Are You Losing Money Because of Poor Tax Planning?

Your investment allocations, risk tolerance, healthcare needs, and other financial strategies need to be monitored and tweaked regularly, but do you give your tax strategies the same attention to detail?
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By Erik Brenner

Most financial advisers understand a good retirement plan will require adjustments. They realize your investment allocations, risk tolerance, healthcare needs, and other financial strategies need to be monitored and tweaked regularly, but do they know that tax strategies require the same attention to detail? Does your advisor even suggest tax-saving strategies when you discuss your retirement plans with them?

Erik Brenner

Erik Brenner

Too many people say to us “my taxes are my taxes” and they don’t think about how they could save money by making some adjustments. We always make those potentially big money saving suggestions to our clients. We believe strongly that the lack of tax planning and strategy is a serious problem for people when they put together their retirement plans. We also believe it is a more serious situation right now because taxes are inevitably going to go up and people need to consider ways to take advantage of the current low rates before they go away.

The United States has enjoyed historically low tax rates in recent years but despite a thriving economy before the COVID-19 pandemic, the national debt has increased significantly. The recent CARES Act passed by Congress to help Americans through the pandemic added $3.2 trillion to the national debt. According to the Congressional Budget Office (CBO) the federal budget deficit for the first nine months of the 2020 fiscal year was $2.7 trillion. The CBO says the federal budget deficit in June of 2020 alone was $863 billion. The national debt, according to the CBO, is now more than $26 trillion. Almost all economists and financial professionals believe taxes will have to increase soon, no matter who wins the upcoming election in November.

One way many can save is by converting their regular 401(k)s and IRAs to Roth IRAs. You pay some tax upfront at the current low rates and then you save significantly when you need the money during your retirement and you don’t have to pay any taxes on it.

Basically, when you convert a traditional IRA to a Roth, you will have to pay taxes on the amount of money in the traditional IRA that would have been taxed upon withdrawal. That amount includes any tax-deductible contributions you may have made to the account. It also includes tax-deferred earnings that grew in the account over the years. All that money would be taxed as income for the year in which you make the conversion. So, you would pay that one-time tax bill at the current low rate, but then when you make withdrawals during retirement you don’t pay any taxes. That will be so important when the tax rates are much higher than they are now. Also, with a Roth, you don’t have to take minimum required distributions. That can be very important, especially if you want to leave the money to a family member or someone else. You don’t have to use it if you don’t need it.

Roth IRAs have been impacted by the SECURE Act, a law that went into effect in January of 2020 after Congress passed it in December. It’s a series of new rules that generally make saving for retirement easier for most people, but it did eliminate the so-called “stretch” IRA in which beneficiaries could stretch payments from an inherited IRA or pension over their lifetimes. The SECURE Act mandates that they withdraw all the money over a 10-year period. However, the distributions on a Roth are tax-free, so you could let the account grow and then take the entire amount as a distribution on year ten and not pay any taxes.

When it comes to making contributions to a Roth IRA there are many factors to consider, including your income. If you are under age 50 you can contribute as much as $6000 per year. You can put in $7000 per year if you are older than 50. There are some limitations based on income, however. For those of you who are single (or head of household), you can make the full contribution if your modified adjusted gross income is less than $124,000. The amount you can contribute decreases between incomes of $124,000 and $139,000. If your income is more than $139,000 you cannot make Roth contributions.

If you are married and file jointly your modified adjusted gross income must be less than $196,000 to make the full contribution. The amount you can contribute decreases between incomes of $196,000 and $206,000. Roth contributions are not allowed for married couples who have income more than $206,000. The tax deadlines for this year have passed, but it may be a good time to start thinking about next year.

If your income exceeds the limits for contributions to a Roth you can still take advantage of the strategy because there are no limits on the size of an IRA that you can convert. So, you can still put money into a traditional IRA and then convert it to a Roth IRA when you are ready to do that. Again, you might want to consider doing it pretty soon, before tax rates increase.

There are other tax implications related to the SECURE Act. Make sure you ask your financial advisor about the ways it could impact your retirement plans. Ask them about the best ways to save on taxes under the new rules.

Another way to save money through good tax strategy is to better understand your effective tax rate, rather than your marginal rate. A marginal rate is typically based on the highest tax bracket someone’s income falls. In the United States there is a progressive tax system in which tax rates increase as income increases and reaches certain levels. However, even though a person’s income reaches a certain level and tax rate that doesn’t mean all of their income is taxed at that rate. Most of their income is usually taxed at a lower rate. The effective tax rate is an average of the taxes someone pays on all income sources. It provides people with a better understanding of the taxes they are paying and therefore a better understanding of ways they might be able to save. Make sure your adviser is asking you for your tax returns and explaining your effective tax rate to you.

Retirement planning is like a football game. There are two halves and the score at the end of the game is what counts. The first half is the accumulation of wealth and most advisers are good at that. The second half is about protecting money and preserving it. The IRS often wins the game because they’re playing the second half against nobody.

It’s important to talk with your adviser about tax strategy, especially important for those of you in the so-called “sweet spot” between the ages of 59 1/2 and 72. When you are between those ages almost all the options are on the table. You just need to make sure you know your options.

About the author: Erik Brenner

Erik Brenner is the president and founder of Hilltop Wealth Solutions in Mishawaka, Ind. He is a certified financial adviser who has been in the business since 1993, and he believes strongly in a holistic approach to financial planning. Brenner is also certified as a national social security adviser and he hosts a weekly TV show called “Your Wealth Health” on the Fox affiliate in South Bend, Ind.