In this episode, podcast host and author of “Control Your Retirement Destiny” covers Chapter 4 of the 2nd edition of the book titled, “Taxes.”

If you want to learn even more than what there is time to cover in the podcast series, you can find the book “Control Your Retirement Destiny” on Amazon.

Or, if you are looking for a customized plan for your retirement, visit us at sensiblemoney.com to see how we can help.

*In this recording, Ms. Anspach incorrectly stated "At least 12% right? After all, in 2017 that was the lowest tax rate."  The 12% tax rate was implemented in 2018, not 2017. The correct sentence would be "At least 15% right? ...at 15% they would pay just over $31,500 in federal taxes.

Chapter 4 – Podcast Script

Hi, this is Dana Anspach. I’m the founder and CEO of Sensible Money, a fee-only financial planning firm. I’m also the author of Control Your Retirement Destiny which was initially published in 2013. A 2nd edition was published in 2016, and now, I am working on the 3rd edition. Why a 3rd edition? Well, the tax laws changed - and we want to update Chapter 4, which covers taxes.

This podcast covers the material in Chapter 4, and I’ll be discussing both the old tax rules and the new tax rules. We’ll continue to follow the case study of Wally and Sally based on the 2nd edition of the book.

The book has incredible 5-stars reviews on Amazon. If you like what you hear today, go to Amazon and search for Control Your Retirement Destiny. You won’t be disappointed. And if you are looking for a customized plan, visit sensiblemoney.com to see how we can help.

Ok, let’s get started. In this podcast, I’ll be covering the highlights from Chapter 4 on the topic of “Taxes.”

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There are very few people I know who enjoy doing their taxes. That includes me. I have actually never done my own tax return. To me, it is worth it to pay someone else to handle this task.

Yet, I know a tremendous amount about personal tax rules. So why wouldn’t I do my own tax return? Well, a tax return is a historical account of what happened. Once it is time to file your return, there is nothing you can do to change the outcome.

I prefer to use my tax knowledge to figure out how to pay less in taxes. And, to help other people pay less. To me, that is one of the most rewarding parts of my work.

To pay less in taxes, you have to plan ahead. How far ahead? The more you want to save, the farther ahead you’ll plan.

Think of tax planning in three levels.

Level 1 is pretty basic. For example, assume you turn your tax documents in to your tax preparer, and he or she let’s you know you could fund an IRA for the previous year, and thus reduce your tax bill.  That wasn’t really planning ahead, but you did learn a step you could take to reduce current year taxes.

But is this really the right step to take to lower your taxes in the long run? Not for everyone. Some people are better off funding a Roth IRA instead of a Traditional Deductible IRA. With a Roth, you make after-tax contributions and from that point on, the money grows tax-free. The Roth IRA has several unique advantages for retirees when they enter the phase where they are regularly withdrawing money. For example, Roth withdrawals do not count in the formula that determines how much of your Social Security is taxable. And Roth IRAs do not have what are called Required Minimum Distributions, which begin at age 70 ½ and require you to take out specified amount each year. These unique advantages of Roth IRAs are often missed by traditional tax preparers.

The reality of Level 1 planning is that many tax preparers are so focused on what you can do to reduce this year’s tax bill, that the advice they are giving, with the best of intentions, may not be advice that is ideal for you.

Next, we have Level 2 tax planning. You must tackle Level 2 planning in the fall, and run a tax projection. The bummer part of doing this is that you have to gather estimates for every item that will be on your upcoming tax return. We do this for most of our clients each year – and I’ll admit, it’s a lot of work. What do we learn from all this work?

We can determine what actions need to be taken before the year is over so that people can save money. There are three items we routinely look for.

1) The opportunity to convert a portion of an IRA to a Roth IRA,

2) the ability to realize capital gains if they will fall into the zero percent tax rate, and

3) the ability to realize capital losses that can be used to offset ordinary income.

If you aren’t sure what these things mean, keep listening. I promise, I’ll explain most of them in more detail.

With Level 2 tax planning you mock up your tax return, and then see what it would look like if you were to take action before the year is over. One of the most memorable results I have from a tax projection was when we told a client that could sell a significant amount of Apple stock and realize $60,000 of capital gains and pay no tax. They were shocked.

How were they able to do this?

They had just retired, and their taxable income was going to be quite low for the year. When your taxable income is low, any capital gains you realize are likely to fall into what is called the “zero percent tax rate” – which means you can realize those gains and pay no tax.

If they had waited even one more year – their taxable income would not have been as low – and they would have paid taxes on the gain at a 15% tax rate, or $9,000 in tax.

Planning ahead saved them $9,000. Pretty cool.

Then, we have Level 3 tax planning.

With level 3 planning, you plan many years ahead. This type of planning can have a big impact on people who are near retirement. Why?

Between the age of 55 and 70 there are a lot of moving parts.

Retirement usually happens in this age range, which results in a change in taxable income. And various other types of income start– such as Social Security, pensions, deferred compensation payouts and IRA withdrawals – and they often all start at different times. If married, spouses may have different retirement dates and different years where each of their Social Security begins.

With all these moving parts, your tax return can look entirely different from year to year – and lots of opportunities exist – if you’re on the lookout for them.

In Chapter 4, we follow the case of Wally and Sally. I show you what Level 3 Tax Planning looks like by going through three potential retirement income plans for Wally and Sally.

All three plans are designed so that their lifestyle spending is identical. The difference in the three plans is when they begin Social Security, and how they withdraw from various accounts. These changes impact how much in taxes they pay in each scenario.

Let’s see how their three scenarios look using the old tax rates. Then we’ll summarize how it might change under the new 2018 rules.

In the 2nd Edition of the book, I describe Wally and Sally’s three retirement income plans as Option A, B, and C.

With Option A, Wally and Sally take their Social Security early, and at the same time withdraw from their non-retirement accounts. They know at age 70 ½ that by law they are required to begin taking distributions from retirement accounts and they plan to wait and tap IRAs only when these mandatory distributions begin. Their cumulative taxes over a 29-year projected lifetime add up to $452,000.

With Option B, they use their suggested Social Security claiming plan, which has them filing a few years later, and they use the same withdrawal order as Option A. Which means they spend non-retirement savings first, while waiting until required distributions begin. Their cumulative taxes total to $487,000.

With Option C, they use their suggested Social Security claiming plan while converting IRA assets to a Roth IRA during low tax years, and they withdraw from IRAs before their required distributions begin. Their cumulative taxes add up to only  $424,000.

That’s a $63,000 difference in taxes paid – depending on how they structure their income plan.

There is also a big difference in how much money they have left after 29 years. When looking at the estimated after-tax value of accounts, with Option A they have  $816,000 left. With Option B, in 29 years, they have $930,000. And with Option C - $1,153,000.

That’s $337,000 more.  

Now, if I have any economists listening, they will realize that $337,000 sounds like a lot – but that is $337,000 twenty-nine years in the future. You must discount that back to today’s dollars to do a fair comparison. Assuming a 3% inflation rate, in today’s dollars that is worth $143,000. That’s still a decent chunk of money you get to keep by planning ahead.

How does this type of planning work?

In the early years in retirement, Wally and Sally will be in a lower tax rate. Later in retirement, a higher tax rate will kick in because of their IRA withdrawals. With Option C, they use this to work to their benefit. They withdraw money from their IRA on purpose when their tax rates are low. They are able to put some of it in a Roth IRA where it grows tax-free. This is called a Roth conversion. The result is that later in retirement their Required IRA distributions are lower, and they have less income taxed at the higher rates.

What does a similar case study look like under the new 2018 tax laws?

I’m working on that right now for the third edition of the book.

Starting in 2018, tax rates are lower than they wer