Avoid The Tax Torpedo
Income taxes usually go up in relatively small increments. But there is one point in retirement where taking just a little bit more money out of your retirement plans could suddenly spike your taxes to rates approaching 50%. Here's how to recognize when you are getting near that point so that you don't get hit by the torpedo.
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https://calendly.com/stevewershing/inquiry
Full Transcript below:
Speaker 1 (00:07):
Welcome back to 30 Minute Money, the podcast that delivers action-oriented smart money ideas and bite-sized pieces. I'm Scott Fitzgerald at Roc Vox Recording and production. Steve Wershing joining me from Focus Wealth Advisors to give us the what for and how, is that what they
Speaker 2 (00:23):
Call it? All that good to see you, Scott. Good
Speaker 1 (00:25):
To see you too. So one of my favorite movies going back into the eighties is the hunt for red October. Yes.
Speaker 2 (00:30):
Great movie
Speaker 1 (00:31):
Shown Rey, and there's torpedoes going by and all this kind of stuff.
Speaker 2 (00:38):
That's right.
Speaker 1 (00:39):
But they're not tax torpedoes.
Speaker 2 (00:41):
Those were not tax torpedoes,
Speaker 1 (00:43):
But I hear they're just as dangerous. There
Speaker 2 (00:45):
Are in fact tax torpedoes.
Speaker 1 (00:48):
I love, we're talk about terms that you guys come up with and I see tax torpedo on my sheet and I'm like, that's
Speaker 2 (00:53):
Right. Okay. And as I was writing this out, I was thinking, you know what we need on this podcast, Scott? We need sound effects. Yes. We need to stick sound effects in here. So one ping only
Speaker 1 (01:04):
Please.
Speaker 2 (01:04):
I'll start. Boom. Yeah, so that's right. Exactly. So what
Speaker 1 (01:11):
Is a tax torpedo?
Speaker 2 (01:12):
And so we should probably do this in our Sean Connery voices, right? Is
Speaker 1 (01:15):
Oh, yes. Yeah, that would be, and watch the listeners drop off is
Speaker 2 (01:18):
Totally unlistenable, right? But yes, we're going to talk about the tax torpedo and especially how to avoid it. And it does not involve sailing quickly underwater at the,
Speaker 1 (01:35):
Or countermeasures
Speaker 2 (01:36):
Or countermeasures or any of that kind of stuff. No, it's easier than that, thank goodness. So before we talk about what the tax torpedo is, I should revisit real quickly that one of the differences between during your working life and during your retirement is that in retirement, your tax different ways, and there are different kinds of taxes that you have to pay. And this is where the torpedo comes from, is that when you're working, you have salary, you're taxed on your salary, right? It's pretty straightforward. In retirement, you have income tax, and when you're working, you have capital gains tax, but then you also have tax on social security, which can be avoided. And you've got something called Irma, which is an additional tax on Medicare if you make enough money. And so we have whole different kinds of taxes that we have to pay, and these all get blended together to figure out what your total tax burden is.
(02:39):
And the tax torpedo refers to some specific points as your increasing income in retirement when all of a sudden your marginal tax rate jumps. It's not when you're working and you have, right now we have income tax rates that are 10%, 12%, 22%, 24%, and so on. It's just a stair step. There's no spike in the middle of it. But when you start adding these other taxes into it, you can have this phenomenon where all of a sudden your marginal rate jumps way above all the rates that get published for a certain amount of time until you work it off, and then it goes back to kind of being normal. That's what the torpedo is. So what we need to be careful of is not to cross over one of those thresholds because if you just take a little step over that line, all of a sudden you'll have way more text than you were anticipating, and that little bit of extra income that you wanted to take, a lot of it may end up going off to the government.
(03:48):
So in retirement, you have income tax, just like in your working life, you've got capital gains tax just like your working life, but social security also can be taxable, and that works differently than tax on your income. So when you're earning a wage, again, it goes up in a little stair step. So when you begin making money, you pay tax at 10%, and then when you make above a certain amount, it goes to 12%. When you make above the next threshold, it goes to 22% and so on and so on. When you hit the threshold for paying tax on social security, all of that social, that amount of social security is suddenly taxable all at your top marginal rate. So it's not a subtle little stair step like income. It kicks in all at once. So either 0% of your social security is taxable, or 50% of your social security is taxable, or 85% of your social security is taxable. And that's when that happens. All of a sudden you're taxed on a whole bunch of money that you weren't taxed on the dollar before. That right there, that's the torpedo.
Speaker 3 (05:02):
How does that
Speaker 2 (05:02):
Happen? Well, it happens because partly because figuring out whether or not social security is taxable is a whole separate calculation than income. So income you have on the front of your 10 40, you've got this amount of income, and then you've got some things that can offset that income. And then you come down to this taxable income down at the bottom of it, adjusted gross income and then taxable income. But with social security, there's a separate calculation called provisional income. And provisional income includes your modified adjusted gross income, plus you add back any tax exempt interest payments. So if you are investing, for example, in municipal bonds or something like that because you don't want to pay tax on it, that's cool, but it may contribute to the taxability of your social security. They add that back in plus half of your social security benefit.
(06:01):
So we have to figure out what that provisional income is to figure out whether or not your social security is taxable. Separate calculation, it involves the adjusted gross from your tax return, but then it adds a bunch of things into it. And if you're married and you're filing jointly that provisional income calculation when it hits $32,000 per year, this is in 2023, if it hits $32,000, then all of a sudden 50% of your social security benefit gets taxed. And if you hit 44,000 of provisional income, then 85% of your social security gets taxed at whatever the top marginal rate that you're paying right then is. And so let's talk a little bit about, so you can go from none of it being taxed to 50% of it being taxed to 85% of it being taxed. And those are not subtle moves. Those are big changes all of a sudden when you cross over that line with provisional income.
(07:05):
Do you have an example? I do. So let's talk about this one couple, John and Jane, they're above 70, they're in their seventies, so they're taking required minimum distributions combined. They have $60,000 of social security income. They have in this one particular example year, they've got $15,000 of capital gains from buying and selling things in their brokerage account, and they're taking $45,000 per year out of their IRAs to supplement their income and do it. So that's the scenario. So you've got 60,000 of social security, you've got 15,000 of capital gains, you've got $45,000 of money coming out of their IRAs, and so they're paying 12%, I'm sorry, they're in the 12% marginal bracket. Let's say that they wanted to take a little extra vacation, so they pulled another thousand dollars out of their I R A. Now if they're in the 12% bracket, you would think that that's just going to mean another $120 of taxes.
(08:15):
Makes sense, right? Sure. But the problem is they cross over a line and they get hit by the torpedo. And so here's what happens. They have to pay the 12% on that 120, that thousand dollars. So that's $120. However, they crossed over that line of provisional income. So now all of a sudden they cross over that line and suddenly their social security becomes more taxable. That adds another a hundred dollars of tax to that a thousand dollars distribution. And because they stepped over the line from the 0% capital gains to the 15% capital gains bracket, they've got another $277 to pay in capital gains tax. So they didn't have to pay before. So if you take the 120 plus the 102 that they're going to have to pay on their social security plus the 277 because now they have to pay tax on all of the capital gains that they've realized that year, that adds another $499 to their tax bill. So taking out a thousand dollars cost 'em $499 worth of tax, which is an effective rate of,
Speaker 1 (09:32):
Wow,
Speaker 2 (09:33):
49%.
Speaker 1 (09:35):
Wow.
Speaker 2 (09:35):
Exactly. That's the torpedo. They went from 22% federal tax to effectively a 49% tax bracket. That's the torpedo right there.
Speaker 1 (09:48):
Yes. So how do you avoid that? That's amazing.
Speaker 2 (09:52):
Yeah, and this is, we call it a torpedo, right? Because it surprises people. It comes out of nowhere and hits you. Yeah. So there are couple ways that you can avoid that. One way is I talk a lot about the secret to managing taxes in retirement is to have a good balance between the three tax buckets. So you want to have some money in the taxable bucket, some money in the tax deferred bucket, some money in the tax free bucket. Taxable bucket is bank accounts, brokerage accounts that have no special labels on 'em, just Scott's brokerage account tax deferred accounts are all those deductible. Retirement plans that use 4 0 1 Ks IRAs, 4 0 3 Bs, all that kind of stuff. And the tax-free accounts are largely Roth IRAs. There are some other tax-free vehicles, but the Roth IRA is the workhorse. So managing taxes in retirement requires that you have a good balance between those. And the biggest problem that I see people coming in with is that they've got a little bit of money in a taxable bucket. They've got 85% of their net worth in tax deferred accounts, which they've been pumping money into as fast as they can because guys like me told 'em to, and they've got very little or nothing in the tax free bucket. Which means if you're near this level and you want to take another thousand dollars out to take this once in a lifetime trip,
(11:15):
You have no alternatives, right? You pull it out of the I R A, you're going to get hit by the torpedo, but what else can you do? If you have a good distribution across those three tax buckets, you would have other places you could pull it from. And so if you're getting close to that threshold, stop pulling money out of your deferred accounts and pull money out of a taxable account or pull money out of a tax-free account. That is, that's how you manage how much tax you pay, and that's how you can avoid the torpedo
Speaker 1 (11:45):
And just goes to show how important someone like you is.
Speaker 2 (11:49):
And that's the other thing in
Speaker 1 (11:49):
This scenario, because I can't imagine that any normal, average, everyday person is going to know about this stuff,
Speaker 2 (11:56):
Right? And God knows I'm not normal. And that's exactly right. That's the other thing. The first thing is having a good balance between the three tax buckets. And then the other secret is talk to somebody who knows what they're doing because this is a complicated machine. There are a lot of gears in this box, and it's really hard to track, especially if you don't have tax tools and that kind of stuff that you can use. It's really hard to track and just keep track of, okay, well here's the income and here's the provisional income and here's the capital gains and keeping track of all those different kinds of taxes. We've got software for that. My
Speaker 1 (12:35):
Mind is boggled more than normal, more than usual ment. Yeah.
Speaker 2 (12:43):
So you want to pay real close attention to where you are in all of those various brackets, all those various calculations. And especially with provisional income. You can't see this if you're listening to Apple Podcasts, but I'll hold this up to the camera here. I mean, this is a table that I'm showing the camera here of how to figure out what the taxable portion of your social security benefits are. And it's a big table, and it's not a straightforward formula. Just like you have to test things three ways, and the least of those three ways is the percent you're going to have to pay on your social security. It's complicated.
Speaker 1 (13:27):
And is that something that changes every year, or is it every time they come out with a new major tax code or something like that?
Speaker 2 (13:36):
Excuse me. How you figure it out is based on tax code, but social security indexes with inflation. So some of these things, the rules, some of the rules index, some of the rules don't index and social security does index. So you could be chugging right along and doing just fine, but then your social security climbs with inflation to the point where all of a sudden you've got provisional income that has to be taxed. So yeah, it's a dynamic thing. You have to look at it all the time.
Speaker 4 (14:12):
Your retirement is at risk, not from the stock market, not from inflation. Taxes are putting your retirement at risk. I'm certified financial planner, Steve Waring and I specialize in helping people create low tax retirements. Unmanaged taxes can take 30, 40, even 50% of your retirement income. Learn how to defend yourself against excess taxation. Our complimentary webinar will cover all the principles you need to know to protect your money for you and your family, and keep it away from the government. This free webinar will cover how taxes are different in retirement, the taxes you pay in retirement that you don't have to pay during your working life, how to move savings into a tax-free environment, the Widows Tax, the Secure Act, the Secure Act 2.0 and what they mean to you. The webinar is free, but you have to register to save your spot. So go to focused wealth advisors.com/webinars and find out more and sign up right there. Even if you're not planning to retire for the next five or 10 years, this information will be critical for you. The longer you have to put the strategies into effect, the more you can accomplish. That's focused wealth advisors.com/webinars to find out more and to sign up today.
Speaker 1 (15:37):
Alright, so how to avoid the tax torpedo. You heard it right here. What's your 30 minute action item?
Speaker 2 (15:43):
30 minute action item is figure out how much income you're going to need next year because then we can figure out how much we take out of each bucket.
Speaker 1 (15:50):
Wow. I have to tell you, this was a big one for me. I'm going to have to go back and listen to this a couple of times. There's a lot of information. It's so important. Yeah, it's so important. Thanks for listening to 30 Minute Money. You can catch us at three zero minute money, of course, on all of the podcast platforms, and the videos can be found at focusedwealthadvisors.com. We'll catch you next time. 30 minute money.