By Dennis Drake

Should you really be concerned about higher taxes in retirement? Didn't taxes just go down? Yes, for most middle-income retirees the Tax Cuts and Jobs Act represents a significant tax cut.

But, let's look at what's going on in our country. On Jan. 1, 2008, the first of now 75 million boomers began to retire from the work force and move onto the rolls of our nation's retirement programs.

Since 2017, payroll taxes alone don't create enough tax to cover the cost of Social Security payments. The government will have to make this revenue from other areas. Where? And what about, Medicare, Medicaid, and on and on? We are currently $20-plus trillion in debt. All indications point toward higher income taxes.

In fact, the Congressional Budget Office projects that if "Social Security, Medicare and Medicaid go unchanged, the rate for the lowest tax bracket would increase from 10% to 25%; the tax rate on the incomes in the current 25% bracket would have to be increased to 63% and the tax rates on the highest bracket would have to be raised from 35% to 88%."

OK, now the good news. The new tax bill is designed to sunset in 2025. Why is that good news? We have a seven-year tax planning window to remove these taxes at a minimal level. The question now is "How do you position your assets to protect yourself from rising taxes?" What are our options? Let's begin by defining the three basic types of investment buckets: taxable, tax-deferred, and tax free.

The Taxable Bucket

This consists of things such as certificates of deposit (CDs), money markets, bonds, mutual funds and checking and savings accounts. Investors pay taxes on the interest income (and in some cases on the dividends and capital gains) from these accounts every year. This would also be considered your liquid account. Financial experts agree that we should have about six months expenses in these accounts as a buffer against life's unexpected emergencies. These are not tax-efficient accounts, so any surplus accumulation should be systematically moved to the tax-free bucket.

The Tax-Deferred Bucket

These are your 401(k)s, 403(b)s, traditional IRAs and the like. Because the tax-deferred bucket is taxed at ordinary income rates upon distribution, it is the bucket most affected by the rise of tax rates over time. Let's explore the planning opportunities we have with the new tax bill and look at the new brackets.

Table 1. Tax Brackets and Rates, 2018

Rate

For Unmarried Individuals, Taxable Income Over

For Married Individuals Filing Joint Returns, Taxable Income Over

For Heads of Households, Taxable Income Over

10%

$0

$0

$0

12%

$9,525

$19,050

$13,600

22%

$38,700

$77,400

$51,800

24%

$82,500

$165,000

$82,500

32%

$157,500

$315,000

$157,500

35%

$200,000

$400,000

$200,000

37%

$500,000

$600,000

$500,000

How much should be left in this bucket? Everyone has a different number but there is a mathematical equation that will tell us the perfect number. It's the amount that your required minimum distributions won't cause you to be taxed. Each case is different, and numbers could change with future tax law.

Everything else should be in the tax-free bucket.

The Tax-Free Bucket

What is a tax-free investment? To be truly tax free, there are two qualifications: First it must grow tax-free. This means free from federal, state and capital gains tax. Second, distributions from this bucket are tax free and not counting against Social Security taxation threshold. What are our options?

Roth IRAs:

  • Contributions up to basis can be withdrawn pre-age 59½ tax free with no penalty.
  • Growth can be withdrawn tax free after age 59½.
  • Distributions do not cause your Social Security to be taxed.
  • There are no required minimum distributions (RMDs).
  • Contributions limited to $5,500 per year per person with an additional catch up of $1,000 if age 50 or older.

Roth Conversions:

  • No age limits.
  • Five-year rule for access to interest.
  • No RMDs.
  • Tax-free distributions, growth and transfer to heirs.
  • No Social Security taxation.
  • No dollar limits.

Cash value life insurance:

  • Death benefit passes to heirs tax-free.
  • Dollars can be distributed pre-age 59½ with no penalty and no taxes.
  • There are no RMDs.
  • Contributions grow tax-deferred.
  • Distributions can be tax-free and cost-free.
  • There are no contribution limits.
  • There are no income limitations.
  • Distributions do not cause your Social Security to be taxed.

Most experts agree that income taxes will be higher in the future. Shouldn't you pay your income taxes now when you can control the amount of tax liability you will face on that money?

So how do we transfer the rest of the money to the tax-free bucket?

Let's look at a couple age 65 filing a joint return for 2018.

Their standard deduction has been raised to $26,400. There are no longer personal exemptions. This couple can now withdraw $26,400 of fully taxable money and pay no income tax. If that couple withdrew $26,400 for 20 years they would withdraw $528,000 and pay no taxes.

The next bracket is the 10% bracket. That means the next $19,050 of fully taxable income is taxed at 10%. That is $1,905. If you divide $1,905 by $45,450 ($26,400 + $19,050) the percentage is 4.2%. That is a reduction from last year's 4.4%. If they withdrew $45,450 of fully taxable money for 20 years and paid taxes on that money every year for 20 years they would withdraw $909,000 of fully taxable money. At this level they would pay 4.2% of $909,000 or $38,178 to eliminate the income tax liability on that money.

Compared to last year, this couple could withdraw an extra $68,000 over 20 years and pay only $1,174 more dollars in income tax that the laws allowed in 2017. Think about it. Why wouldn't anyone do this?

The next $58,350 of income is now taxed at 12% rather than 15%. That is $7,002. If you divide $8,907 ($1,905 + $7,002) by $103,800 ($26,400 + $77,400) the percentage is 8.6%.

If they withdrew $103,800 per year for 20 years and paid the taxes on that money every year for 20 years they could withdraw $2,076,000 of fully taxable money. At this level they would pay 8.6% of $2,076,000 or $178,536 to eliminate the income tax liability on $2,076,000. This couple could now withdraw $90,000 more of fully taxable income and pay $29,954 (less) in taxes.

Now, I believe the new tax law allows us to go even further -- and move money quicker.

The next tax bracket under the new law is the 22% bracket. That means the next $87,600 of taxable income is taxed at 22% or $19,272. If you divide $28,179 ($1,905 + $7,002 + $19272) by $191,400 ($26,400 + $19,050 + $58,350 + $87,600) the effective tax rate is 14.7%.

Think about this: if you withdrew every year $191,400 for 20 years, you could withdraw $3,828,000 of fully taxable money. The tax on that would be 14.7%, or $562,716. If you could eliminate the income tax liability on $3,828,000 and it would only cost you $562,716 would you do it? Of course, you would.

It is imaginable that tax on that same $3,828,000 could be $1 million, $1.5 million, or even almost $2 million if left for the children to inherit and piled on top of their income.

Ask yourself, is there someone at the IRS that you are so madly in love with that you want to leave them a whole bunch of your money? Shouldn't you be in control of your income tax liability instead of allowing the IRS to be in control?

When trying to have a tax-free retirement it's crucial that we be proactive in making calculated contributions to the three types of investment accounts. A successful strategy will enable you to take tax-free distributions from your traditional IRA (up to the standard deduction), Roth IRA, Social Security as well as the cash value life insurance.

Doing this correctly will put you in the 0% tax bracket, giving you peace of mind and protection, not to mention more money, even in the face of dramatically higher taxes.

About the author: Dennis Drake is president of SMART Tax-Free Retirement and a member of Ed Slott's Elite IRA Advisor Group. For more information about this group, or to find a member near you, visit www.irahelp.com.

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