making sure what's happened already is being reported correctly to protect you and making sure you're settled up with good old Aunt Iris, which is my nickname for the IRS. In addition, many tax professionals come tax time are looking to save you as much as possible in taxes now.
While that's great, and it seems heroic at the time, that may not be good for you later. Tax planning is about reducing your overall tax bill over your entire lifetime. Sometimes it's better to pay the devil you know today and get a better benefit later when you may need it more. Tax preparers are essential and, again, still very important. And some tax professionals do, in fact, do great tax planning as well, but they are few and far between.
Because of this, you need to be able to recognize this and make sure you are properly planning ahead for taxes to come, which will likely be your largest bill throughout retirement. One of the most opportune times to take advantage of the tax code we've been so kindly provided is before, during, and after the transition into your version of retirement. More specifically, when your primary income sources begin to shift. In practice, this time period typically lasts anywhere from three to ten years or so, depending on your exact situation. This is primarily due to the fact that in the United States, between ages 62 and 70 are when most people are eligible to do things like claim Social Security, are Medicare eligible, they start taking pensions if they're fortunate enough to have one, and are the most common retirement years in general. Unless, of course, you sell a business earlier on or work in a civil service or military capacity of some sort. So teachers, firemen, police, paramedics, et cetera.
Not only that, but at ages 73 or 75, depending on the year you were born, you will also be required to start taking taxable distributions from any pretax retirement accounts you may own, such as things like 401(k)s, 403B's, 457 plans, or IRAs, for example. These are known as required minimum distributions, or RMDs for short.
Basically, Aunt Iris says that you've been stashing away money and sheltering it from taxes for too long, and now they want their tax dollars. And lastly, for those of you out there who started investing in rental properties, maybe in your 30s or 40s, this might be a time period where your properties start to cash flow a little bit better because mortgages may start to become paid off.
As you can see, there are many instances where income will be shifting and changing during these years. Some professional planners refer to these years as the gap years. These are precisely the years where, if you implement some clever strategies, you can begin saving money in taxes for the rest of your life, meaning more money for you to spend and enjoy in retirement and more preservation of wealth for a spouse or children.
So let's dive into some examples of why tax planning makes so much sense at this time. I want to begin with Social Security and different income sources and how they're taxed. As I mentioned, age 62 is the earliest age at which most people can begin to collect Social Security. There are some exceptions for those of you who may have certain disabilities, and you can wait as long as age 70. But just because you can take it early doesn't mean you should.
Taking it as early as possible results in a permanently reduced benefit for life, and one of the trickiest things about Social Security benefits lies in the taxation of those benefits. At the federal level, Social Security can be either tax-free, 50% taxable, or at most 85% taxable, depending on the other income sources you have while collecting. For example, if your benefit is, say, $2,500 per month and only 50% of that benefit is taxable given your situation, then the IRS only considers 1,250 of that benefit as taxable income, and then you are taxed at your applicable tax rate on that $1,250. So if you're in the 22% tax bracket, you would owe, say, $275 in federal taxes on that monthly benefit. No matter what your income is, no one's Social Security benefit will be fully subject to taxation, which is a good thing.
In addition, many states do not even tax Social Security benefits, period. But be sure to check if your state does or if the state you're considering moving to in retirement taxes these benefits. Because the taxes you pay on your benefits depend on your other income sources, you might see how you may be able to do some cool planning here.
While there are many strategies to consider, I will just hit some of the more basic ones. The first is that if you have other assets or income sources like investments or a pension, let’s say. You may consider deferring claiming your Social Security benefits longer up to age 70.
This will do several things that can benefit you over and above taxes. First, it will allow your Social Security benefit to grow guaranteed by our government. Because of that, when you do collect, you will have a larger amount of benefits that will also continue to get cost of living adjustments for inflation over the remainder of your retirement. So more guaranteed money and higher adjustments to help you combat inflation for a potential 20 to 30-year retirement, a powerful one-two punch. Delaying your benefits can also help preserve more of your wealth in the event that you were to predecease your spouse.
This is because a surviving spouse is eligible to collect 100% of the benefit that the deceased was collecting before they passed if it was higher than the surviving spouse's benefit. More income means that they may spend less out of assets that they both accumulated during their lifetimes, leaving more money or more flexibility, I should say, for taxes and survivor and legacy planning. Now, when it comes to the tax benefits, if you use other assets to live on while delaying Social Security, you will have more flexibility on what type of income hits your tax return and, therefore, more control over what you'll pay.
For instance, let's say you and your spouse were in the 22% tax bracket for several years before you decided to retire at age 63 and completely stop working and collecting a paycheck. You decide to delay Social Security and figure out a way to draw income from your retirement savings.
You have some money in a 401(k) plan, and your spouse may have inherited some money from Mom and Dad, and now it's in their own personal nonretirement account, such as a trust account, for example. Again, you have no income sources right now, and the only income you would receive is via any withdrawals from one or both of these accounts. If you take from your pretax 401(k), all of that income is subject to income taxes similar to income received while you were working. The money you earn in the nonretirement account or the trust account, in my example, can be taxed in multiple different ways depending on the types of investments that are held inside and that are generating that income. Some can be tax-free, some are taxed at a lower, more preferred rate called a capital gain rate, and some are taxed as income similar to the 401(k).
This is where we can get really creative. Assuming you have no other income, you're essentially starting from square one on the tax tables. Once you've determined how much money you will need to live on for your various bills and expenses, as well as some money for discretionary retirement spending or fun money, you can back into the tables and see what will happen tax-wise, if you withdraw that amount of money from these accounts and plan accordingly.
Let's go over some hypothetical examples to help make sense of this. Let's say you and your spouse are ages 60 and 63. You decide that you currently need around $70,000 in net income per year since the mortgage was recently paid off. Instead of immediately taking Social Security for income, you decide to strategically spend down from the assets that you've been saving and maybe inherited. You decide to draw the full $70,000 from the 401(k) since that's why you've saved all those years into that account. To use it in retirement. Using the 2024 tax numbers for a married couple, using the standard deduction, and assuming no other income was coming in, you would owe a little over $4,000 in taxes to the Fed. 4 to $5,000.00.
For this example, we are ignoring any state taxes that might be owed. So, in this case, in order to get a net $70,000 for spending money, you actually would need to take about $75,000 from the account, and you would owe, like I said, around 4 to $5,000 in federal taxes. Again, ignoring state taxes. That leaves you with that rough $70,000 that you'll need.
That's around six and a half percent in federal taxes, which is extremely low, which is a good thing. But can we get it lower? What if we kept it easy and simply took half from the inherited nonretirement money and half from the 401(k)? What would be the difference? Well, using the same 2024 filing tax metrics as before, if you took $35,000 from the 401(k) and $35,000 from the nonretirement account, so still $70,000 total, you would hypothetically owe a few hundred dollars in taxes to the Fed.
That's compared to $5,000 using the previous method. In fact, what's so interesting about this is that if, say, you inherited that nonretirement account money years ago and had invested it in the meantime, and at the time you go to withdraw some of it, it was full of capital gains because you made a good investment, the timing happened to be great, and you've earned some money on that investment. You could still recognize that same $35,000 even if it was pure gains and not actually owe any taxes on those gains in that example. So, to put this in perspective, so far, we're getting money out of pretax retirement accounts, paying extremely little in taxes, not even 1% in that example, paying no capital gains taxes on our gains, reducing the pretax retirement account balance, which will help with RMDs later on down the road since they will be lower in our mid or early to mid-seventies and allowing us to delay Social Security or a pension for a bigger benefit. So hopefully, now you're starting to see the power of this kind of preparation.
To make this even more fun, again, using the same metrics in the previous example, filing married in 2024, you could technically not take any withdrawals from your retirement account because maybe you don't have one and instead use this time to sell maybe an appreciated asset, possibly shielding up to nearly $125,000 in capital gains from federal taxation.
The same could be said for other assets you may have, such as some stock or something you've held for years that's been very successful and has significant gains. Maybe these are restricted stock units or stock options that you exercised previously that you received from your previous employer or just an investment that you made earlier in life. This is because long-term capital gains are taxed at preferential rates and because of how the tax tables and the standard deduction work.
If you haven't already, you can use the link in today's show notes to sign up for our monthly newsletter, where we are going to include a bonus tax cheat sheet for 2024 taxes so you can see the numbers for yourself. These are just some basic hypothetical examples. There are many, many more. Your situation and tax outcomes will be unique to you, of course. There are actually so many different ways to think about this and opportunities that will arise depending on the types of assets that you have at your disposal, how they are invested, and what your plans are with them in the long run.
The main thing I want you to take away from all this is that in order to have options like this in retirement, you have to do this planning years in advance, not during the two months before you retire. So let's take a step back and say you didn't do any of this planning and simply went ahead and applied for Social Security when you retired at age 63 to supplement some of your withdrawals from your 401(k) because this was the easiest thing to do. It's the easy button. In this case, you've now turned the faucet on, and the handle breaks that income from Social Security is coming in, and you can't control it any longer.
Yeah, you feel great because now you have income to live on, and you feel confident since you don't need to withdraw as much money from your retirement savings. However, the possible issue that crops up is that now you are taking Social Security and another income source.
Depending on the amounts you need to take from that size of your Social Security benefit, you may now be paying taxes on 85% of your benefits and possibly a higher tax rate on your 401(k) withdrawals. When looking at the income you receive net after taxes, which is all that matters, by the way, since that's what you'll have to spend at the end of the day, it may be similar to what you would be able to live on if you were to take from just the 401(k) or a combination of the 401(k) and the nonretirement account. All the while, you could have been delaying Social Security, which permanently grows your benefit, increasing the income to your spouse should you predecease them, and incurring a lower tax rate on the money coming out of your 401(k) as opposed to taking it out later.
So you may be thinking, well, wait, if I delay Social Security and my benefit grows, won't I just have more income later and pay more taxes later? Now this is possible, but again, with good planning, highly unlikely for several reasons. One of the tricky reasons is because as you spend down and live on the money from the pretax retirement accounts while delaying your Social Security, you are likely to be decreasing the balance of that account over that time frame that you're delaying. However, this will also depend on the investment performance of that account. Now, because that balance is likely decreasing over time, that means your required minimum distributions, those RMDs that kick in at age 73 or 75, will be smaller than they would have been otherwise, like I mentioned in the example earlier.
This is because those minimums that you have to take are based on your age and the size of your retirement accounts. The larger the account, the more income you have to take and pay taxes on, whether you need it or not. The smaller the balance, the lower the required income that hits your tax return later on.
On a side note, this is a prime example of something your tax preparer may not be able to account for since they may not know that you even have this pretax retirement account or multiple or how much is even in them. If you have simply been saving into it your whole life and haven't been making any distributions from it, which is the case for just about everyone up until they stop working, there are no tax forms that are generated for that tax preparer to see, and therefore they may not even know it exists. So how would they know to prepare you for those RMDs later in life? Well, they can't unless, of course, this planning had been done well ahead of time.
Another reason you may not pay more taxes later by having a higher Social Security benefit is because as you get into your later retirement years, you may have things like larger medical expenses than you've ever had before if, say, you needed care at home or in a facility of some sort. When you begin incurring these large expenses for health or medical expenses, sometimes you're able to deduct a large portion on your taxes. Oftentimes these are so significant that they can possibly wipe out your tax liability entirely, depending on your income.
While I'm definitely not making the claim that everyone should be delaying a pension or Social Security as long as possible, there are many benefits to doing so, depending on your situation. This is why tax planning is so important. To put all of this together into context, one example I see happen all too often is when someone has what I call the triple threat, sometimes the quadruple threat. This is for those of you who are fortunate enough to receive a pension from your previous employment or have sold a business, did a phenomenal job saving for retirement on your own, and have enough work credits to receive Social Security benefits.
If you're in a situation like this, good for you. You're very lucky and have also made great financial decisions throughout your working life. However, that being said, if you don't do any tax planning, you are bound to pay more than you need to in taxes in a situation like this. Realize that as you age in retirement, your income will likely continue to grow, which is good for you financially but can wreak havoc tax-wise.
For example, you retire, you take your pension, or collect income from your business, then you end up taking Social Security, then you reach RMD age and have to take large amounts from your retirement accounts, which by the way, have been possibly growing even more all this time. This is the triple threat. If you also have, say, rental properties, that's the quadruple threat. You have all of these income sources that, over time, begin to stack on top of each other, and most, if not all of them, you cannot simply turn off or reduce.
Once you get to the point where you are collecting income from all of them, you are left with little to no flexibility when it comes to taxes. Sometimes it's more income than you need, but it won't matter. You'll still be forced to pay taxes on that additional money coming in. Because your income in these situations will go higher, you'll likely be kicked into higher tax brackets and likely be subject to surcharges on your Medicare premiums, which in my opinion, is another form of tax. These are known as IRMAA surcharges.
IRMAA, I-R-M-A-A, stands for income-related adjustment amounts, and they are surcharges that are tacked onto your part B and part D Medicare premiums. I will dive more into IRMAA in a future episode, but just be aware that it is a tax that is often unseen, and they can be very substantial, and they are per person. So if you're married, they are for you and your spouse separately. These IRMAA surcharge brackets are available on the 2024 tax cheat sheet as well when you sign up for our monthly newsletter.
Lastly, I want to take a moment to go over the opportunity to do Roth conversions during these gap years. If you aren't familiar, a Roth conversion is a strategy where you take money from pretax retirement accounts like an IRA or a 401(k), and move that money into a Roth retirement account. When you do this, you will owe taxes on the amount that you convert in the year you do the conversion. This is to say that you will voluntarily pay taxes on that money now and pay the devil, you know, in order to not pay it later, when income may be higher, as in my last example, or when tax laws may change and tax rates may go up. And just to give you a heads up, this is already going to happen starting in 2026. It's already in the tax law as of today.
Now, a Roth IRA, for example, is a retirement account where the earnings on your investments inside of the account can accumulate tax-free, meaning that when you eventually take the money out, you pay no taxes, provided you meet a few simple requirements. And by the way, I will add a link in today's show notes regarding those requirements. In addition, because no taxes are owed on distributions from these accounts, they also don't have those required minimum distributions, or RMDs, which means more flexibility in controlling your taxable income in retirement. Roth accounts are very powerful. So you may be wondering, when are those opportune times to do these Roth conversions during our gap years? Well, let me give you a basic example.
If let's say, you did some retirement planning in the years, not months, leading up to retirement, and you saved some cash to live on in your first couple of years of retirement, you theoretically would again have no income to report in that first year of retirement or the following calendar year after you retire. You could use this as an opportunity to implement sizable Roth conversions and pay the taxes owed because you can control how much you will pay. For example, you may decide to do a Roth conversion up to the top of the 12% federal tax bracket, which is a historically low tax rate, which would all be reported as income in the year that you convert it. However, that would be your only taxable income that year, which in 2024 could be as much as $123,500 or more, actually, depending on your specific tax deductions. Even then, the tax rates are marginal, so you theoretically would only pay around eight to 9% in total Federal taxes, in that hypothetical scenario.
Although you are paying taxes in this situation, you would be paying, like I said, 8 to 12% versus possibly 20 to 30 plus percent in taxes later in life. Not to mention certain things like Medicare surcharges, like I talked about before. This tax savings can amount to be in the tens, if not hundreds of thousands of dollars throughout the rest of your life. People do not overlook these opportunities. Using this same example, instead of saving up cash before retirement, you may decide to live on money that maybe you inherited from a parent instead, again using that as leverage to do conversions and save money in taxes. There are lots of ways to look at this.
Now, one final tip for you to take away from all of this is that if you do end up in a situation where you don't owe any taxes or a very minimal amount, that is not necessarily a good thing. That may mean that you are losing out on significant savings. For example, you could have a bunch of rental property and have so much in deductions that you pay almost no taxes, and you feel proud of it. However, if you also have things like retirement accounts, again, you could possibly be doing things like Roth conversions and paying taxes now on purpose. However, at much lower rates than you or your family will inevitably pay if they were to inherit the accounts or if you were to take the money out later in life. Again, don't just consider taxes paid today but over a lifetime. Saving in taxes is an enormous part of the wealth-building and wealth-preservation game. Don't overlook it, and don't assume you are already doing everything possible. There are many strategies out there.
Hopefully now you are more aware of these opportunities and will be ready to capitalize on them when the time comes. The best part is that you don't have to become a tax or retirement wizard to do any of this if this ain't your shtick. You can always delegate this to the professionals to help you implement, saving you time and money so you can enjoy retirement as intended.
That does it for today's episode. There's a lot more when it comes to planning during the years surrounding your dream retirement. Remember that simply being aware is much more impactful than doing nothing at all. Educating yourself on what's available is just step one. Implementing is the necessary step and is paramount to keeping more of your hard-earned money.
If you want more insight or help preparing your dream retirement and you want to keep Aunt Iris out of the cookie jar, feel free to reach out to us at Retiredishpodcast.com or email us at email@example.com. You can also ask a question to me personally that I will answer anonymously in a future episode.
If you can spare a minute and find this information actionable and insightful, please subscribe to or follow the show on your podcast app and share it with a friend. If you'd like to learn more about the topics that we discussed on today's show in more detail, you can find links to the resources I mentioned earlier in the episode. We have provided those in the show notes that are right there on your podcast app, or you can find them at retiredishpodcast.com/34.
Be sure to sign up for our monthly Retired-ish newsletter, where each month, we discuss many of the topics we cover on the podcast and more relevant and up-to-date information surrounding the retirement landscape. Again, this can all be found at Retiredishpodcast.com/34. Thanks again for tuning in and following along. See you guys next time on Retired-ish.
Securities and advisory services are offered through LPL Financial, a registered investment advisor, member FINRA, SIPC. The opinions voiced in this podcast are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA.
In addition, if you are required to take a required minimum distribution, RMD, in the year you convert, you must do so before converting to a Roth IRA. Investing involves risk, including the potential loss of principle. No investment strategy can guarantee a profit or protect against loss. Past performance is not a guarantee of future results.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, and bonds are subject to availability and change in price. Government bonds and treasury bills are guaranteed by the US government as to the timely payment of principal and interest, and if held to maturity, offer a fixed rate of return and fixed principal value.
Treasury inflation-protected securities, or TIPS, are subject to market risk and significant interest rate risk as their longer duration makes a more sensitive to price declines associated with higher interest rates. Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free, but other state and local taxes may apply. If sold prior to maturity, capital gain tax could apply.
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Asset allocation does not ensure a profit or protect against a loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
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