Retirement and Taxation

In my business I interact with many small to medium business owners and their employees. Since I deal with accounting, I naturally get asked questions about personal finances and more specifically retirement planning. Just to be transparent, I am not a certified financial planner and what I share is not meant to be construed as advice. I read a lot and share what I learn and can offer the solutions to my clients. If it fits and works in a given situation, then we run with it and get the solution in place. If it is not a solution I can provide, I let you know and offer alternatives outside of my expertise. While a 100% tax-free retirement would be great, it is more realistic to be tax SMART and lower your tax burden as much as possible to provide more income in retirement.

Regarding retirement and taxation, I believe that the banking and investment world has sold the American employee the belief that a qualified retirement plan such as a standard tax-deductible IRA or 401(k) is in their best interest. The transition to pushing these products heavily in the 1980’s was portending the end of the pension era. Pensions were funded by the employer and managed by the employers fund management. With that management comes a lot of pressure to perform and pay the pensioners what they are promised in retirement. A vast majority of companies liked the concept of the 401(k) as it is funded by the employee (generally also contributed to or matched up to 3% by the employer) and directed by the employee on its management.

Employees liked the 401(k) because they were given matching funds by their employer to entice them to build their retirement. Who doesn’t want free money? The lure of tax-deferred growth was also sold as very beneficial. The retiree would pay taxes at an assumed lower rate since they were no longer working and Social Security benefits are provided tax-free.

The reality is different. Retirees are finding they no longer have itemized deductions they did when they were working. No mortgage interest write-off after paying off the house. No school loan interest write-off with the kids out of the nest. Just a standard deduction. The current 2020 tax rate for ‘married filed jointly’ for income less than $80,250 is 12% for a tax bill of up to $9,630. It jumps to 22% over $80,250 ($17,655 in income tax for $80,251 in income – yikes!) and goes up to 37%. The money you withdraw from the IRA and 401(K) is taxable income (not capital gains). Retirees are finding that if they want to live a lifestyle befitting a well-off retired person that they have to contend with a higher tax rate than expected which eats away at the nest egg. This forces some to reduce the lifestyle they were expecting if they want the money to last. If you have a 30 year retirement, it is said by Morningstar research that you should only withdraw 2.8% a year on a million dollar retirement fund (pre-tax) in order for it to stay funded (producing money for you) over that 30 year period. 2.8% on $1,000,000 is $28,000 – that’s pre-tax! A millionaire having to live on $28,000 a year. That’s sad. It also speaks volumes about our current retirement planning system. Oh yeah, remember when I said Social Security benefits are paid tax-free? Not so fast – if you are taking Social Security and you have a retirement distributions funded by an IRA or 401(k), you are eligible to be taxed on your Social Security payments through the Provisional Income model. The IRS adds 50% of your Social Security income to all of your annual IRA/401(k) distribution to set your Provisional Income and then tax it according to the income tax schedule. If that total is over $80,250 then expect to pay a minimum of 22% in tax or $17,655. So much for tax free Social Security benefits. Note – if all your income is just Social Security – it is tax-free in full.

What are your options, you ask? There are several good paths.

One is to fund a Roth IRA with after-tax dollars and also participate in a matching 401(k) up to the maximum. A Roth IRA is taxable now; and then generally tax-free upon withdrawal in retirement years. The 401(k) with the matching funds is a no-brainer for free money. If your employer offers a matching 401(k), take the money and match the contribution, but when you want to go over 3% (which you should as 3% is only covering the cost of inflation), put that money into a Roth IRA at up to $6,000 a year if less than 50 years old or $7,000 if over 50. Any money available after the additional $6,000 may go into a standard IRA for conversion into a Roth later on. This is a blended solution to provide tax-free growth benefits from the Roth IRA and matching contributions

Another path to Roth IRA is to convert funds from a qualified account, pay the taxes now, and convert the funds to a Roth IRA. It’s also good to do this in a down year for income. That means a 50 year old with $57,000 converted into a Roth IRA has about $50,000 (taking into account a 12% tax) that grows it to $225,000 (4x basis) over the course of 20 years can enjoy ALL of that money tax-free at retirement paying tax on just the original $57,000 basis (the amount he originally put into the account). In 2020, with the corona virus and economic hardships and job layoffs, a 12% tax rate is feasible for many. Conversions to Roth IRA’s are ideal during low income years. A $57,000 (or more) conversion for a business owner who has a loss in 2020 would hit the 12% tax rate. You do need to keep in mind the tax implication of converting too much each year in combination with your income could put you into a higher tax bracket for that year.

Another path to tax-free retirement funding is through an over-funded high cash value 10-pay whole life insurance policy through a non-participating mutual insurance company. You get many benefits with such a policy. You get a guaranteed death benefit. You get tax-free withdrawals in retirement. You get access to cash via loans where the interest charged can be offset by dividends provided by the policy. You get guaranteed growth of your basis as well as non-guaranteed growth by way of dividends and indexing.

As a member of the SMART Advisor Network, I am trained to providing solutions as listed above to you. I can help individuals (the employee or business owner) as well as companies create options to assist your employees plan for a smarter retirement. Click this link to fill out a contact form or watch a video on more of these concepts. I’ll get back with you ASAP!