Tax Deferred to Tax Free: Navigating Taxes in Retirement

My name is Brian Scribonia and on this episode of the Common Sense Financial Podcast. So if you were to make a taxable distribution in 2024, that premium adjustment wouldn't be realized until 2026. This is one of those things that often comes as a surprise when people make decisions about distributions without understanding all of these rules. There are multiple things to consider before taking a taxable distribution, including a Roth conversion, but there are things you can do to help reduce the tax burden of switching from tax deferred to tax free.

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Consider the outcome, not just popular opinion and the whole teaching there is about preparedness and being ready. There's a difference between what's real and what's true. You're listening to the Common Sense Financial Podcast. I'm your host, Brian Scribonian. Thanks for tuning in and let's get into today topic. If you envision the ideal retirement plan, you'll likely imagine an exclusively tax free income. But for many baby boomers who have for decades saved money in tax deferred accounts, the opposite may be true. After many years of deferring taxes, retirees are facing a sizable tax bill on distributions taken from their retirement accounts. That could be a third or more of what has been accumulated. If this is you, though, you may wish that you had done things differently. There is hope. But before we jump to the solution, it's important to understand what you are really trying to accomplish. When you're saving for retirement, you're growing assets for your future. And now I have to assume you understand that. But what many retirees lose sight of is that once retired, growing assets no longer is the priority. Yes, of course it is important. Everybody wants their assets to grow, but it is not the priority. The priority is is actually creating sustainable income to support you through retirement. While Minimizing Taxes now in my experience, many retirees realize there are taxes owed on their tax deferred accounts, but most do not understand the full extent of the problem. There is this propensity to focus on growth, searching for that best investment while ignoring the tax issues until they are faced with the bill. In retirement, the rules are different than when you were working. There are more tax considerations. You have Social Security taxation, Medicare premiums on top of the taxable income on retirement account distributions. The icing on the cake here is that you most likely have fewer deductions in retirement to help offset the tax burden. When you're working, you deferred taxes and retirement plans may have had children to write off and maybe mortgage interest to itemize, but those are gone for most people by the time they are retired. So this makes the tax problem more complex considering many retirees we work with tend to have the same income goals in retirement, yet with fewer deductions. And if you think you can just simply kick the can down the road by not taking distributions, keep in mind that as the account continues to grow, the tax problem becomes bigger and required minimum distributions, or what they're known as RMDs, will eventually force you to take distributions. There is no hiding from what is owed. The IRS has been waiting patiently for you to accumulate this money and will ultimately push you to get its share of your piece. It is a pay me now or pay me later scenario. Once you are in retirement, there are two tax issues you face. Taxes you must contend with today, and taxes you will be burdened with in the future. The thought of what tax liability you may be facing today is enough, but much less thinking about what those tax liabilities could be over the next 20 or 30 years if account values grow and tax rates increase. One of the most common references people make to me is regarding government spending. According to the usdebtclock.org, our government is currently deficit spending about $1.7 billion and that number only increases by the second. And knowing that the government revenue is essentially our tax dollars, I'll ask you do you think taxes are going down or going up in the future? We all have our opinions, but we have to focus on what we can control now in 2024. We know what the tax rates are, but we also know that the current rate sunset December 31st of 2025 and are scheduled to increase on January 1st, 2026. So it really isn't a question of whether taxes are going up. Rather it's a question of what you're going to do about it. So there are two possibilities to help minimize the level at which you participate in paying your fair share towards the government's future revenue increases. You can either complete a Roth conversion or through tax deferred withdrawals, contribute to an overfunded permanent life insurance policy. Both options provide the ability to grow and access the money on a tax favored basis, but deciding to do one or both options is the easy part. The trick really is completing this process with minimal tax liabilities today. And that is a much more complex issue that requires a fair amount of knowledge about tax laws and strategies. In other words, this is not what I would consider a DIY process for most people and I believe you could benefit by working with an experienced team of professionals the first consideration for converting to tax free is understanding the tax code and how it works. In the United States of America we have a progressive tax code. A portion of taxable income may be taxed at one rate, while another portion of that income may be taxed at another. For example, if you're married filing jointly in 2024 with taxable income of 94,000, the first 23,000 would be taxed at 10% and the other $71,000 would be taxed at 12%. In this example, if you were to add a taxable distribution on top of this taxable income, any amount converted would breach the next income tax bracket and we'd be taxed at 22% up to $201,000 of taxable income. The progressive nature of the code makes this complicated and miscalculating this could result in having a larger tax liability than anticipated. The other consideration for a taxable distribution is the taxation on your Social Security. Depending on your income level, a taxable distribution can subject your Social Security to additional taxes. This is a separate calculation from the income tax brackets and uses a two step process to determine how much of your Social Security will be subject to taxation. The first step is to calculate what is known as provisional income. To calculate provisional income, you add together your adjusted gross income, your tax exempt interest, and 50% of your Social Security benefit. The next step is to use this provisional income sum to determine what percentage of your Social Security will be subject to income taxes. Falling into the first tier would result in having 50% of your Social Security subject to income tax and the highest tier is 85%. The good news is is that Social Security isn't 100% taxed and if your provisional income falls below certain amounts based on whether you're filing single or married jointly there is actually no tax at all on the Social Security. This is important to note because a taxable distribution may not only push you into a higher income tax bracket, but it could trigger additional taxes on your Social Security, which could result in a higher effective rate. Now, if the income tax brackets and Social Security tiers aren't enough, you should also be aware of the impact a taxable distribution can have on Medicare premiums. This typically isn't an issue unless your income is above $103,000 if you're single and $206,000 if you're married in 2024. But keep in mind that these figures would also include any taxable distributions from retirement accounts. The impact of any possible premium increase is typically delayed by two years, so if you were to make a taxable distribution in 2024, that premium adjustment wouldn't be realized until 2026. This is one of those things that often comes as a surprise when people make decision without understanding all of these rules. There are multiple things to consider before taking a taxable distribution, including a Roth conversion, but there are things you can do to help reduce the tax burden of switching from tax deferred to tax free. The goal in this process is to find ways that are both legal and ethical to help offset the additional income you show on your tax return resulting from a taxable distribution. The antidote to taxable income is deductions, credits and losses, which can help reduce the net income subject to tax. There are a few ways to approach this, but not all options are appropriate for everyone. Some things work and some may not, which underscores the need to have an experienced professional team of advisors guiding you through this process. The first thing is a Donor Advised Fund or daf. This allows you to contribute future charitable donations into a fund that you control when distributions are made, but can also receive the tax benefit of the donation in the year you make the contribution into the fund. By making multiple years of donations in a single year into that fund, you have the potential of helping offsetting a taxable distribution from your retirement account in that year. You also have something known as a charitable remainder Trust or crt. This allows you to contribute future charitable donations into the trust that you control when distributions are made, typically at death, but can receive the tax benefit of the donation in the year you make the contribution. You can also receive income from the trust while you're living within IRS limits. Like a daf, making multiple years of donations in a single year could potentially help offset a taxable distribution from your retirement account. A CRT is a more complex arrangement than a DAF with many options and requires an attorney to draft the trust. There's also something known as a Qualified charitable donation or QCD, which allows for anyone over the age of 70 and a half to make a direct donation from a qualified account to a charity, or which bypasses the standard deduction limits and allows the donation to be a tax free transfer. You also have something known as idcs or Intangible Drilling Costs, which allows accredited investors to participate in the drilling expenses of an oil and gas company that could provide reportable tax losses that can help offset all forms of income as well as the potential for cash flow back to the investor once the wells are operational. The tax benefit of this can be significant, but there are risks to consider that are best discussed with a financial advisor who is familiar with all the intricacies of these types of investments. Of course, this is not an exhaustive list of available options. There are other strategies to consider, but these are common strategies that can be used to help offset tax liabilities. When converting tax deferred assets to tax free, it's important to recognize that orchestrating these types of strategies requires careful planning and understanding the details of the strategies being deployed is a must to help limit the potential risks that are when using complex tax strategies. If you're listening to this and want to get assistance with moving tax deferred assets to tax free, you can request help from my team by booking a consult through my website@www.scriboniafinancial.com. that concludes today's show. I'm Brian Scribonia. Thank you for listening to the Common Sense Financial Podcast. Thanks for listening to today's show. If you liked what you heard, be sure to subscribe on YouTube and Spotify so that you can receive notifications when we release new episodes. I'm Brian Scribonia and this is the Common Sense Financial Podcast.

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