Facebook Live session between Gina Bednarski of White Glove and Nick Naseman, President of Iron Mountain Financial.
Gina: As most of you know, Nick is a military veteran who lives in Colorado Springs with his wife, Angie. He’s been helping seniors prepare for retirement for over 10 years and has been providing financial literacy classes for over 7. As a Retirement Income Certified Professional, Nick focuses on designing and implementing holistic strategies to help retirees get the most from their retirement.
Gina: I’ve been investing and saving for my entire career, why should I do anything different in retirement?
Nick: It’s very common to think that if you do what you’ve always done you’ll be fine. However, figuring out the best way to take income from your investments is much different than saving and building your nest egg.
Most wealth and investment advisors focus on building your wealth and they help a lot of people to do that. Very few of them learn strategies on how to take income tax efficiently in retirement.
See, once you stop working and that consistent paycheck stops, you can’t afford to make a mistake – There are no ‘do-overs’ in retirement. One of the biggest concerns for retirees is taxes and how those taxes will impact their lifestyle.
I think about it like this. If you ask most people what the goal of a mountain climber is, it’s fairly obvious; to make it up the mountain, right? But if you asked experienced climbers the same question, you get a slightly different answer. They would tell you that their goal is to make it safely up and safely down the mountain. That's because the vast majority of climbing accidents happen on the way down the mountain, not on the way up. Now you might wonder why that is. You would think that getting down the mountain isn't any more difficult than getting up the mountain.
If anything, you would think it was easier, right? And what does that have to do with retirement and making our income last? Well, here's the thing. It's one thing to have a strategy that will grow your nest egg. That's a lot like climbing the mountain. We save and invest the best we can for years until we reach the summit and get to that place where we can finally quit working.
And we assume that getting up the mountain was the hard part and that getting down the retirement mountain, which means staying retired without giving up our lifestyle, isn't going to be any harder or any different than the climb up. If anything, it's going to be easier, but it doesn't work that way. That's the thing that mountain climbers have learned. And it's the reason they answer the question the way they answer it. Retirement income specialists understand the different risks seniors face in retirement that they didn’t have to deal with when they were still working.
Gina: But won’t I be in a lower tax bracket in retirement?
Nick: Maybe you will, maybe you won’t. We’ve been told to max out our retirement accounts for close to 50 years now. But, with the lower tax rates of the 2017 Tax Cuts and Jobs Act, that may not have been the best move. Those lower tax rates are set to expire at the end of 2025, if not sooner.
You got a tax break at your current rate when you contributed to your retirement accounts, but the government gets to set the tax rate in the future when you withdraw your money. And who knows what that rate will be?
Depending on where you’ve saved for retirement, that money will most likely be taxed as ordinary income. And…as we get older, we lose deductions. The kids are out of the house so there are fewer dependent deductions or student loan interest deductions, and the house may be paid off so there’s no more mortgage interest deduction.
Even if you as a couple are in a lower tax bracket when you retire, when one spouse passes away, that may not be the case. The surviving spouse will be hit with what’s called the Widow’s tax.
She will lose up to half of the couple’s Social Security income and potentially part or even all of the deceased spouse’s pension. More of her Social Security is likely to be taxed since the tax threshold is lower for a single person than a couple.
She won’t be filing jointly anymore and will be filing as a single taxpayer, so she is likely to be in a higher tax bracket.
She’ll lose half the standard deduction, even though her expenses won’t be cut in half.
She’ll have a lower capital gains exclusion when she sells the home. And that exclusion may be going away for some higher income earners. And she may be paying more in Medicare part B and D as well, as the income-related monthly adjustment amount (IRMAA) thresholds are also lower.
Gina: My parents did OK with their retirement, and they didn’t change anything. Why should I worry about this now?
Nick: That’s a good question. Taxes are low right now and that’s led to complacency in tax planning. However, our nation is facing significant financial pressures that Americans need to sit up and pay attention to.
1. The American Rescue Plan, the American Jobs Plan, and the American Families Plan that make up the Build Back Better agenda we’ve all been hearing about, are largely funded by tax increases. Altogether, that’s a projected $7 trillion package of government spending.
2. Medicare Part A, the coverage that helps offset hospital stays, by 2024, will only be able to pay 83% of hospital related expenses.
3. By 2026, the Pension Benefit Guaranty Corporation, which guarantees pension fund solvency, is likely to be insolvent itself and not able to insure pension funds. Quite a few pension funds were underfunded before the pandemic and COVID only made that situation worse. Another market correction could prevent those pensions from meeting their obligations.
4. Most people have heard that our Social Security system is in trouble. By 2031 or possibly even sooner – the Social Security trust fund is projected to be depleted and Social Security will only be able to pay about 75% of benefits.
Government can solve these shortages by spending less or raising taxes. The question you should ask yourself is, “Do you think our government will spend less?” With the increased government spending, who’s going to pay for this? The government doesn’t pay for anything. It takes the money through taxes from the people who’ve earned it to pay for these programs. We’ve been taught to max out our tax-deferred accounts like 401(k)s and IRAs to get the immediate tax savings. But if taxes go up, is that the most beneficial action to take?
Gina: How can people prepare for these changes?
Nick: The first thing you need to do is determine where you’re at now financially. That involves identifying what types of accounts you have, if they’re taxable, tax-deferred, or pre-taxed. Then complete a thorough cash flow analysis. You need to know what you’re spending now before you can determine how much you’ll need in the future. You can plan for retirement only after you analyze your current situation.
I compare it to planning a trip. You need to determine where you’re at now before you figure out how to get to where you want to be. I can drop you in the middle of a forest with the best map money can buy. But unless you figure out exactly where you are, trying to use that map to get out of the forest is useless. It’s the same in retirement, you can have a great retirement plan, but unless you know where you’re starting from, you’ll end up wandering around without any clear direction and may not end up where you want to be.
Gina: What are some strategies to lower my taxes in retirement?
Nick: Conventional wisdom says to spend down your taxable accounts first, then your traditional IRAs, and then your Roth. However, that’s over simplified and not the best strategy. Your individual circumstances will dictate the best strategy to use, but there are general guidelines you can follow.
Tax bracket management is something everyone should do: that’s coordinating withdrawals from several tax buckets to minimize your taxes over the span of your retirement. Most retirees just look for short term tax savings and very few plan for their entire retirement or the loss of a spouse and how that will impact them tax-wise.
If you regularly contribute to charity, consider using a Qualified Charitable Deduction to contribute directly from your IRA to your favorite charity. You can use this strategy to satisfy your required minimum distribution and not pay taxes on that withdrawal.
Another popular strategy is a Roth conversion. You pay taxes now before they increase, to get tax free growth and tax-free distributions in the future. You’ll also be paying taxes on a smaller amount of money that you can build into a large amount of money that the Internal Revenue Service can never get their hands on. Just like any strategy, there are rules you need to follow in order to get the maximum benefit and not pay unnecessary penalties. Roth conversions are especially beneficial if you think your tax rates will be higher in the future.
A Roth conversion doesn’t have to be all or nothing. Using a Roth conversion laddering technique can keep you in lower tax brackets to minimize taxes over your entire retirement. Roth conversions are something everyone should consider because the distributions don’t count against Social Security taxability, Medicare surcharges, or long term capital gains taxation.
A back door Roth may be another option. Higher income earners are not allowed to directly contribute to a Roth. But they can do a Roth conversion. A back door Roth refers to making a non-deductible IRA contribution and then converting it to a Roth. Again, special rules apply so make sure you fully understand the process and potential tax implications before doing this.
If you have a high deductible health care plan, the Health Savings Account is the best thing available. You can contribute pre-tax money into the account, it will grow tax free, and as long as you use the money for health care, it comes out tax free. That’s a triple win when it comes to taxes.
If you aren’t yet retired, you can use the Rich Man’s Roth: Cash Value Life Insurance.
When set up correctly, life insurance can build cash value which can be used as tax free retirement income or for any other purpose you decide, like medical expenses.
Just like a Roth, income from a life insurance policy doesn’t count against Social Security taxation, the Medicare Income-Related Monthly Adjustment Amount (IRMAA), long term capital gains taxation.
If you don’t use your life insurance as a retirement income supplement, your beneficiaries will get a tax-free lump sum to replace the income lost from your passing, pay the increased tax rates caused by filing a single return vs a joint return, pay any estate taxes, or pay Roth conversion taxes.
One last idea everyone should do is understand how your Social Security is taxed. Most people are shocked to learn that up to 85% of their Social Security benefits are taxable. Learning how your provisional income is calculated and how to reduce that amount can save you significantly in taxes over the course of your retirement.
Gina: So how do I know what’s best for me?
Nick: The only way you’re going to learn about these strategies is if you do a lot of research on your own or work with a specialist that focuses on holistic retirement income planning. That person should have access to a wide variety of solutions, not just insurance-based or stock-market based and know how they work together. He or she also needs access to multiple companies’ solutions to be able to find the best fit for your situation. There is no company out there that has the best solution for everyone.
I can’t emphasize enough that the strategy that’s great for your neighbor may be OK for you and terrible for the couple across the street. Everyone is different and there is no single strategy that’s right for everyone. Be careful of salesmen trying to make your situation fit whatever they’re selling.
Gina: That’s a lot to take in. Is there anything else you want to add?
Nick: Now that the 2020 tax season is over for most of us, it’s time to start planning for future tax increases. I would encourage everyone to take some time to get educated before you make a decision that could last the rest of your life. Remember…There are no do-overs in retirement. I’m back to providing in-person classes at the Colorado Springs Senior Center every month. So if you want to learn more about getting the most from your retirement, visit their website to sign up.
If you want a second opinion on your plan or just don’t know where to start, you can get a tax review checklist by contacting me at Nick@iron-mountain-financial.com. For those who want to take it one step further, I offer a no-cost, no obligation tax analysis to discover any potential tax breaks you’re missing. This analysis is fairly comprehensive, so I can only offer it for a short amount of time.