Latest / Federal Retirement Advisors | FedLegacy / The Federal Tax Window: What To Decide Before TSP Withdrawals Start
Transcript
- William Smith: How's everybody doing tonight? Tonight we'll continue our We've been talking a lot about proper retirement planning as we always do. And tonight the the key topic is the tax window in retirement. Tax window, the window in retirement is a very topic because it's so new it's so unique to this current time. Because before 2001, ⁓ This was not a conversation that was had much. ⁓ well, it was had, but it wasn't as urgent as it is now because there was no such thing as a Secure Act two point ⁓ that that that mandated that 10 year rule you pass away, right? And what happens to your money when you pass away. That has created a lot of urgency when it as come to retirement planning because now There's there's there's consequences if you're leaving a bunch of money in your traditional TSP or your traditional IRA or your old 401ks, money that's considered qualified. And so money that's considered qualified is money that the IRS just hasn't taxed yet. So we're gonna go deep into that today. and so and so one of the things that I was talking to a client about the other day in one of our retirement sessions is this because they were asking me, they said, Mr. Smith, well. Why is this so pertinent during this time around proper tax planning? And here's the answer I gave. I I said, well, if you think about it, before 2022, 2021, when the Secure Act was passed. Government knows how much money is in qualified in traditional TSP, which is considered qualified funds. And so let's take if you're the if you're the government and you look and you say, okay, we have, and I'm just making this number up, we have $10 billion or $100 billion in our TSP plan. Of that $100 billion, $75 billion of that is still considered qualified money. And by qualified money, that means That is money that we've deferred the taxes on and the taxes are still due to us. If you're looking at that and you're the government and you're doing some financial planning for the future and you need tax revenue, if you look at that $75 billion that still has taxes owed on it, the thing the next question you might have is this. Well, how when are we going to get that money? There's no way of knowing. But in the past, they had what was called a stretch IRA, that when when you pass on that money. that you that you have will go to your children or your spouse, they could use what's called a stretch IRA, which will allow them to not take that money until they're at the RMD age, requirement and distribution age. And so that's the way it was for years and years and years. But after two thousand, after the Secure Act was passed, once you pass on, your family has ten years to then take that money out and and and give the IRS their portion. So going back to my initial example, that's 75 million that the I and and I'm just that number's made up. That's 75 million in qualified seventy five billion in qualified funds that the government's looking at, they're saying, okay, if we s if we pass this Secure Act, we put a 10 year limit on how how long a ch a this a descendant can an can ⁓ can hold the money, they have 10 years and they have to take them they have to pay to pay the taxes on it. Now we know, okay, well, the average life expectancy is one thing. The kid is had to have it for 10 years. So we know, okay, over the next 20 years or 30 years, we're gonna have X amount of revenue coming in this way. And now we can control it and we get to that money a lot faster. Why is it important to you now in this moment? Because that's what they did back when the Secure Act was passed. There's nothing stopping them again From doing it again. Maybe that's raising taxes. Maybe that's you know, putting another stipulation in there to go get that money that's still theirs, and that can change at any time. So the goal that I have for you is you want to take control of the money that you have. And so one thing we always talk about is this there's no way to avoid paying taxes. There's just no way, right? People, you you cannot avoid paying taxes. Even if you're a business owner, yes, you can reduce the amount of taxes you pay, but there's no way to avoid it. The thing you can do through proper planning is you can reduce the amount of taxes that you pay through proper planning. And so when it comes to your planning, that's the thing you want to do, right? And so when it comes to federal employees, and I always say this, you all's benefit package is different than everybody else's. So what you see on the news and what you read in the And in the newspaper, people still read newspapers or what you read online, general financial advice is very different for you all. And so the thing that makes federal employees different is that you have what we call a tax window. Now that tax window is after you retire. And the reason why that is, the reason why that exists, and it's two different ones. You have your tax window if you retire before 57, I mean after 57, before 62. So have your 57 to 62 tax window. That's an important tax window because at that point, let's just say for an example, your salary and to keep it simple, let's say your salary is $100,000. When you retire, and that's your salary when you're working, $100,000. When you retire, and let's say you're 57, your income, and let's say, and again, ⁓ just doing simple math. Let's say you're bringing in. $100,000. When you retire, between your pension and your first supplement, if you're eligible for the first supplement, now you're bringing in, let's call it $60,000 because you're making less income. From 57 to 62 as a federal employee, you're not going to get any raises during that time period. There's no cost of living increases or anything like that. anybody that retires from 57 to 62. Now there are some stipulations if you're on here and you're law enforcement and things like that or foreign services, you do get those increases. But if you're law enforcement, I mean if you're a regular GS employee, you're not gonna get any raises from 57 to 62 from your pension. So you're in a lower tax bracket at that point. You know what your income's gonna be during that time period. And so that's a good that's that's the first window if you retire, because now you have reduced income. Your social security hasn't quite kicked in because your first supplement is going to be less than your first up than your than your social security. So what do you do during that time? During that time, what we like to do is we like to look at your tax brackets and we like to say, okay, you're in this current tax bracket, you know, let's call it the 12% tax bracket. So we wanna look and we can look at it like a glass of water or a glass. We wanna make sure. If you're at a quarter of that glass, which is the tax bracket, we want to fill that bracket all the way up to the top to the most we can without going over. Now, if we go over into the 22, that's okay, you know. it's just depending on how much you have. But we want to at least fill that bracket up with the Roth conversion, meaning moving money from the Roth to the traditional to from the traditional side to the Roth side. Super important thing to do, right? And the reason why that's important is because You're not triggering any extra events like Medicare, Irma, which I'll go through in a minute. You're not, you're not raising your your your your your your you're just not raising your taxes in general. And so that's that first window. The next window 62, right? So let's say you're not retired and you're and you're you're retiring after 62. At 62 is a little different because at that point, now you have your first pension, but you're Also eligible for Social Security. Now, depending on what your situation is, you might not need to take Social Security. And because you don't need to take Social Security, you also have a window there. You could take income from your traditional TSP and utilize that to as income because you just want to draw down on your amount of money that's in your traditional account. And you could do that, right? That's one strategy. Or you need Your pension plus your social security plus some extra income. That creates his own scenario. But the thing is, when you're doing that, you want to make sure that you're staying within that bracket as much as possible. So I was meeting with a client the other day and we were going through his retirement plan. And, you know, he's very excited. He was 64. He was retiring to 65. He was very, he's very excited. he had some bills he wanted to pay off. He had, All the stuff he wanted to do, but he hadn't really looked at his tax bracket. And so when we looked at everything, looked at what his pension was, we looked at his social security, we looked at his wife's income, and we noticed that he was about 30,000 off before he would go into the higher the 32% tax bracket, I believe it was. Right. And so what we did was we're like, all right, I know you, I know you, I know you want to take I know you need, I think he he needed about 55,000. And I said, look. I know you need 55,000, but how about we take 30, but 25 was how about we take 25,000 now? Because what we didn't want to do, we didn't want to increase his Irma premiums, which is a big thing. we wanted to make sure that he stayed within that lower tax bracket. That was really important to him. And so what we did was we laid out a plan over the next five years that keeps him in that lower tax bracket, keeps his Medicare premiums lower. And we and we did it like that. But we would have if if if he would have done it on his own without planning, it could have been problematic, but we were able to s we were able to smooth it all out because we were in that window where he still had the opportunity to make a choice. And so we say this all the time at Fed Legacy. It's one thing ⁓ have your numbers and know your numbers and things like that. It's another thing to a plan. Then The next window is right when you're at your required minimum distribution. And so while that's important is because when you get to the required minimum distribution, gets pretty interesting at that point. And the reason why it gets interesting at that point is because at that point, the government's like, look, it's time for you to pay, it's time for you to pay us. Right. And so you lose a lot of control at that point because the more money you have, in your traditional account during that time period is the more that you're going to be taxed. And so we just want to make sure that before you get to that point, you have taken out as much as you can from your traditional accounts. Super, super important. And so what we've noticed over time people that plan from the beginning, from when you first retire from 62 or 57, wherever it is, and you plan From then up into RMDs. The difference is hundreds of thousands of dollars when you look at it in the long run. And so just to simplify it, right? Let's say, say you have $500,000 in your TSP and it's all traditional. If you have $500,000 in your TSP and it's all traditional, well I often ask people, how much of that money is actually yours? And that, and that answer can vary. But what I will say, in most cases, when you take, when you look at the federal, and then you look at what I which I hate the most, honestly, no disrespect the state. Because it's one thing, you know you got to pay the federal. But then when the state kicks in, you're just like, ⁓ man, and you too. Because it's like it feels like, feels like it's like, all right, man, like here, here. And then it's like this other person right around the corner, like, and me too, right? The smaller person is like me too. That's how it feels when it comes to paying the state. No disrespecting the state, the Love the state. But it's just it's just that's what it feels like. And so when it comes when it comes to RMDs, the thing you have to think about is if you have 500,000, 300, you know, 70% of that is yours. 30% of that is going to the federal government and the state. Minimum in most cases. You know, and so it could be more, right? But you want to make sure that as five if using your that $500,000 example. 30% of 500,000 is about one is 150. As that money grows, now we have 600, now we have 700. That 30% gets a lot bigger, and that's more money going to the federal government, going to the state. And so that's another advantage of dealing with RMDs. I mean, Roth convergence and having a tax strategy early on in your retirement. Another question we get around the tax window should I use my tax window while I'm working? What does that window look like? Here's what we say about that, especially as federal employees. Until TSP fixes that inner service transfers, because right now what they have you doing is you have to pay the taxes out of pocket. Which a lot of times if you have a hundred thousand dollars and you're rolling it over to the tradition to the to the if you take a hundred thousand dollars, you roll it to the Roth, to the Roth side, Roth TSP, number one, if you make a hundred and fifty thousand, now you're taxed on two hundred and fifty thousand that year. That's how that works. But then now your taxable income goes up, plus on that transfer, you you pay the taxes based on that too. So now let's just say, let's call let's say you're in a twenty percent tax bracket, which you'd probably be you'll be higher, you know, you'll be in a higher tax bracket. If you if you if your earned income is 250,000. But now let's just keep the map simple. Now you got to pay out of pocket 20,000 cash. Now I'm not saying you, whoever's listening, does don't have that, but the you know, closer you get to retirement, having emergency money is really, really important because as we've talked about on many of these webinars, we you know, you know, people don't know when they're gonna get that first real check. And so oftentimes when we're talking to people about retirement, it's all we're always encouraging them, encouraging you to make sure you have a nice size emergency fund set aside this liquid cash that you can use in case you need it before they process your paperwork. And so the problem with in-service transfers is just that the cash is required to do that transaction. But the main thing is also when you're working and you do it, now you're getting taxed on your current income plus that. Conversion and it often puts you in a higher tax bracket. Whereas when you're retired and it happens, you're in a much lower tax bracket, and you can do it being taxed on less money when you do it that way. Right. And so that's why having that tax window and planted on that tax window is super, super important. And that's why we love having that conversation because we've seen the benefits over the long run with people that do proper tax planning. And those that don't. And another big thing, when you do it early on in your retirement, if you don't have any Roth TSP at all, and w will say this too, for any of you all that are still working, make sure you start contributing to the Roth TSP. Because when it comes to Roth accounts, you have to have money in there for five years. You want to start that you wanna start that time. You wanna start that timer where you have five years in a Roth account. That's super important to have. You wanna start that because if you wait till you retired, now you have that you have that five year window where you well, you could take money from your principal, but the growth you can't really take. But you just wanna have that five-year window started. But here's the benefit. The benefit of it is, is when you have a bunch of money in your Roth account, money that's already been taxed. So you have big things you wanna do in retirement. You know, we I was talking to a client and they wanted to Pay off their kids' student loans and their wife, their wife's student loans. So he's like, that's something I want to do. My wife went, got all these grad school student loans. My kids, you know, they they're they're raising their young kids and you know, their student loans are kicking their butt. It's just a is a pain in their side. I have all this money in my Roth, my income is fine. What can I do with it? I s you know, he's like, I w I really wanna pay off their loans. I was like, okay, cool, do it. And he did it. And it wasn't a hard transaction. Money's already taxed, it's an easy thing to do. And so that's the other benefit, especially for people that don't have any long-term care, need long-term care, often tell federal employees it's like, hey, let's start funding a Roth IRA now when you're retired, so that money can grow. Because what that will do also is if you ever have in a long-term care event when you're retired, that money can serve. as a conduit for that. Again, my whole thing all the time is making sure that you have peace of mind when you're in your retirement years so that you're not stressing. And so for federal employees, you know, people buy long term care all the time, there's nothing wrong with it. But as a federal employee, oftentimes, and again this is not for everybody, but I'm saying for ⁓ and what I've noticed in most cases, if you're a federal employee, you're a federal employee, you can at use as an option being self-funded with self-funded with your long-term care if you use your TSP properly. Again, I just want to put a disclaimer out there that's not for everybody. Everybody's situation is different. But what I've seen, if you sit down, you create a financial plan, your TSP oftentimes is not going to be something that you use every day for income, but it is something that you can use for long-term care planning if done properly. And it makes it a lot easier to do it when you have done the the the Did a did a proper tax strategy in the beginning, you let that money continue to grow and compound. You're older, you need it. It's easy just to take that money out without having to think about how much do you know, how much is how much do I have to pay the IRS every time I do this? You know, and calculate the 20% or 30% or whatever it is that you have to pay, get the IRS paid early on. In that early window, you get your your 57 to 62 window where you got a flat line income, you know your taxes are gonna be lower. Then in 62, you get a bit of a bump with Social Security because Social Security is going to be more than your first supplement. But also, if you have enough resources, you don't necessarily have to take your Social Security right there. You could just not take Social Security, take money from your TSP as income, but that you pay the taxes on that when you do it, you know, and then delay your Social Security and take social security at that point. the things you want to you look at and wanna wanna make sure you understand is. What are your potential Irma premiums? Super important because you don't want to trigger that just by doing Roth conversions and not understanding exactly what it is. Super important. And then understanding what happens with your spouse when you retire and things like that. So, and then that 10 year rule is really, really important.