We often say on our radio show that retirees are one of the highest and most unfairly taxed groups out there. This is especially true in Kansas, as Kiplinger has our state rated as the third least friendly state in the entire country for taxes on retirees.
At The Retirement Team, we help people approaching or in retirement maximize how much of their retirement income and investment return they keep through smarter tax planning. We primarily work with middle and upper middle class individuals, which is a group that often gets hit particularly hard due to the ridiculous way that Social Security tax law is written both at the federal and state levels. When Social Security first came into existence, FDR proclaimed it was never intended to be taxed. That all changed, though, in 1983.
Not only did Social Security start being subjected to taxation in 1983, but that taxation increased in 1993. The wild part is that the income thresholds put in place for this taxation from 30 and 40 years ago have never been changed to account for inflation. While only a small single digit number of retirees lost some of their Social Security to taxes back then, the majority do today as a result of this.
While most of the rest of the tax code adjusts for inflation each year, the failure to modify when taxation on Social Security occurs isn’t even what we view as the biggest issue. Our objection is to how those that saved for retirement to have income above and beyond Social Security are unfairly penalized. The way the current system is set up, if your income outside of Social Security is fairly low, you pay no tax at all on your Social Security. As your income goes up, though, you must pay tax, not only on that income, but also additional tax on your Social Security.
One of the biggest myths we dispel is the one stating that people should put all of their retirement contributions in the pretax or traditional side of their retirement accounts like an IRA, 401k, 403(b), 457, etc. and not pay tax on that money now since their income may be lower when they’re retired. Just because your income may be lower, doesn’t mean the tax you’ll pay on a retirement account withdrawal will be lower. Even if your income drops enough to put you in a lower tax bracket, you may actually pay more in taxes when taking money out once you’re retired. Why? Well, when you take money out later, and you’re receiving Social Security, the withdrawn money counts as income. Since it counts as income it can cause you to pay additional tax on your Social Security that wouldn’t have occurred otherwise. In an instance like this, taking money out of a retirement account results in you paying two different taxes instead of one. Triggering paying two taxes in a lower tax bracket can mean you pay a higher overall tax than if you merely pay a single tax in a higher tax bracket, like what would happen before starting Social Security.
Don’t make the mistake thinking that there are only two taxes that can be activated when you take money out of a retirement account later. Extra Medicare costs (which we view as a tax), new or higher taxes on stock dividends and interest from bank accounts and bonds, and loss of tax credits for things like helping a child or grandchild with college or doing home improvements are just a small sampling of some others.
Extreme care is needed to effectively navigate all of these and other potential tax traps. Ensuring you’re getting good advice from someone that has deep knowledge in this area is critical. Recently we met with someone that was working with an advisor from one of the large name brand brokerage firms. They had been advised to take out $10,000 from their retirement accounts, pay the tax now, and move that money to a tax free Roth. While we often recommend clients take money out of their pretax retirement accounts and move them over to a tax free Roth, we only do so in amounts each year that would cause them to pay an overall lower amount in taxes now versus what they would face later. The advice this person was given by someone at the big brokerage firm, though, was for almost the worst possible amount. Why? Well, that $10,000 they were told to take out resulted in them paying over $7,000 in taxes! How can this be when the highest tax bracket is only 37%? The tax bracket you’re in is only one factor determining the total tax you’ll face when taking money out of a retirement account. Unfortunately in this case, that $10,000 coming out not only resulted in more federal tax on Social Security, but it also pushed them from paying zero state tax on Social Security to it all being taxed (which is another topic we’ll address in a future article), caused the dividends on their stocks to jump from having zero tax to a 15% tax, and made them pay more for Medicare. This is how a $10,000 withdrawal led to $7,000, or 70%, being lost to taxes.
Many in the financial services industry talk about the importance of accounting and planning for taxes. Unfortunately, few have the knowledge and ability to help fully minimize them and sometimes, like in the example above, bad advice actually results in more tax being paid, not less.
It is important to work with a team that understands and specializes in situations like your own. At The Retirement Team, the people we help reduce their taxes best are Kansas residents that are in or within 10 years of retirement and have or will have between $500,000 and $5 million in investments at retirement (which would include things like potential lump sum pension buyouts). The tax issues people in this group face are ones we have a deep knowledgebase and extensive experience with. Many times we find that when someone feels like they’re paying too much in taxes, it’s because they are. If you’re in this group, and would like your current tax plan reviewed or to have one created, then I suggest scheduling a time with one of our advisors in Topeka at The Retirement Team by either filling out the form below or calling 785-228-0222. If you’re not in this group, it’s important to find someone that works with a lot of individuals like yourself to ensure you keep more of your own hard earned money.
Material discussed is meant for general/informational purposes and is not intended to be used as the sole basis for any financial decisions, nor be construed as advice to meet your particular needs. Please consult a financial advisor or tax professional for further information.