Alo Financial Planning

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Dodging Tax Jail and the Tax Torpedo

We really enjoy our semi-annual meetings with clients to review their retirement plans, goals/ideas, taxes, portfolios, and financial activities for the year. In a conversation this week, one astute client asked how retirement plan deductions might affect their retirement plan. This is a common question many retirees have and I’m glad he expressed it.

While he probably meant retirement plan withdrawals or distributions, rather than deductions, and is about 10 years from their “making work optional” age, this client identified a two key Retirement Planning Tax Traps – Tax Jail and the Tax Torpedo.

What is Tax Jail and the Tax Torpedo?

A jail and torpedo are two visuals to think of with regards to forced higher income in retirement that can then spiral into higher taxes.

Tax Jail

You may have played Monopoly a hundred times and remember the phrase “go directly to jail, do not pass go, do not collect $200.”

This is what it can feel like once a retiree reaches their age of required minimum distributions from their IRAs/401(k)s – currently age 72. At this age, you are “required” to transfer money out of your tax-deferred retirement account into a taxable account, also known as RMD. The IRS needs you to eventually report and pay taxes on this money – period.

Tax Jail happens when a couple saves “too-much” money in their retirement accounts and are forced to withdraw more money than they need at a high tax bracket they don’t want to pay.

The minimum withdrawal amount depends on someone’s age and IRA balances. For example, a 72-year-old needs to withdraw 3.65% of their account balance while an 80-year-old's RMD is 4.95%. On a $2,000,000 IRA balance this would result in RMDs of $73,000 or $99,000 per year. This page from Fidelity provides the formula by age for most retirees.

The punishment for saving and deferring income is that the RMD can force someone up 1-2 tax brackets – say from 12% to 24% or 24% to 35%. And ironically, retirees, who likely spend less in their 80s, are stuck distributing more and more income and pay more taxes.

Tax Torpedo

The Retirement Tax Torpedo is the combination of three tax items that can snowball in retirement with required minimum distributions from retirement accounts.

  1. RMDs force a larger percentage of Social Security income to be taxable, maybe from 0% to 85%, thus taxable income increases from RMD AND Social Security

  2. Higher taxable income forces the taxpayer into a higher tax bracket

  3. Higher taxable income causes the taxpayer to pay more for Medicare with Income Related Monthly Adjustment Amount (IRMAA)

To show you how RMD could cause a Tax Torpedo, we’ve calculated the scenarios below using one of our favorite tools, https://www.dinkytown.net/. In the example, the inclusion of $100,000 RMD from an IRA increased the amount of Taxable Social Security, increased taxes by over $25,000, and created almost $2,000 of IRMAA for a 27% tax on the RMD. A direct hit on retirees, thus called the Tax Torpedo.

Ideas to Avoid Jail and the Torpedo

1 – Diversify investments and savings by tax type

People typically think of diversification by types of investments – stocks and bonds; US and international. By diversifying investments across types of accounts like tax-deferred (IRA/401(k)), taxable (regular, after-tax), and tax-free (Roth), a taxpayer may be less concentrated in tax-deferred and reduce the impact of Tax Jail and Torpedo.

2 – Use Qualified Charitable Distributions

If a taxpayer donates their RMD (or a portion) to charitable organizations, that distribution is tax-free.

3 – Use tax-deferred accounts for retirement before RMD

The conventional wisdom of sourcing retirement income is the following sequential order

  1. After-tax accounts

  2. Tax-deferred accounts

  3. Tax-free accounts

Unfortunately, this sequential order can result in less flexible options as we age and larger RMDs. More optimal income sourcing strategies may include pro-rata or using tax-deferred accounts up to a defined tax bracket.

4 – Make strategic Roth Conversions

If someone is already planning on using the above three ideas, converting some IRA to Roth over time can be a great approach. After estimating their taxable income for the year, a taxpayer can convert enough IRA to fill up a specific tax bracket – see below for tax brackets by income.

Unfortunately, it may not be possible to dodge all instances of Tax Jail and Tax Torpedoes. However, some extra planning and maybe some intentionally higher taxes in the short-term to lead to more flexibility and less taxes in the long-term.