Tax season has come around once again. What better time to talk about the importance of tax planning and what it can bring to you and your ideal retirement?
Taxes are a subject that people generally don’t like to deal with, but tax planning can allow you to see that you have the pieces in place to help you keep more money in your pocket and less in Uncle Sam’s. Plus, while it may not feel like it, you have more control over your taxes than you might think — especially when you’re proactive by doing some tax planning before you reach retirement.
Read on to learn all about what tax planning can do for you and your retirement!
Tax Planning vs. Tax Advice
Is your ‘tax person’ giving you tax planning or just tax advice?
Many times, when people think about tax planning, they’re only considering how they can reduce last year’s taxes. If that’s the case then you are actually looking at tax advice - helping you file and make changes to your current tax year. And by current tax year you’re probably thinking about last year. Doing your taxes this year, is only looking at things that already happened last year.
On the other hand, tax planning is where you make some assumptions about your situation and see how those assumptions could affect you over your whole lifetime. And that's where we feel you can get the biggest bang for your time and for your buck. Usually, the rest of your life is going to be longer than last year. So when someone like your financial planner says, “You have your required minimum distributions coming up in 10 years, and it might push you into a higher tax bracket, so let's do something about it now,” that forward-thinking allows you to make decisions that might affect you 10 years down the road. In reality, if you don't make those decisions, those distributions are still going to affect you down the road, so you might as well make decisions when you've thought through and weighed the pros and cons.
Remember, tax advice is important, but usually deals with getting last year’s numbers correct. Tax planning is looking at the future and being proactive.
Effective vs. Marginal vs. Tax Bracket
There can be a lot of confusion amongst three related, but very different tax terms; effective, marginal and tax bracket rates.Your effective tax rate is the average rate that your income is taxed at. So if you make $100k income, and you paid $10k in taxes, your tax person might tell you that your effective tax rate is 10%.You might think that’s your tax bracket, but that’s very unlikely, and you probably have never heard of ‘marginal rate,’ but that specifically is the most important of them all!
Here’s why it's so hard: With the U.S. tax code, the first few dollars pay a lower rate and then as you make more money, those next dollars pay a higher rate. That’s why your effective tax rate isn’t necessarily the same as your tax bracket.
Your effective rate is really an average of all your tax brackets - and it involves your total income before you take your deductions!
Your tax bracket is basically where your last dollar of taxable income is sitting, after you take your deductions.
Now let’s start turn to an example of marginal tax rates. With this concept, if you have an extra $1,000 of income, or maybe have an extra $1,000 as a deduction, the marginal rate is how the tax is going to change on that specific $1,000. This is the rate that matters, because when you are making a decision on adding income, or taking it away through deductions, you can’t let your judgement be clouded about your effective tax rate or bracket on your other money. You need to focus on what happens tax-wise to this specific amount of money - that’s your marginal rate.
Now, here’s an example of an effective tax rate at work. If you earned $100,000 in income and paid $8,000 in taxes and federal taxes, your tax person will say that you had an effective tax rate of 8% — but you might be in the 12% tax bracket.
Effective vs. Marginal vs. Tax Bracket in Reality
Let's use some round numbers for this example. Every year the tax brackets change so please use this as an example, not a strict interpretation.
Say your income is $105,000, and your deductions are $25,000 - you're getting close to the top of that 12% bracket. If you hit the top of the 12% bracket, the next bracket is 22%. You might think you’re in the 12% tax bracket, and maybe your tax person figured out that you paid $8,400 in taxes, so you have an effective tax rate of 8%.
So when you’re thinking about taking money out of your IRA you might remember that your tax person said your effective rate is 8% and think that applies, or you may have looked up the tax tables and saw that you are at the top of the 12% bracket and that applies.
But in reality, your marginal rate, the next $1,000 if you made $106,000 as an example, goes into the 22% bracket. Now for that $1,000 itself, you paid $220 in taxes on it. That's a 22% marginal tax rate on that specific decision on that specific dollar amount, and that's the one that really matters.
That's probably the tax rate you see the least, but that's the one that affects you the most. And that's why a good tax planner will key in on what your marginal tax rate is and how it will change based on certain situations or certain decisions you make.
Taxes and Retirement
Most people understand their taxes will change in retirement, but they are probably unaware of how much and how often they will change.
Your taxes will probably change before and after retirement. When you collect social security, your taxes will probably change again. Later on, you might get to the age of 72 and start required minimum distributions. Your taxes might change before and after that happens.
One change that a lot of people don't realize, or plan for, is the fact that their taxes will probably change when there are two people filing taxes together and then it goes down to one later on in retirement when the first spouse dies. When that happens, you're no longer married and are considered to be a single individual — and your taxes are going to change.
With tax planning, we can look at each of these crossover points and see what's going to happen before and after retirement and how the marginal tax rate is going to be showing up. And I don't know about you, but if I see a marginal rate that's lower than the rest, I'm going to try to pay taxes at that rate versus another one.
Controlling Your Taxes
The first concept to be aware of is that when it comes to retirement, you have a lot of control over your taxes. If you're not yet retired, you’ve likely had 30 or 40 years of the same thing where you make your salary, you have some deductions, and you fill out your taxes. It feels like you can't really change it, right?
But in retirement, there are quite a few things you can change with some proper tax planning. Before you retire, your 401(k) and IRAs can affect your deductions. But after retirement, you get to choose not just your deductions, but also when your income shows up on your tax return. For example, when you’re retired, you can call up your 401(k) or IRA and say, “Hey, next year I need some money, but I’m going to take it out this year,” so you can make your taxable income show up in one year, but actually use it the next year.
Or, you could do the opposite. You could use some money in one year, but push off the taxes to another. By doing this, you could take money from your savings account that you’re not paying taxes on and then maybe replenish it the next year from your Traditional 401(k) or IRA, and that’s when the taxes are going to show up.
Social Security and Taxes
A good retirement plan helps you create a strategy for when you take social security. This is important for maximizing how much you could get from social security, but the way social security gets taxed makes this strategy even more vital to your retirement success.
This is where your marginal rate comes in. Because of the way tax rates on social security are calculated, it’s important to have a tax planner help you figure out how much you’re going to be taxed. Your social security amount, whether it’s $10,000, $30,000, or $50,000 — will be taxed at 0%, 85%, or anywhere in between.
Although, it’s important to note that it’s 85% taxable, not an 85% tax rate — which means that your $1,000 of social security might show up as zero, or it might show up as $850 or anywhere in between. And this is where we get a little danger coming in from this idea of “Oh, I have an 8% effective tax rate.”
If we refer back to our previous example of being at the top of the 12% bracket.. When you pull out an extra $1,000, if you’re at the top of the 12% tax bracket, guess what? You’re actually at the bottom of the 22% bracket. So that $1,000 will come out at the 22% rate.
And, with the way that social security is taxed, sometimes when you take out that extra $1,000 from your traditional IRA, that $1,000 of extra income might suddenly bring $850 more of your social security into the tax form. So it’s not the $1,000 that shows up on your tax form, it’s $1,850. And because you’re at the bottom of the 22%, while you thought you’re paying 12% taxes, you’re actually paying 22% on that $1,850, which is about $410 on that thousand dollars, making it a 41% marginal rate.
So, please be aware that after you take social security, your marginal rates could wildly swing. That’s why you might want to run your tax forms through planning software and talk with a person who knows what they’re doing so you can figure this out. By the time you hit April and you’re filling out your tax forms and your taxes are higher than you thought it would be, it’s too late. So please plan ahead.
Why Bother Doing Tax Planning?
With a traditional 401(k) or IRA, you have a tax deduction when you put the money in, but you have to report it as income whenever you take the money out. That’s why when people retire, we constantly hear, “I’m just going to live on my other money and I’m going to wait to take money out of my IRA and 401(k) until they force me to.”
However, usually when you do something because you want to, rather than being forced to, you can get a better tax situation. If I’m 65 and don’t need to take the money out, but do it anyway, why did I do it? Not because I’m forced to, but because I figured out the tax situation is better to take it out at 65 versus what’s now 72 for required minimum distributions.
That’s why this is so important to figure this out with someone who knows what they’re doing. Let's look at what your marginal rate will be before the required minimums and what it will be after required minimums. If you have a lower marginal rate today, why don't we take the money out? There are so many different ways you can do it, but why don't we take the money out now before you're forced to?
Surviving Spouses and Tax Planning
During the retirement planning process, we plan a lot for what will happen to the surviving spouse’s income once the other passes away. The same goes for taxes. When there are two of you, your tax bracket is different than when there’s one of you.
If you’re in a couple and make, for example, $100,000 a year as a couple, you’re probably in the 12% tax bracket. Based on how the tax brackets work, roughly half your income is in the 12% bracket while some if it is in the 10% bracket. When the first person dies and the lowest social security goes away, a widow’s income, for example, might drop to $85,000. But now she’s no longer in the 12% tax bracket. She is now filing as a single person making $85,000, and she has a lot of income above the point where it turns from the 12% bracket to the 22%. Roughly speaking, he went from half her income going to the 12% bracket as a married couple to roughly half her income being in the 22% bracket as a single individual. This example demonstrates why a lot of times you have people who have less income as a surviving spouse, and their taxes go up. It’s unfortunate, but that’s the way the tax system works.
That’s why we’d rather you figure this out now as you’re planning for retirement versus finding out at tax time that you had a higher tax bracket last year. Let’s plan for your retirement and taxes now, and let’s take back some control.