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The Retirement Tax Trap and How to Dodge It · Retire and Thrive

• 0:00
  You have control of what tax brackets you're going to be in
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  to some extent when you retire. We've almost tripled the amount
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  of debt this country has just over the last 15 to 20 years.
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  And so if you look at the government as a business, they
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  need to drive revenue, which the majority of that's coming from
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  taxes, and put something in the rock.
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  I don't care if it's three percent, 5% because what you
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  really don't want is to get to be 65 or 60 years old and you've
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  got 100% of your money pre tax and you are 100% dependent on
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  what future tax rates are. Welcome back to another edition
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  of Retire and Thrive, where we help you build your life with
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  purpose, wealth, and confidence. Yes, whoo, it's Halloween.
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  And you look at how festive you are.
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  You look. Perfect.
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  I know finances don't have to be scary.
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  We're releasing this on Halloween.
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  You might watch it whenever, but we appreciate you joining us and
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  we hope that we can help you thrive with your finances.
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  I'm Cammy, This is Dan, and we have a lot to talk about today.
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  We've been touching on taxes, but we also get off on a few
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  tangents sometimes. And last week, last episode, we
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  discussed Roth IRA's a little bit and Dan teased that we were
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  going to continue that conversation this week.
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  So let's get to it right away. Alright with you.
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  Thank you for reminding me, yeah.
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  You said it. So like we got to remember, we
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  have to remember we're touching on Roth IR as because he gets
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  very excited when we touch on Roth IR AS.
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  So first let's get right into how can I put my money in a Roth
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  IRA? What does it cost me?
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  How do I go about it? Where do I start?
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  Yeah, so I don't want this to be Cammy.
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  Too spooky? You're so good, Dan.
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  Aren't they, aren't they funny? Yeah.
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  To answer your question, there's, there's three ways to
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  get money into a Roth IRA and it doesn't necessarily matter if
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  you're working or not working. If you're not working, you know
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  you don't have the same. You could, you could do a couple
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  different scenarios, but let's first start out with the
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  traditional Roth IRA and that is contributing to a Roth account.
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  And as long as you meet certain income thresholds, in other
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  words, if you have too much income, you can't contribute to
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  a Roth IRA. So as long as you have earned
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  income, because often times I get asked the question how much
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  can I contribute to that Roth IRA.
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  And the dollar amount is the amount that you can contribute.
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  It is a fixed dollar amount and it changes year after year tends
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  to go up. However, if you have too much
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  income, you are not eligible to contribute to a Roth.
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  And again, those numbers vary whether you're finding a single
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  tax return or a joint tax return, but but you can
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  contribute and that's just a traditional Roth where you're
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  contributing. How much does it cost?
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  It cost nothing. It depends on where you invest
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  that money. So you could put $7000 if you're
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  contributing $7000 this year, you can contribute that and you
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  could put it in your bank. You could put it with an
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  investment firm and they may charge you some fees.
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  And so it just depends on how you invest it.
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  But that's the first one is just contributing what we call the
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  traditional Roth. OK.
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  The second one, you have to be working for this and your
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  employer has to allow it inside of their retirement plan.
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  But what a lot of people don't realize is that most retirement
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  plans, 4 O1, KS40, 3BS have a component in there that you can
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  put money into a Roth. And so people get a little bit
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  confused. They're like, well, I'm just
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  putting it in my 4 O 1K and I'm like, why?
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  You put it all pre tax or some Roth and they're like what's
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  just going into the four O 1K. And I said the four O 1K is the
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  type, but you can choose to put it in pre tax or you can put it
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  into Roth and there is a significant difference.
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  And so if you put it pre tax, and again, I just will use a
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  very basic number. If you put in a total of $5000
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  pre tax and you've got an income of $75,000, you will reduce your
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  income by the amount you're contributing to that four O 1K
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  from your regular income. If I'm making $75,000, I put in
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  $5000 into into my pre tax. My income that I report now is
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  70,000. And of course you're going to
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  have standard deductions, you're going to have other deductions.
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  We're talking about, you know, health, health insurance and you
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  know, the Medicare and, and Social Security.
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  But for all practical purposes, if you invest pre tax, you
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  basically reduce your income by the amount you're contributing
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  to that. The downside to that Cammy, is
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  if you're putting in $5000 every year pre tax into your
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  retirement plan as it continues to grow and grow and grow, when
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  you do go to use that in retirement, every dollar you
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  pull out is fully taxable. Why?
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  Because you've never paid tax on that money.
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  OK, so. Pre tax, yes.
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  Let me let me give you an example.
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  This is in my book. It's, it's kind of a little
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  funny story, but it, it, I think it hits home.
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  So there's a section in the book that says, would you borrow from
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  your rich uncle? And I've done this, you know,
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  when I've spoken to, to larger groups also, I've given the same
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  story. And so the story is basically
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  this. If you've got a rich uncle and
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  you needed some money and you went to your rich uncle and
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  said, hey, Uncle Joe, can you borrow me $100,000?
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  And he looks at you and he says, yeah, let me get out my
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  checkbook and write you a check and gives you $100,000.
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  And you're feeling really good about that.
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  And then you get up and you start to to leave his office and
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  you're like, oh, by the way, what's my interest rate on this
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  loan? You're borrowing me.
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  And he looks at you and says, yeah, don't worry about the
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  interest rate. He said, I'm doing pretty well
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  right now. And you're like, well, how about
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  my payments? How much do I have to pay back?
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  And his response is, don't worry about payments.
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  I'll let you know when I need money.
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  And I asked people in the audience or people I've talked
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  to, I'm like, would you sign up for that?
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  And everybody's like, well, no, I wouldn't do that.
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  I mean, you don't even know what your payments are.
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  You don't know what you have to pay back.
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  Well, that's really what the pre tax 4O1K is because you're
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  borrowing, IE you're not paying your fair share taxes because in
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  that scenario you avoided claiming 5000 of incomes.
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  So you avoided taxes, IE it's kind of like a loan.
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  And when you go to pull it out, you have no idea what tax rates
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  are going to be. So there's that element of
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  uncertainty. Risky.
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  Yeah, I think just we, we. We think the tax rate would
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  likely go up and not down. I would say with a high degree
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  of certainty, taxes will go higher, not lower, not lower,
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  but I don't know, I, I, I feel like I know this is a, a, a, an
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  episode on taxes. So I'm going to touch on this.
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  If I look back to the 1920s all the way through, current tax
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  rates up until 1986 have always been higher.
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  The top marginal bracket has always been higher than 50%.
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  So from the 1920s all the way through 1986, they never were
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  lower than 50%. In fact, in 1940, the top
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  marginal tax bracket, it was either 92 or 94%.
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  Today the top marginal bracket is 37% on the federal.
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  So is it likely to go up? You know, since 1986, we've
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  never seen taxes go above 50%, but prior 1986, it was always
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  about 50%. And there are people that have
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  commented when I've made that statement before to say, well,
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  you had deductions back then. And I get all of that.
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  I'm just saying in general, we're not really in a high tax
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  bracket relative to historically where we've been.
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  And the second component that I feel like we are likely going to
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  see higher tax rates down the road.
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  Again, I've mentioned this last time, not necessarily in the
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  next few years. I'm talking in the next 1015
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  years, I think you'll see a fairly large tax increase.
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  And that is the government has taken on a lot of debt over the
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  past simply five years. And again, we've almost tripled
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  the amount of debt this country has just over the last 15 to 20
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  years. And so if you look at the
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  government as a business, we've got revenue on the top and
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  everything else below it. They need to drive revenue,
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  which the majority of that's coming from taxes.
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  And again, I don't want to go too deep on that 'cause we're
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  talking about the Ross, but you can contribute through a
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  traditional contribution. That's way #1 The second way is
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  you can contribute if it's allowed in your employer. 4O1K.
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  So let me or 4 O 3B, whatever the qualified plan is.
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  But let me finish up on that because we're talking about pre
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  tax. So you make $75,000.
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  You put $5000 into the pre tax you pay.
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  You don't claim that 5000 as income, you only report 70,000.
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  That's the simple version. In the Roth you make $75,000.
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  And if you contributed that same 5000 into the Roth component of
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  your 4O1K or 4O3B, you still report 75,000 of income.
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  In other words, there is no deduction.
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  But here's the beautiful thing. If you put $5000 a year in every
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  year during your working years for 15/20/25 years, all of the
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  earnings, so hypothetically, let's just say you did $5000 a
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  year for 20 years, you've put in a total of $100,000.
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  Maybe at the end of that 20 years, depending on rate of
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  return, it's worth $300,000. That $200,000 of growth 0 tax.
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  In other words, even if they're invested exactly the same,
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  forget about performance for a minute, but if you contributed
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  $5000 a year every year into the pre tax and it grew to 300,000,
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  every dollar you pull out of that 300,000 is 100% taxable.
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  In the Roth, none of it's taxable and US you basically pay
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  tax on the 100,000, but there's no tax on the growth, which is
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  huge. Why would you go the other
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  option then? Why would you go the other
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  route? Either people aren't informed or
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  they think taxes are going to go down or their focus is very
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  short sighted. It's like I want to save taxes
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  now because if I'm the 30% combined tax bracket and I put
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  $5000 into pre tax, that's going to save me approximately $1500
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  in taxes. And so I, I, I think that often
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  times we are very short sighted in our decisions about saving
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  taxes here and now and not looking out the next 1520 thirty
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  years. When can you pull out of a Roth?
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  Depends on which type. If you make contributions and
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  you're contributing to four O 1 K, first of all, you have to
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  retire inside the four O 1K. So those take on the qualified
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  rules. So let's forget about that for
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  just a minute. But let's say you put in $2000 a
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  year every year in a Roth account for 20 years.
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  You've contributed a total of 40,000 dollars, $2000 a year, 20
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  years, and let's say it's worth 100,000.
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  You have to wait five years from the date of contribution to pull
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  out that money. But you have to wait till you're
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  59 and I have to pull the earnings.
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  But no matter what age, you can always pull out your initial
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  contribution amount without penalty.
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  So if I'm 40 years old and I contribute $5000 a year for ten
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  years or $50,000 at age 50, I can always pull out that 50,000.
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  It's the earnings. I have to wait until either five
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  years or 59 1/2 and you always have to wait till you're 59 1/2
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  to avoid any penalties. Sure, sure.
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  One final question. We'll keep it brief and then
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  we'll move on. Why is it called a Roth?
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  Yeah. So Roth was brought before
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  Congress by Senator Roth. So that's where the name, the
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  name Senator Roth comes from. And it was in the 90s that the
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  Roth got implemented. OK.
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  But before you leave me, there were three ways to contribute.
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  I've talked about two and I know I get a little long winded, so
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  apologies for that. The other way that is very, very
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  common is what's referred to as a Roth conversion.
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  And a Roth conversion is nothing more than if you have pre tax
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  money. So let's say you've got money in
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  your 4O1K, you're now 60 years old and you've got 300,000 bucks
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  and you're like, hey, I want to take 100 of that and move it
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  from IRA to Roth. You do pay tax on that
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  conversion, so you report that 100,000, but then whatever that
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  100,000 grows to 0 tax. So in summary, traditional is
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  just contributing. You could do it through your
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  employer's work, or you can take IRA money and move it to a Roth,
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  which is called a Roth conversion.
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  OK, a lot of information. Thank you so much, though.
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  I mean, that can apply to everyone, which is fantastic.
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  Absolutely fantastic. All right, let's talk about
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  retirement and taxes. And sometimes there is the
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  retirement tax trap. Is that a thing and how does it
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  come to be? I think a tax trap is real.
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  And I think the tax trap, at least in my view, is, you know
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  what, I made a lot of money in my earlier years.
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  Now that I retire, I'm going to be in a much lower tax bracket.
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  And that to me is a tax trap. And I think that depends on a
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  lot of factors. But we find a lot of people that
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  live, and I don't know if it's a Midwest thing or what, but live
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  a very conservative lifestyle and they get to retirement and
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  they've got two $3,000,000 that they've saved at 65 years old.
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  They had no idea. And all of a sudden they think
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  they're going to be a lower bracket and they realize they're
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  not in a lower bracket. Forget about tax rates.
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  I'm just talking about their income actually goes up, not
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  down. Right.
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  OK. So that that comes into play,
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  why is it important to think about your taxes before heading
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  into retirement? If we're talking at age 50, it's
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  important, but if we're talking in the 30s, why that's
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  important? I think we touched on the Roth,
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  why that is important, right? And that's just kind of that
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  whole compound effect that, you know, the money's just
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  compounding and you want it to compound where you can pull it
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  out with 0 tax or do you want it to compound where you pay taxes?
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  And the uncertainty with, again, that rich uncle, so to speak.
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  But as you head in, you know, often times people will say, how
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  much should I have in my Roth account?
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  And it hasn't happened often, but there's been a few times
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  where I'm like, I think you've got a bigger percentage in there
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  than you need to. In other words, you're always
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  going to be in the 12% bracket. So stop converting or stop
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  contributing because you don't have a lot of other sources of
• 14:04
  income other than Social Security.
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  So again, it varies based on, you know, each situation.
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  But when you're in your 50s and you're starting to approach
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  retirement, you know, one of the first things that we do, Cammy,
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  is we look at the overall balance sheet.
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  And the balance sheet of course is all of your assets less what
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  you owe or liabilities. But oftentimes we look at people
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  that have been very, very good savers and they're in their mid
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  50s and they want to retire in seven, 8-9 years.
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  And we look at their balance sheet and we take oftentimes
• 14:33
  their real estate out of the equation.
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  So we look at just their portfolio.
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  Sometimes we'll see 6070% of their entire portfolio is in pre
• 14:40
  tax that's never been taxed. And I can tell you specifically,
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  we've got a client of ours that just retired a year and a half
• 14:47
  ago and very aggressive saver. He was an executive at a Fortune
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  500 company and we did this analysis probably 8 or 9 years
• 14:55
  ago and he was in his early 50s and he literally had 90% in his
• 14:59
  four O 1K. Very generous match by the
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  employer. Plus he was maxing it out every
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  year and I said you are setting yourself for a tax bomb.
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  And so he, even though he was at a very high income tax bracket,
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  he was in the 24%. Sometimes he'd creep into the
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  35%. But even though he was in a high
• 15:19
  bracket, we convinced him to start contributing some, not all
• 15:24
  into the Roth component of his four O 1K.
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  And Fast forward today, he's got about 30% in Roth and set of the
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  retirement accounts. I should say he's got about 30%
• 15:35
  in Roth and about 70% pre tax. And he's a, he's a prime
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  example. He made the comment to me.
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  He's like, well, I feel like I should have a lot more into the
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  Roths. And I'm like, look, you had
• 15:45
  none, OK, practically none. You had some after tax money,
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  but you had none in Roths, you know, 10 years ago.
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  Now you've got 30% of your portfolio that's in Roth and
• 15:55
  when I look at how much you should have in a Roth account,
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  it's not always about I want to have as much as I possibly can
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  so I don't pay taxes. What it allows you to do once
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  you're in retirement, big difference between accumulation
• 16:06
  retirement. You have control of what tax
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  brackets you're going to be in to some extent when you retire.
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  What buckets do we pull from to supplement shortages?
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  And that's exactly what happens is if I've got 700,000 in pre
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  tax and 300,000 in a Roth and I'm getting Social Security and
• 16:22
  my spouse took the pension and all of a sudden we're, we've
• 16:25
  made the decision that we want to buy a motorhome or we want to
• 16:30
  buy a boat, which we see this thing all the time.
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  And they'll call me up. And it's just a simple question.
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  Hey, Dan, can we afford $130,000 motorhome?
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  We'll run the analysis, Cammy. We come back and say, Yep, you
• 16:42
  can afford it. And they're like, all right,
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  just send me a check. And I'm like, hold on, hold on.
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  Where are we going to pull it from?
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  And we'll look at the numbers and we'll say you can pull
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  50,000 out of your IRA. You're still in that 12%
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  bracket, but we're going to pull the other 50,000 out of your
• 16:58
  Roth. And So what that does and the
• 17:00
  way I explain it to people is the beautiful thing about the
• 17:02
  Roth is you are in the driver's seat.
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  You have complete control. In other words, if they didn't
• 17:07
  have any Roths and we had to pull all 100,000, they're going
• 17:11
  to go from 12% to 22% on that additional $50,000.
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  In other words, it'll cost them a little over almost 11,000 in
• 17:18
  taxes versus being in the 12% plus whatever the state portion
• 17:22
  is. So it doesn't really matter how
• 17:24
  much you've got in Roth accounts.
• 17:26
  Obviously more is better, but at the end of the day it's about
• 17:28
  your ability to control it for these one off expenses.
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  So I am not educated when it comes to the tax brackets and
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  when is it important to start looking at that?
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  Is it whenever or is it once you're closer to that retirement
• 17:43
  age? And for those who also have no
• 17:46
  idea about the tax brackets and where they fall, how can they go
• 17:49
  about learning more about it? I mean, obviously financial
• 17:53
  folks, advisors can help, but is there a way at home that they
• 17:56
  can start assessing where they'll be?
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  Yeah, I think that is a great question because I think I even,
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  I even look at people that are in their 20s and 30s and they
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  have no idea. And so I want to just clarify
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  what your question is, because I don't think you really even know
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  what I'm about to tell you because my mind goes different
• 18:17
  ways at different times. But when we're talking tax
• 18:19
  brackets, there's two things I want to clarify. 1 is the tax
• 18:22
  bracket that you're in. The other is your effective tax
• 18:26
  rate, which are two totally separate things.
• 18:28
  So when we talk about marginal tax brackets, I had mentioned
• 18:32
  this on the previous episode, it starts at 10, then it goes to
• 18:35
  12, jumps to 22, then 243235 and 37.
• 18:41
  So those are the marginal tax brackets.
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  What's really important is if you look at your effective tax
• 18:49
  rate and the difference is that if you are in the 12% tax
• 18:54
  bracket based on your income and you earn another $1000, it's
• 18:58
  only the $1000 that puts you into the 22%, not all of your
• 19:02
  income. So if you just creep into the
• 19:04
  next tax bracket, your effective rate might go from 12% to 12.8.
• 19:11
  But if you've got an extra $40,000 worth of income that
• 19:14
  creeped into the 22% bracket, now you might be in the 16%
• 19:17
  effective tax bracket. And then you throw in the Social
• 19:21
  Security and the taxability based on different brackets.
• 19:23
  And that's why just staying in the 12% bracket isn't the end
• 19:27
  all be all, because some people get taxed at Social Security
• 19:31
  even though they're still in that 12% bracket.
• 19:33
  But for somebody your age, absolutely.
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  And where do you start? First thing I would do is I
• 19:39
  would go home today. I'll wait to get your text
• 19:42
  tomorrow so you can tell me you did your homework.
• 19:45
  But take a look at your tax return and look at what
• 19:49
  everything when we talk about tax brackets, by the way, Cami,
• 19:51
  we're talking about effective tax rate and effective and it's
• 19:56
  the based on the taxable income. So your gross income is the
• 20:01
  total. But then again, if you're
• 20:02
  contributing to pre tax that gets reduced.
• 20:04
  We're talking about standard deductions that gets reduced.
• 20:07
  So we're looking at your total taxable income after all
• 20:10
  deductions and then you look at. The bracket that that falls in
• 20:15
  and you can use, go online, you can say, well, how much income,
• 20:18
  again, it depends on whether you're filing a single tax
• 20:21
  return, a married, married filing separate, but just look
• 20:25
  at the tax type that you're filing.
• 20:27
  Look at your taxable income on your tax return.
• 20:30
  It'll tell you what bracket you're in.
• 20:32
  Then the effective rate is look at the bottom line, the total
• 20:37
  tax you owe before it talks about withholding.
• 20:40
  That says total tax you owe. Divide that by your taxable
• 20:43
  income and that is your effective tax rate.
• 20:47
  And yeah, that's important. And let me tell you why I feel
• 20:49
  like I'm rambling here, but this is so heavy.
• 20:53
  Why is that important? OK, well, let's say that right
• 20:57
  now, your income is such that you, you were in the 12%
• 21:03
  bracket. I mean, I'm just grabbing
• 21:05
  numbers here, but let's say you're in the 12% bracket and
• 21:07
  you're contributing $10,000 to your retirement plan.
• 21:10
  And for me to come in and just say, you know what, put it all
• 21:12
  into the Roth account and you'd be like, OK, that's what Dan
• 21:15
  said to do, so let's do it. Well now if you're putting
• 21:19
  $10,000 into your 4O1K and you're still, and that's keeping
• 21:24
  you within that 12% bracket because remember if you're
• 21:27
  making 75 and you're putting in $10,000, you're reporting
• 21:30
  65,000. Now you contribute to a Roth and
• 21:33
  you're going to now report 75,000.
• 21:35
  In other words, it's important you know your tax bracket so
• 21:38
  that how much do I put in the Roth versus how much do I put in
• 21:42
  pre tax? Because if, if putting money
• 21:45
  into the pre tax is keeping you in those lower brackets, the
• 21:47
  last thing you want to do is jump up 10% just to put money
• 21:51
  into Roths. And so if we don't know all
• 21:53
  these answers, at a minimum, I always tell people that are
• 21:56
  younger, put something in the Roth.
• 21:58
  I don't care if it's three percent, 5%, I don't care if
• 22:01
  you're putting in 10%, do 5:00 and 5:00, but start putting
• 22:05
  something in there. Because what you really don't
• 22:07
  want is to get to be 65 or 60 years old and you've got 100% of
• 22:11
  your money pre tax and you are 100% depending on what future
• 22:15
  tax rates are. And it's like, it's a little bit
• 22:19
  of a corny analogy, but it's so true.
• 22:20
  I could have the largest 4O1K that I ever imagined, but if
• 22:26
  I've never paid tax on it, it's almost like the largest
• 22:28
  mortgage. It's a debt.
• 22:29
  You owe money on that. And one of the advisors at our
• 22:32
  firm says, well, you literally own that jointly with the IRS
• 22:35
  because they're going to grab some of it, right?
• 22:37
  Right, and that can be disheartening when you get to
• 22:41
  that point where you're pulling that money out.
• 22:43
  Oh, we've covered a lot here. There's a lot to talk about.
• 22:46
  Anything more that you'd like to touch on?
• 22:47
  We touched on the tax traps slightly.
• 22:49
  If anyone takes anything away from this episode, what would
• 22:52
  you like it to be? I I think the pre planning and I
• 22:55
  feel like I say that often, but if you are in your 50s, take a
• 22:59
  look at you, you still have time.
• 23:01
  I guess that's kind of the message.
• 23:02
  I'm saying if you're in your 50s and you're not going to retire
• 23:05
  for 7-8, ten years, take a look at your balance sheet or just
• 23:09
  your portfolio. See how much you've got in pre
• 23:11
  tax, see how much you've got in Roth, see how much you've got in
• 23:14
  non retirement and just start looking at the percentages.
• 23:18
  And if those percentages look out of whack, you need to do
• 23:21
  something. And there's no hard fast rule to
• 23:23
  say you need to have 30% in Ross and only 40% in pre tax.
• 23:27
  There's no hard and fast rule because in everyone's situation
• 23:29
  is different. But you'll know, I mean, if
• 23:31
  you've got 8090%, that's all pre tax and you're patting yourself
• 23:34
  on the back saying, jeez, I'm 55 years old and I already got
• 23:36
  1,000,000 bucks. That's awesome.
• 23:38
  But again, you in essence own that jointly.
• 23:40
  And there's that big uncertainty of what future tax rates are
• 23:43
  all. Right, good advice.
• 23:44
  Anything more? I think we went a little heavier
• 23:47
  on the Roth than I was anticipating.
• 23:49
  So I again, that's just, I'm very passionate about it because
• 23:52
  it does take away a big, big, big uncertainty of future tax
• 23:56
  rates if you've got that money into the Roths.
• 23:58
  But I would like to circle back as we kind of wrap up next week
• 24:02
  with this lesson 6 about taxes. I do want to circle back because
• 24:07
  there are some things I'd like to touch on specifically for
• 24:09
  retirees. I do want to say something
• 24:12
  probably less financial but more personal.
• 24:15
  As we've you know, here we are in episode 20, and I just was
• 24:18
  thinking about this the other day and I'm like, we're already
• 24:21
  going to be on lesson 6 and there's seven lessons in the
• 24:24
  book. So the podcast will not end.
• 24:27
  Let me make that very clear. But I had someone the other day
• 24:30
  that was asking me very specific questions around Medicare and he
• 24:34
  literally said it's so confusing and it's so overwhelming.
• 24:38
  I feel like you should talk about it.
• 24:39
  So there's lots of other topics we'll talk about, but yeah, it's
• 24:42
  just amazing how. There's a lot to get to and
• 24:45
  people have a lot of questions and it can always be reiterated
• 24:48
  too. All right, Dan, thank you so
• 24:50
  much. Thanks to you for joining us
• 24:51
  here this week. We hope you have a great rest of
• 24:54
  your day. And we will be back here next
• 24:56
  week with another podcast each week for dropping.
• 25:00
  Thanks again for joining us. You can follow us anywhere.
• 25:03
  You get your podcasts and we will be there.
• 25:06
  And if you're on YouTube, you can subscribe and just write
• 25:10
  down any questions you have too, because we will take a look at
• 25:13
  the comments, whether it be on Spotify or YouTube or wherever
• 25:15
  you get your podcast. And we hope to answer your
• 25:17
  questions. If there is something specific,
• 25:19
  we will take a look. Happy Halloween, by the way.
• 25:22
  Happy Halloween to all of you as well.
• 25:24
  Have a great rest of your week. We'll see you later.
• 25:27
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• 25:30
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• 25:33
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