Jason and Bob talk about tax planning as you prepare for and transition into and through retirement.

Below is the full transcript:


Announcer: Welcome back, America, to Sound Retirement Radio where we bring you concepts, ideas, and strategies designed to help you achieve clarity, confidence, and freedom as you prepare for and transition through retirement. And now here is your host, Jason Parker.

Jason: America, welcome back to another round of Sound Retirement Radio. So glad you have you here, and you’re listening to episode 118; the title is Unbirthday. We’re going to be talking about tax planning today. It’s my good fortune to have Mr. Bob Harksen back in the studio with me. Bob, welcome back.

Bob: It’s great to be here, Jason.

Jason: I’m excited to be here. I’ve got a verse for us this morning, Bob, to renew our minds before we get going. This is one of those verses, Bob, that I read for years and I thought I understood it and then one day I realized I didn’t understand it at all. So it’s amazing how-

Bob: It’s kind of like raising teenage girls.

Jason: Really? How so?

Bob: You think you understand them, and then you realize you really don’t.

Jason: Oh, I haven’t had teenage girls yet. My daughter’s only … She’s only nine.

Bob: I’ve had four, so believe me. It’s true.

Jason: Okay, well here’s our verse. “The kingdom of heaven is like a treasure hidden in a field. When a man found it, he hid again. And then in his joy went and sold all he had and bought that field.” That’s a great one. We’ll let our listeners think about that. That’s Matthew 13:44.

Then, of course, if you’re going to go visit the grandkids this weekend we want you to have a joke that you can share with them. So, Bob, I’ve got one for you here. What did one snowman say to the other snowman?

Bob: I don’t know. I didn’t know they could speak, but …

Jason: Do you smell carrots?

Bob: Ba-dum tch.

Jason: All right, Bob.

Bob: They’ll like that one. They will. That’s a good one.

Jason: Do you smell carrots? I mean, come on. All right. We are here with this idea of “unbirthday”, so I’ve got a little something special for you this morning. Bring back some memories.


There you have it, Bob. Very merry unbirthday. What movie was that from?

Bob: Sounds Disney.

Jason: Alice in Wonderland. Alice in Wonderland, but I wanted to talk about the unbirthday because the IRS has this really funky rule that says when you turn 70-1/2 you get to pay more money in taxes.

Bob: Exactly.

Jason: I think it’s so weird, 70-1/2. Why didn’t they just say when you turn 70? They did this unbirthday thing.

Bob: Yeah, it’s in the year you turn 70-1/2 is when you have to pay your Required Minimum Distribution.

Jason: Happy birthday.

Bob: Your first one and you do that until you’re taken from this earth.

Jason: Happy birthday. You’ve deferred taxes all these years. You’ve let these accounts grow and compound, and get bigger and bigger. We’ve been in some of the lowest tax rates, tax brackets, in the history of our country for the last 10 years plus, and you turned 70-1/2. Happy birthday, you’re going to get to pay taxes on all that deferred money. That’s the small little incremental savings that you made over the years that you didn’t pay taxes on. You felt so good about the tax savings, now you get to pay taxes on … I like to think of it like an apple tree, or an apple … What’s the word I’m thinking of here, Bob? Instead of an apple tree, you have an apple grove. You have a whole-

Bob: Orchard.

Jason: Orchard. There you go. There you go. So you’ve got this apple orchard now. You started with one apple seed and now you have a whole apple orchard, and you’re going to not just pay tax on the one apple that you originally had but you get to pay taxes on all the growth of all of those apples over time. 70-1/2. The unbirthday.

Let’s remind our listeners why that’s important, and how it impacts different parts of their tax return, and what they can expect at 70-1/2. First of all, the rule says that you have to take Required Minimum Distribution. You have to pull money out of your IRAs, your qualified accounts, in the year you turn 70-1/2 or by April 15th of the year following the year you turn 70-1/2. What happens, Bob, if you wait until April 15th of the year following the year you turn 70-1/2?

Bob: Well, then you have to take two of them, so it doubles it. Which in a few circumstances can help you, in some cases it doesn’t, but we don’t generally recommend you do that.

Jason: Generally not, but I remember we came across an instance recently where a woman was trying to make that determination decision. I remember when we crunched the numbers because we … In order to do that you have to use a tax return and say, “Well, if I take my RMD this year or I wait and take two RMDs next year …” You have to actually analyze the tax return to see what makes the most sense. So it really is an individualized decision, but in most instances you’re right. Having to take two RMDs in one year just means you have all this ordinary income tax coming in and that can create a big tax hit for some people.

Bob: Absolutely. Particularly if you’re planning working to 70 or beyond.

Jason: I remember there was a gentleman I was working with recently, and when we structured the portfolio we kept his tax rates really low all the way up until the point we got to 70-1/2 and then all of a sudden … In fact, I don’t think he was paying any money in taxes because the way we structured the income and where the sources of income were coming from. But then when he got to 70-1/2 and those RMDs started, oh man, there was a shock. There was kind of a sticker shock. It was like, “Wow, how much am I gonna have to pay in taxes?”

Bob: Ouch.

Jason: Yeah. Let’s talk about the divisor. The first year, here’s another thing the IRS just doesn’t make simple. They could come out and say what percent you have to take, but instead they give you a divisor to work with. So that first year, what is it 27 point-

Bob: Yeah, 1/27.5. Which means you have to pull out 3.636% of the value of your account at the end of the prior year, from December 31st.

Jason: From the December 31st value from the prior year, about 3.6%.

Bob: Right. So if you have a million dollars, that’s over $36,000 of taxable income that will come out.

Jason: Happy unbirthday to you. One of the things that people don’t think about … They know that that tax liability is there, but many people don’t realize that not all of the money in your retirement account belongs to you.

Bob: Yeah. In fact, if you look at your retirement account, for a lot of us, you could say 15 to 25 to 30% of it belongs to Uncle Sam.

Jason: That’s kind of depressing. You have a million dollars and, really, 30% of it doesn’t belong to you. It’s going to go to the government.

Bob: Yeah, and I think the thing that we have to realize that these divisors every year change based upon your mortality. If you’re account continues to grow, you could see your Required Minimum Distributions continue to grow significantly over time.

Jason: Yeah. This brings up some unique planning opportunities, some unique perspectives, things people need to be thinking about. Number one is, I want to make sure we hit on this before we run out of time, but the qualified charitable distributions and the fact that when you do turn 70-1/2 it does open up this opportunity. Because we work with a lot of people that tithe, they give to their church on a regular basis, they’re very generous people. They give to different charitable organizations. The qualified charitable distribution was made a permanent part of the tax code, so we don’t have to worry any more if Congress is going to give us this midnight special deal like we had to for years and years and years. But, Bob, just real quickly help our listeners understand why the QCD is powerful and what they should be thinking about there.

Bob: Well, generally when you want to deduct charitable giving you add it to your list of itemized deductions. But let’s say, for example, you’re somebody who’s paid off their home and so maybe the only thing you have to itemize is a property tax of $3,000, a little bit of medical, state income tax. Maybe you only have $5,000, but you’re married and you get $14,800 in the standard deduction. You want to give away $20,000 or $10,000. Basically, you’re better off not itemizing, and taking the standard deduction. Then the other money basically goes directly to the charity. It bypasses your tax return so you’re not paying tax on that withdrawal, or that Required Minimum Distribution, or whatever you’re pulling out from the IRA.

So if you pull out $10,000, rather than adding it to another 4,000 and still being under the amount that’s the standard deduction, you can take 14 … So basically, it can, basically in that scenario you would in effect increase your tax deduction from about 14,800 to 24,800.

Jason: Yeah, it can be kind of confusing and hard to understand, so I actually wrote a blog post about this … You can go to soundretirementplanning.com. There’s a little search box, and just type in QCD, qualified charitable distribution, QCD … Where I actually take and I run this through. I do some tax planning. You always have to be careful, because a tax return there’s so many moving parts. Just to use a hypothetical scenario to show people the impact of giving directly from the IRA instead of … Some people think, “Well, I’ll just take the money and take it as a distribution. Take it as a Required Minimum Distribution. Have it hit my bank account and then I’ll go give the money that I want to give and then I’ll just itemize it and it’s a wash. It doesn’t really matter.” But when you actually sit down and crunch the numbers, it really does matter because to not have that money hit your tax return in the first place could be very significant.

That’s what this spreadsheet that I created, that you can see on soundretirementplanning, just go and type QCD … And one of the reasons I feel so passionate about this is a lot of people don’t know this exists. I really think pastors of churches need to know this, and they need to be educating their congregation about it. Because if people can be good tithers and give the way that they believe they’re supposed to be giving, but at the same time pay less money in taxes, that’s responsible stewardship all the way around. Maybe it even means people can give a little bit more than they had been giving because they understand the tax implications. So I really want, if people are involved in ministry, maybe they’re an elder of their church, I want them to make sure that they’re taking into consideration the tax implication.

One of the ways that this plays in, at least in this hypothetical scenario that I created that people can read about, is that how that impacts the taxation of Social Security benefits. Now this isn’t always going to be the case. In the hypothetical scenario that I showed, it’s the best-case scenario because it kept people’s income, their provisional income, lower by not having that RMD hit their tax return which meant that they ended up paying less. Less of their Social Security ended up being taxable.

So let’s talk about provisional income rules, too, because one of the things that many people don’t realize also is that Social Security income … It’s possible that none of your Social Security income could be taxable, or it’s possible that as much as 85% of your Social Security income could be taxable, and it’s all based on these provisional income rules. Let’s just take a minute and talk about that because something like the QCD plays into provisional income rules. Bob, what are your thoughts about provisional income rules?

Bob: Well basically, a provisional income rule is a formula that Social Security, and that the Federal government, IRS, uses to see how much of your Social Security is taxable. Basically you take your combined, if you’re married or single, whatever, whatever your total Social Security is, you cut that in half and then you add your other sources of income. They do add back in things like tax-free bond interest, you add all your IRA income interest, pensions, all that.

Jason: So all these other sources of income come into play and half of your Social Security benefit gets added up and then that determines what percentage of your Social Security benefit’s taxable. If you’re really low income, you may have to not pay any tax on your Social Security income. What was it for … was it $44,000 for a married couples, if you’re … was that the number last year?

Bob: Yeah, that’s it. So in other words, if you have … Let’s say you have $32,000 of Social Security income and $16,000 of other income, well they only take half the Social Security so it’s 16 plus 16; 32,000. There’s no tax at all on your Social Security, but you’re actually getting $48,000 of income because you’re getting 32,000 from Social Security and 16,000 from other sources. That’s where you want to be careful where you choose to take income on those other sources. If you can take it from something that’s not taxable, a Roth or non-qualified account, you can adjust the numbers to really lower your liability of Federal income tax.

Jason: Well that brings up another good point. When it comes to this unbirthday, this 70-1/2 Required Minimum Distribution, one of the things that doesn’t count against provisional income rules. Because like you said, tax-free income from municipal bonds, it counts. You have to add that back into that provisional income calculation. However, taking money out of a Roth IRA does not count against your provisional income rules. It’s possible, if all of your money was in a Roth, you could have $100,000 of Roth IRA income and $35,000 of Social Security income, and if those were your only two income sources, you’d pay zero tax on your Social Security income because you don’t have to add that Roth IRA income.

Bob: And possibly no tax at all, depending upon the rest of your financial situation.

Jason: So when people think about tax planning, they don’t necessarily think about how all of these small little choices on when they’re taking distributions and how they hit that tax return, how that plays out. Like I said, there’s a lot of moving parts in the tax return. One of the things I wanted to talk about is health insurance, because now the income that shows up on your tax return, it’s not just how much money you’re going to pay in taxes. It also is going to determine, potentially, how much money you’re going to pay for your health insurance if you’re before age 65 under ObamaCare’s Affordable Care Act, or it’s going to determine how much money you pay for Medicare Part B and Part D premiums. Because all of that, those premiums, are all dependent on your income; Modified Adjusted Gross Income.

Let’s take a quick minute and make sure your clients understand that with the Affordable Care Act it’s based on …

Bob: Well it’s based upon, it’s called your Modified Adjusted Gross Income. Where they will add back all of your Social Security payments as income. There’s no non-taxable portion of Social Security for the purpose of determining your rates. That, all your tax free income, they add it all back to determine what your income is and see what you’re eligible-

Jason: Tax-free income, excluding again that Roth IRA.

Bob: Except that Roth IRA. Correct.

Jason: Imagine that. It’s possible you could … if you have enough money in your Roth IRA, maybe you’re taking $100,000 a year of tax free income from their Roth IRA, and then if you’re 60 years old, you’re not qualified or eligible for Medicare yet … you potentially would pay zero, or have a very highly subsidized health insurance premium. Because according to the formula for determining how much you pay for health insurance, you may not be paying very much money for health insurance. That’s pretty wild to think about.

Bob: Well, also keep in mind that maybe you have savings that you could draw from one year, or maybe you have investment accounts that aren’t retirement accounts, or maybe if you pull money out there isn’t much of a tax liability. You may want to choose from there, both for the purposes of the taxation of Social Security and for your ObamaCare premium. You could have a lot of that worth and get a big subsidy for ObamaCare. How’s that fair? I don’t know, but depending where you pull the income from it’s very interesting.

Jason: It is interesting. IRMA. IRMA is not that aunt that comes over for Christmas every year and brings that great stuffing that you enjoy so much. IRMA, as we talk about with Medicare, is Income Related Medicare Adjustments. Many people don’t know this exists, Bob. But again, going back to the tax return, and especially those RMDs, it’s possible that you will pay more for your Part B and your Part D premiums based on how much income that you have. I know we’ve got a chart here, do you have your chart handy. I thought maybe we could just real quickly give people an idea, a run down, on these different break points. Do you have that handy?

Bob: Right here. For example, if you are a married couple and you have a Modified Adjusted Gross Income of $170,000 or more, then your Medicare premium is going to jump to $170.50 per person plus you’ll be a Part D, which is the prescription drug-

Jason: Now, hold on. Hold on a second there. Let’s go back. If you don’t … If your income is less than $170,000-

Bob: You don’t have to worry.

Jason: You still pay premiums, though. It’s $121.80 right now if you have less than, for Medicare Part B. But what you’re saying is when they go up over the $170,000, from 170 to 214, now instead of paying $121 for your Medicare Part B premiums now you’re paying $170.50 for your Medicare Part B premiums, per person?

Bob: Right. And where you have to be cautious is if you’re single, then it drops to $85,000. Then if you’re single and you go above $107,000 then the premium goes to $246.60 for the Medicare premium and $32.80 for the Part D.

Jason: And this can go all the way as high as, if your income is up over $428,000 for a married couple, you’re looking at $389 per person for Medicare Part B premiums and that doesn’t include the additional you pay for your Medicare Part D premiums.

Bob: So, if you’re considering a Roth conversion and you’re on Medicare, when you convert from a Traditional to a Roth, that’s taxable income and I’ve seen clients who do the large conversion and all of a sudden they’re shocked by the fact that their Medicare has doubled or tripled for that year.

Jason: Or sometimes people have highly appreciated stock and non-qualified accounts and they’re ready to harvest a little bit of that. If you’re not careful about how much you sell in one year … Again there’s all these moving parts in a tax return. Little things like doing Roth conversions, making sure that you’re not bumping yourself up into such a high tax bracket that not only are you paying more money in taxes but then you’re getting hit with these other little, I would call them “sneak attacks”. That’s kind of a fun play on words. Sneak a-tax.

Bob: Well I had a client who spent $10,000 for a stock and they got a phone call saying, “The company’s been sold. We’re sending you a check for $500,000.” They thought that was great and then a year and a half later their Social Security check got walloped because they each had to pay over $400 a month in Medicare tax each, including the Part D premium. Just took them totally by surprise. They went from $121 a month to over $400 a month.

Jason: Still not a bad problem to have. Buy a $10,000 stock and it’s $500,000. I’ll pay a little bit more in my premiums for that.

Bob: I get the phone call and they go, “Why did our Social Security get cut in half?” I had to explain what happened, and it’s a delay. So for example, if your income went up in 2014 you’ll feel it in 2016. You won’t know for a couple years.

Jason: That’s right, yeah. There is a little bit of a delay on that, so it is a sneak-

Bob: It is a sneak attack.

Jason: Tax. Sneak a-tax.

Bob: Sneak a-tax. Well, I think that amount of money could be an attack, too, so we’ll see.

Jason: But you’re right, one of the things you just touched on was Roth conversions. All of this is leading into this discussion about should people be considering a Roth conversion as part of their retirement plan, and based on the conversation we’ve had this morning, Bob, people might walk away from this saying, “I got to go home and convert money to a Roth.” Now first of all, let me just say that could be really bad news for some people because if you do a conversion to a Roth, it means you’re going to pay more money in taxes right now. Today. For some people doing a conversion to a Roth could mean you’re going to run out of money in retirement, because it’s going to take away some of the net worth that you’ve saved up, some of the wealth that you’ve saved up and send it to Uncle Sam right away. Maybe you will be in a lower tax bracket.

A lot of this tax planning really has to do with higher net worth individuals that are going to have higher income in retirement, that have saved a lot of money for retirement. I would definitely recommend people don’t run out and just do a Roth conversion because they like tax free. They definitely want to sit down and say, “How would that decision impact my future cash flow,” because we never make a decision about retirement planning based solely on the emotions of not wanting to pay more money in taxes. That’s a mistake. It’s a benefit, and it’s definitely something worth considering, but it’s not our number one motivator. Our number one motivator in retirement has to be cash flow.

Bob: Yep.

Jason: Yep, because if you have no cash flow and you’re not paying money in taxes, you don’t have a retirement either. Right?

Bob: And we have to watch out for the unintended consequences from a good idea.

Jason: Yeah, the unintended consequences of a good idea. I think that’s a good thing of saying, because there are consequences for our decisions, for our actions.

Bob: All the way throughout life.

Jason: Everything we do, yeah.

Bob: Yep.

Jason: But the Roth conversion is a powerful planning strategy because one of the things that people want to think about is you don’t have to take a Required Minimum Distribution from a Roth IRA. So you can turn 70-1/2, have that unbirthday, and not have to take a penny out of that account. Then what’s really cool, is if you die with money in that Roth IRA and your kids inherit it, the way the rules stand right now today, is they don’t have to take as a lump sum. They can actually leave it in the inherited Roth IRA and only take … Now they do have to start taking Required Minimum Distributions at that point-

Bob: As an inheritor, correct.

Jason: As an inheritor, but that’s tax free money. So they have this account that can sit there and continue to compound and grow tax free, and they’re only going to be taking money out as they are required to as an inherited account. What a cool way to leave money to the next generation.

Bob: Or your kids can use that tax money to pay for some of the expenses of settling the estate without paying tax on it. Because if you take money out of an IRA when the person dies, then they have to pay not only … They have to pay for the expenses but they also have to pay the tax on the money they pulled out.

Jason: Before we run out of time, I want to remind our listeners I created a new video called The Sound Retirement Planning Blueprint. You can find this at soundretirementplanning.com, and it’s a four minute video and you can watch it right there online. I think it’s really going to … I think if people have a better understanding of creating a cash flow plan in retirement that their life is going to be better. I really encourage you folks, if you’re driving down the road this morning in Seattle or if you’re out jogging, wherever you’re at around the country and you’re tuning in to Sound Retirement Radio, by all means watch the Sound Retirement Planning Blueprint. Again, it’s just a four minute video and I think it’s really going to give you some clarity on what a good retirement cash flow plan should look like and addresses some of the concerns people have right now. It just helps people understand how to structure it, because it can seem very overwhelming when you’re trying to put together that plan.

Bob, just real quickly. There is the opportunity to do gifting every year and the limit is $14,000 that people can gift to any one person and not have to worry about taxes. So there’s kind of a neat opportunity, too, from a tax standpoint. But, Bob, we’re out of time. Thanks for being here on Sound Retirement Planning with me again.

Bob: All right.

Jason:  This is Jason Parker, signing out.

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