Power Up Wealth podcast – Is Your Retirement Account a Tax Bomb?– Episode 51 transcript:
Sharla Jessop 0:00
Have you unexpectedly created a tax time bomb? If you have a large balance in a 401k or IRA, you may have done just that. I’m Sharla Jessop, and today my guest and colleague, Mikal Aune, will share ways to defuse a tax time bomb.
Welcome to the SFS Power Up Wealth podcast, where we provide impactful insight and expert opinions on timeless financial principles and timely investment topics, preparing you to make smarter decisions with your money.
Mikal, thanks for joining me today.
Mikal Aune 0:50
Glad to be here, Sharla.
Sharla Jessop 0:51
Mikal Aune is a CFP with Smedley Financial Services. And he’s Vice President of our Wealth Management Team. Mikal attacks, timebomb sounds like a really serious situation.
Mikal Aune 1:03
If you aren’t wise with what you’re doing, you could have things blow up in your face. And I think the problem is there’s there’s a lot of conventional wisdom or rules of thumb that we follow the can come back to bite.
Sharla Jessop 1:15
How do people get into this situation where they are working so hard saving, you know, we all have the American dream, we want to save for retirement and live out our golden years very comfortably. And so you know, we’re just very conscientiously putting money aside every paycheck.
Mikal Aune 1:30
And I have to give kudos to everybody that’s doing that because it takes a lot of discipline and hard work to go without certain things because you are saving more for retirement. So we don’t want to dissuade anybody from saving for retirement, putting money in your 401k or IRA is like keep doing that. It’s just being wise about how do you get the money out after the fact.
Sharla Jessop 1:51
So if I’m a young person, and I’m a worker still working, how should I be saving for retirement? What should things should I be thinking about or considering to prevent a tax time bomb?
Mikal Aune 2:02
So when you’re young, and usually we said, hey, in retirement, you’re going to be in a lower tax bracket? Okay. Well, the reality is that’s not true. For a few people it’s true, that maybe they’re in the 22% tax bracket in retirement, they’re in the 12% tax bracket. But that’s more the exception than the rule. The rule is, you’re almost in the same tax bracket, as you as you were in your working years.
Sharla Jessop 2:27
And we do have a national debt out there that’s going to have to be paid off sometime. You think taxes will be going up?
Mikal Aune 2:33
Yeah. One of my new favorite sayings is, that Congress does not like four letter words. And there’s one particular one that they don’t like, and that’s m a t h. They don’t like math, because if you did the math, based on the amount of deficit that we have right now, taxes need to double on everybody. So if that has to happen right now, Congress is not going to pass something and raise taxes that fast, they don’t work like that. But they’re going to kick the can down the road as long as they can. It’ll come to a point where they can’t kick debt can down the road anymore, and taxes will most likely go up.
Sharla Jessop 3:10
So knowing today that that could be a problem in the future, how should I be saving?
Mikal Aune 3:15
So in the past, we’ve said, hey, if you’re in the 12% tax bracket, go ahead and put your money in Roth. But if you’re above that, like in a 22% tax bracket, then you should be sticking your money pre-tax because you’re going to be lower in retirement. But I’m changing my thoughts on that, you know, looking at a lot of the younger generation saying, if you’re in the 22%, I would probably still put a lot of your 401k contribution into Roth, and not into pre-tax. In some people, it might even make sense if they’re in the 24% tax bracket. So you have to look at each one of those, it’s good to consult with your CPA or wealth manager that we have to see where you are and where you might be in retirement based on your income in retirement and start putting more of that into Roth. You can contribute $23,500 into a 401k. And if you have the Roth option, you can put all $23,500 into Roth now. You’re choosing to pay the tax on it. But the benefit of the Roth is that you never have to pay taxes again on that money. And also, when you get older in retirement, you’re over set 73 You don’t have to take any required minimum distributions from a Roth. Another benefit if you’re over age 50, you can put in extra. You can put an a total of $30,000 into your 401k. So depending on your tax bracket, we might say, hey, put it all into Roth, we could say put a portion into Roth and a portion to do pre-tax depending on where you fall. But you might want to start thinking about it differently. And not just put it all into pre-tax because that could be creating the tax time bomb for the future.
Sharla Jessop 4:50
Other things that they could consider are things that aren’t even tied to retirement.
Mikal Aune 4:54
You can look at things like just a standard investment account. If you’re married you do a joint account or a trust account where the trust is the owner. You can have an individual account that’s just in your name. It’s an investment account where you’re saving for the future. It doesn’t give you any tax breaks now, but it’s liquid, and you can tap into it at any time. You can put in as much as you want, take money out. Like that’s a great place to stick money for things like cars or home renovations, or, you know, anything that you might need money and be able to spend it now, because your 401k or IRA, you really can’t tap into those until you’re 59 and a half. That’s the earliest. There’s some rules and caveats that allow you a ways to tap into it sooner. But for all intents and purposes, they should be left alone, because they’re for retirement, the retirement planning.
Sharla Jessop 5:41
And non retirement accounts, there’s not a limit as to how much you can save.
Mikal Aune 5:44
You can put in as much as you want in those. You just have to pay attention to taxes each year. But there are ways that you can make a tax-efficient and different tools that you can use to make sure that you’re not paying a boatload in taxes on the money that you’re saving on top of your 401k or IRA.
Sharla Jessop 5:59
And even so those types of accounts are taxed at capital gains rates for anything held over a year and a day.
Mikal Aune 6:04
Things that people have to keep in mind: there’s dividends and interest, that’s just like interest that you get in the bank, you will pay tax on that every single year. But capital gains you don’t pay until you actually sell the investment that you’re holding. Think about it like a house, I bought my house, but I’m gonna hold it for 10 or 20 years, I don’t have to worry about taxes until I sell it. And that’s how it is with mutual funds or stocks, I hold the stock for 10 years, I don’t have to worry about a capital gains tax until I sell it after 10 years. But that capital gains tax, like you said, is always lower than your ordinary income tax rate. And right now the maximum was 20%. So that’s much better than paying 22 or 24, or 32% in tax.
Sharla Jessop 6:45
Let’s say that we’ve already saved for retirement and we’re close. We’re getting right up there on the door of retirement, we’ve got this text time bomb ticking in the back of our head, and we are going to start using our money. What do we do for people in that situation?
Mikal Aune 6:58
So some of that depends on where you fall. If you have less than a million dollars, you can usually spread that out over time and lessen the tax burden in any given year. Okay, there are some awesome tools that we love. One is called a qualified charitable distribution. You must be 70 and a half or older to use this. But you can donate to a charity directly from your IRA, and you don’t pay any tax. You know, the tax rate is zero. So that’s the best or most efficient way to get money out of your IRA once you’re 70 and a half, but not everybody’s going to donate to charity or donate all of their, what they have to pull out to charity. Cause one of the things you run into is when you’re now 73, they used to be age 72, they’ve pushed out the age to 73, you are required to take minimum distributions from your IRA or 401k. And those usually start out around 4% is what you have to take out. So when you hit age 73 and you’re required to take money out, does it push you into a higher tax bracket? I’ve had plenty of people that are living on Social Security, because that’s all they need, they’re comfortable and then they hit 73 and now I have to take money out. And now all of a sudden, I’m in a higher tax bracket, but not only just for the money that I have to pull out, but I’m paying more taxes on Social Security as well. So Social Security, if you don’t have enough income, you don’t pay tax on Social Security. Think about Social Security though like the foam on top of root beer. The more root beer I pour in, if more of my foam goes above the rim of the cup, it becomes subject to tax. So for every dollar of income that I pour in, it could cause one or 85 cents of Social Security to become subject to tax. So I’ve had a number of people where I’ve done the math on and they’re technically in the 12% tax bracket. But because more of their Social Security is becoming subject to tax at the same time, they’re really paying 22% in tax. So you have to be wise about okay, how am I taking distributions? When am I taking it? Is it causing my Social Security to become subject to tax. If you have less than a million dollars, you can usually spread that out and work through things. If you have more than a million dollars, you know, one and a half, two, three, you know, five mil. If you have a big amount in your 401k, all of a sudden you’ve created a big tax burden. And if it’s not for you, it could be a big tax burden for your kids.
Sharla Jessop 9:21
So how do they avoid that? How can people avoid paying that huge tax burden? Is there things that they can do while they’re still living in retirement to prevent that?
Mikal Aune 9:30
Yeah, one you just have to worry about distributions. And you have to think about the future too. Because what what happens if let’s say I have an IRA, let’s start with a big number and say it’s $5 million okay that I have in an IRA. Each year I have to take out $200,000 just to meet my required minimum distribution. That’s a lot of money that I am required to take out. That’s a good position to be in to say that you have to take out that much money because then you can use it for things that you want to but if you’re not using it all, then what about your kids because I have a number of people by the end of retirement they’re going to at least have that much money, if not more left to go to their kids. So even if it’s the same $5 million that gets left to the kids, let’s say there’s two kids, they split it, they each get two and a half million dollars. Well, tax rules are different for inheritors, where you have to take the money out over 10 years. So the inheritors, the kids, are going to be taking at least $250,000 per year over 10 years to get that out. That’s going to be on top of their other income that they already have. So it can put them in a really high tax bracket, and they’re getting killed on taxes paying 37% plus some additional taxes. I mean, they can easily get over 40% that they’re paying in tax. Do you really want them to be in that situation?
Sharla Jessop 10:45
That’s huge!
Mikal Aune 10:46
It is huge. And it can take a real bite out of what you’re trying to leave to your your kids inheritance. Even if your main goal is to take care of yourself, there are things that you can do, right. So the first thing that we talked about was the QCD, that qualified charitable distribution, because that can get money out of your IRA tax-free. Keep in mind that can only be done from an IRA, it cannot be done from a 401k. But the next is to do Roth conversions. And you can do Roth conversions up to your tax limit. Let’s say that you have enough income already to where your Social Security is subject to tax. You’re in the 22, or on the borderline of the 24% tax bracket. You could fill up the 24% tax bracket, meaning I’m going to take an extra 80, 90 or $100,000, whatever I need to to get up to the top limit of the 24% tax bracket without dropping over into the 32%. Because that’s a pretty big jump, you know, an 8% increase in taxes, we don’t want to go there if you if you can avoid it. But if I fill up that tax bracket, I can do bigger conversions each year, that means more and more of my 401k I’m able to get out. My required minimum distribution actually goes down over time. So we did one case where somebody with close to 5 mil if we did large conversions over time, if they just followed conventional wisdom and just took out what they had to take out, they’re still going to leave like four and a half million to their kids. And their kids would have to pay tax on that full four and a half million. So the kids are just grateful to receive the money. So they don’t really think about this until you explain it to him. And then they’re like, oh, because if we did a different ended Roth conversions and did big Roth conversions, at the end of retirement, instead of having like four and a half mil, they would have had 4.7. So you actually have more money to give to the kids. But like 4.6 of it would be Roth, and it would be fully tax-free, and the kids would not have to pay any tax on it. And it didn’t really change the parents tax bracket. They’re still in the 24% tax bracket. So it saved a boatload of taxes that the kids don’t really have to pay anything talk about a way to perpetuate generational wealth and to help the next generation start out on a good foot.
Sharla Jessop 12:51
I think that makes perfect sense. And it’s what most of us who are saving for retirement want to do we want to put our children in a better situation.
Mikal Aune 12:57
Yeah.
Sharla Jessop 12:57
If we don’t need the money.
Mikal Aune 12:58
Yeah, you don’t have to have $5 million. Like it, we looked at it with somebody with a you know, $1.5 million. And we could do Roth conversions and do large ones, and it would take them 11 years to fully convert their 401k into a Roth IRA. But at that point, they’re done. They don’t have to have any more required minimum distributions. And in normal circumstances, they would have left like $1.4 million to the kids, the kids would have to pay tax on it in this circumstance, because we’ve already paid the tax on it, and it can just grow for the future. They would leave $3.3 million for the kids all in Roth, all tax-free. Like it’s a huge win to be able to do this tax planning and look at Roth conversions.
Sharla Jessop 13:39
I agree. And I think there’s many people who don’t understand the intricacies of making those Roth conversions and how it is sometimes it’s a year by year situation, you have to look at exactly the income, the tax bracket and determine what can be converted.
Mikal Aune 13:52
Yeah, and you have to look long-term. Every single year, you’re looking at it saying hey, is it a good idea? And we like to consult with each of the clients CPAs to say, okay, we’re thinking of covering this much is this a good idea? And they can say yes, it’s a good idea for this year. But a lot of times, we don’t know what the tax bracket is going to be in the future. So is it better now versus then we don’t, there’s no guarantee that taxes are going to go up on you, but there’s really good likelihood that they will. So if we look at it over time, we can say, hey, this is going to benefit you big time down the road. And if we can show that to the CPA and the CPA gets on board, they’re like, okay, we can see the difference that this is going to make in the long run. So work with your CPA, your accountant that you’re working with, work with your private wealth manager to make sure that this is something that could really benefit you and your heirs down the road.
Sharla Jessop 14:38
I think this is great information. But I think also there’s sometimes a sweet spot that people don’t recognize, talk about the sweet spot for Roth conversions.
Mikal Aune 14:46
A lot of it depends on Social Security and what income you have coming in. So let’s say you’ve retired early and you’re delaying Social Security for a few years. Before you start Social Security. You can do Roth conversions at that period, and that’s a sweet spot to do Roth conversions. Once you have started Social Security, then it really just depends on if your security is already subject to tax or not. So for a lot of people, we don’t do Roth conversions, we say, you’re in that period where every dollar that we pour in of income is going to cause $1 of Social Security to become subject to tax and we want to avoid that. And so we’re going to do more of those qualified charitable distributions, and other things to reduce income. But once you get past that, where Social Security is subject to tax, then that’s kind of the sweet spot to do it. Another thing that you have to think about is if you’re married, you’re in a much better tax bracket to do conversions. I have a lot of widows and widowers that their income is almost the same as what it was before that, you know, before they lost their spouse, but they are now their tax bracket is in essence cut in half. And so they hit the 24% tax bracket much faster and a Roth conversion, it doesn’t help them as much. So before you start Social Security is great. While you’re married, if your security is already fully subject to tax, then that’s a perfect time sweet spot to do it.
Sharla Jessop 16:03
You know, what I love about tax planning is that it’s so unique for each individual. There’s not a cookie cutter way to do it. It’s not a rule of thumb. It is an actual plan for each person. And you have to review it each year to see what makes sense.
Mikal Aune 16:18
Yes. We always answer the question with it depends. And in this case, it really does because each person is so unique and individual with what they’re trying to do with their money because some people love to give to charities and some people don’t. Some people want to take all the money to be able to live on. Some people want to leave it for their kids. So it really does come down what what are your values and your goals? What are you trying to accomplish? And then let’s use tax planning and a lot of the other tools that we have to get you there.
Sharla Jessop 16:43
Sounds like everyone who’s planning to retire someday could benefit from a financial plan and tax plan.
Mikal Aune 16:48
Most definitely.
Sharla Jessop 16:49
Mikal, thank you for joining us today.
Mikal Aune 16:51
Glad to be here.
Shane Thomas 16:51
Thank you for joining the Power Up Wealth podcast. Smedley Financial is located at 102 S 200 E Ste 100 in Salt Lake City, UT 84111. Call us today at 800-748-4788. You can also find us on the web at Smedleyfinancial.com, Facebook, Instagram, Twitter, and LinkedIn. The views expressed are Smedley Financials and should not be construed directly or indirectly as an offer to buy or sell any securities or services mentioned herein. Investing is subject to risks, including loss of principal invested. Past performance is not a guarantee of future results. No strategy can assure a profit nor protect against loss. Please note that individual situations can vary. Therefore, the information should only be relied upon when coordinated with individual professional advice. Securities offered through Securities America. Inc., Member FlNRA/SIPC. Roger M. Smedley, Sharla J. Jessop, James R. Derrick, Shane P. Thomas, Mikal B. Aune, Jordan R. Hadfield, Registered Representatives. Investment Advisor Representatives of Smedley Financial Services, Inc.®. Advisory services offered through Smedley Financial Services, Inc.® Smedley Financial Services, Inc.®, and Securities America, Inc. are separate entities.
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