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Long-Term Tax Planning to Build Your Wealth

As we mentioned last time, it’s important to start your tax planning well before year-end.   Once the calendar turns to 2020 most of the best opportunities for cutting your 2019 tax bill are gone.  

Our previous tax planning blog focused on short-term strategies such as tax bracket management and gain/loss harvesting.  This week, we’re going to be looking at ways to manage your long-term tax planning with ideas for IRA distributions, Social Security, and the Medicare IRMAA.

First, a comment on the goal of tax planning: while it may be tempting to drive your current year’s tax bill as low as possible and give yourself a fist pump for a job well done, the most effective planning takes a long-term view considering not just the current year but how to best manage your total lifetime tax liability.   Managing your long-term tax obligation is one of the best ways to optimize your family’s lifetime wealth.  Annual tax planning serves you best when it supports your strategic wealth plan by helping target your income and tax rate to its optimal level, avoiding income troughs which can cause you to lose valuable opportunities and income spikes which can drive you into higher marginal-tax brackets.

Proper long-term tax planning over the many years of retirement is the single largest controllable factor most retirees have in conserving their family’s wealth.  Yes, the market’s performance may have a bigger impact, but it is out of your control.  The foundation for effective lifetime tax planning for your retirement years is established between ages 55 and 70 ½ (soon to be 72 if/when pending legislation is passed). This is the age range where the IRS generally allows you do what is financially best for you, without imposing any overarching requirements.  That is why HCM places such an emphasis on incorporating multi-year tax planning in the design of our clients’ wealth plans, beginning several years before their actual retirement.  

IRA Distributions

An Individual Retirement Account (IRA), is a long-term, tax-advantaged investment account designed to help people save for retirement.  The two most popular types of IRAs, traditional and Roth, allow individuals to stash away up to $6,000 per year, with a $1,000 bonus for people 50 or older (both are subject to certain limits).  Distributions from these accounts have very different tax consequences.  Taking advantage of those differences can be very helpful in building out tax strategies.  If you’re curious about the basics of IRAs, click here for more information.

There are two important ages for IRA distributions: 59 ½ and 70 ½ (the older age may soon be 72, if pending legislation passes).  Before 59 ½, you’ll be taking early distributions.  For traditional IRAs, if you withdraw any funds from the account before 59 ½, the withdrawal will be subject to a 10% penalty.  There are several exceptions to the early distribution penalty, so if you must take IRA distributions early, check with your advisor to see if an exception applies.  You can always take your original contributions from a Roth IRA before age 59 ½ without tax or penalty, but if the investment gain portion is withdrawn before 59 ½ taxes and penalties will likely apply.  There are exceptions to these rules as well, so talk to your advisor if you feel the need to make a withdrawal from your Roth before 59 ½ and less than five years since it was established.

The other important age for a traditional IRA holder is 70 ½.  That’s the age when the IRS requires that you begin to withdraw Required Minimum Distributions (RMDs) from your account.  This distribution is taxed as ordinary income, the most expensive from a tax standpoint.  Each year’s RMD is calculated by dividing the total balance of all your IRAs as of December 31 of the prior year by a factor based on your age.  Beneficiaries who inherit an IRA gain a tax advantage as they may stretch the time over which the inherited IRA must be distributed.   

One key planning tactic for those with IRAs who haven’t reached 70 ½ yet is to consider their future tax situation and adjust their current income accordingly.  This could mean accelerating or deferring elective IRA distributions to avoid an unnecessary spike in taxes later in life.  Converting larger amounts (discussed later) may also help reduce future high-tax RMDs while building a tax-free reserve and fully utilizing your deductions and lowest brackets today.   This may result in paying a little more than is absolutely necessary today in order to reduce you tax burden more in the future.  

If the IRS makes you take IRA distributions that you do not require to meet your living needs, then make sure you manage your estimated tax obligation through withholding directly from your required IRA distribution.  A more elegant strategy and one that will leave your tax money in your pocket as long as possible is to withhold your entire estimated tax obligation for the year from you IRA’s required distribution at year end.  By doing this, you avoid the hassle of quarterly tax payments and avoid potential penalties for the late payment of estimates.  By keeping the money in your account longer you eliminate the paperwork of quarterly payments while allowing your money to continue working for you longer.  

If your traditional IRA contributions are non-deductible due to employer plan participation, and your income is too high for you to be eligible to make a Roth contribution, it is possible that a Back-Door Roth will work in your situation.  Your situation must be just right. If it is, or if it can be made right, you may be able to slip in through the “back door” and begin to build a tax-free portfolio.  This can be a complicated process, so please speak to your advisor if this situation applies to you.

If your income is lower this year than it will be in the future, especially if that future income is the result of potential RMDs from retirement accounts, a Roth Conversion may be just the ticket.  A Roth Conversion is when you take part or all of your traditional IRA and convert it to a Roth IRA.  Remember, Roth IRAs grow tax-free, and qualified withdrawals aren’t taxed, so if you plan on having a higher tax rate in the future, especially when your RMDs begin, this could be a profitable long-term strategy for you.  If you won’t need all of the money from your RMDs to live on, this could be a very advantageous strategy as it removes money from your taxable estate, and puts the conversion dollars into a tax-free environment that, under current law, can be inherited by younger generations and allowed to grow tax free for decades.  Conversions are taxed as ordinary income so planning must be thoughtful, however this can be an excellent long-term family wealth building strategy.  

Don’t forget that it is important to take your annual required distribution in a timely manner.   Those who forget are subject to a 50% penalty.

Medicare IRMAA

The Medicare Income-Related Monthly Adjustment Amount (IRMAA) is an additional cost paid by higher-income individuals for Medicare services.  There is no premium or surcharge for Part A.  The following table shows the extra premiums paid for Medicare Parts B and D for each income bracket for 2019:

If your MAGI in 2017 was

You pay (in 2019)

File Individual tax return

File Joint Tax Return

File Married & separate tax return

Part B

Monthly Premium

Part D

Monthly Premium

$85,000 or less

$170,000 or less

$85,000 or less

$135.50

Your plan premium

above $85,000 up to $107,000

above $170,000 up to $214,000

not applicable

$189.60

$12.40 + your plan premium

above $107,000 up to $133,500

above $214,000 up to $267,000

not applicable

$270.90

$31.90 + your plan premium

above $133,500 up to $160,000

above $267,000 up to $320,000

not applicable

$352.20

$51.40 + your plan premium

above $160,000 up to $500,000

above $320,000 up to $750,000

above $85,000 and less than $415,000

$433.40

$70.90 + your plan premium

$500,000 or above

$750,000 and above

$415,000 and above

$460.50

$77.40 + your plan premium

The income measurement used to see if you are subject to these extra taxes is Modified Adjusted Gross Income (MAGI).  While there is a technical definition for MAGI, it is basically everything that you made, including your tax-free income without any deductions.  If you trip over one of the income “cliff” thresholds, even if it’s just by a dollar, you could stumble into thousands in extra Medicare premiums for the exact same service.  Higher income taxpayers can pay increased monthly Part B premiums of 35%, 50%, 65%, 80%, or 85% of the total Medicare premium, so, if possible, you should actively manage your MAGI.  One way to do this is through delaying or decreasing income from an investment or a business.  Distributions from Roth IRAs and qualified health savings account withdrawals are not included in IRMAAs.  The eventual need to manage your MAGI is another good reason to fund Roth IRAs and HSAs prior to claiming Medicare. If you are in RMD status, you can also reduce your income by making a Qualified Charitable Distribution (QCD) through your IRA.

There is the possibility of being excused from the IRMAA penalty if you’ve gone through a “life-changing event.”   A life-changing event could be a marriage, divorce or annulment, work reduction or stoppage, death of a spouse, loss of income-producing property, loss of employer pension, or receipt of settlement payment from a current or former employer. In this instance, you can apply to the Social Security Administration on form SSA-44 to have the IRMAA reduced or removed from your Medicare premiums.  If there are additional factors that you would like considered that are not listed above, you can file a Request for Reconsideration.  So far, we have found the Social Security Administration very reasonable in evaluating the requests for reconsideration that we have submitted.

When to Claim Social Security

Deciding when to begin your social security benefits falls under the larger tax-planning strategy and is a subset of the overall Wealth Plan that everyone should have to help them maximize lifetime wealth and security.  

There are several factors to consider when determining when to claim your social security benefits.  Usually, postponing at least one spouse’s benefit as long as possible makes economic sense as you’ll receive a larger payment for the rest of your life.  You can claim benefits as early as age 62, but they’ll be 25-30% lower than benefits received by someone retiring at their full retirement age.  And if you wait longer to claim, your lifetime payments go even higher.  There are tax implications to consider.  Depending on your income, you will be taxed on different amounts of your Social Security benefits.  If your “combined income” (AGI + nontaxable interest + half of your Social Security) is above a certain threshold ($25,000 for single person or $32,000 for joint filers), then you’ll owe taxes on some of your social security benefits (if your income goes above $34,000 or $44,000 respectively you will owe even more income tax on your Social Security).  So, if you have a traditional IRA, you’ll be required to take RMDs when you’re 70 ½.   It may benefit you to draw down some of your retirement plan balances or convert them to a Roth before you take Social Security benefits to help minimize the amount of your social security that will be taxed and keep you from going into higher tax brackets.

Conclusion

Improving your tax situation is not a simple process.  It requires long-term strategic thinking coordinated with short-term tactical actions that need to be considered annually, as factors in your life, the world around you and the tax law change.  If you haven’t discussed your tax situation with us before, now’s a great time to start.   And, if you have had a tax planning session with us in years past, be sure to schedule another one soon to make sure your plan is up to date.

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