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Stuffing The Brackets

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I’m a creature of habit, and my Saturday morning routine is pretty consistent. I wake up, hop in the shower, get dressed for the day, make a non-fat latte in a to-go cup, pack the previous weeks laundry into the truck, and I’m off to the gym. 

After about 75 minutes at the gym, I work my way across town to my favorite dry cleaners. I’ve been taking my prized business attire to this specific establishment for over 10 years. I trust their work because they have always treated me and my laundry with the utmost respect and care. 

I’ve come to know the owner, and his team over the years. It’s a bit like visiting family every Saturday morning, and it’s become an interaction that I look forward to each week. 

The owner knows that I work in the financial services industry, but he has made it clear on another occasion that he has an advisor already, and one whom he seems to be happy with. We really never have talked specifically about his personal finances, and I don’t pry. I don’t make it a habit of talking business with folks unsolicited. I am uncomfortable with it. I don’t like the feeling that I am bugging folks, intruding in in their personal affairs, or forcing myself on them unwillingly. I know many folks in our industry who will do that, but it seems yucky to me. 

On this day however, my friend asked me some questions.  Specifically, he was asking about his personal retirement accounts and circumstances. He had already offered some information about how he and his wife were handling some of their retirement funds. Since his wife had retired, they had been using his after-tax money to supplement their income. Their intentions are to delay taking distributions from their pre-tax accounts (IRAs for example). It seemed like he was thinking this was a great strategy because they would avoid paying taxes on their pre-tax accounts keeping their current taxes very low, at least for the time being. 

When folks ask me for advice on the street, it makes me a bit uncomfortable. I don’t make recommendations without first fully understanding all of the aspects of their financial life and lifestyle. Our Triplett-Westendorf PT5 Retirement Screening Process is a required prerequisite before any advice is administered, period. Therefore, it puts me in an odd position because they often want something I am unable to give them. However, I’ve learned to ask good questions that will help folks think critically, and see things from other angles that perhaps they had never thought to look from, and in doing so giving them a new perspective without giving advice. 

How Much Did You Pay Last Year?

That day, I was blessed with an opportunity to ask a question that opened up a deeper more impactful dialogue for my friend. Out of curiosity, I turned to him and said, “How much did you pay in taxes last year?” Each corner of his mouth turned upwards swiftly into a prolific grin as he proclaimed, “not much.” Then I asked him about the highest marginal tax bracket he and his wife had fallen into. Still grinning, he replied with a surprisingly low bracket. He was in a very low marginal tax bracket primarily because of how they were intentionally structuring distributions from retirement assets. More specifically, supplementing their income with after tax dollars rather than distributing any pre-tax dollars.

Then I asked one more question that seemingly no one had thought to ask him before. “What do you suppose happens to the unused capacity in each of the lower tax brackets that you have managed to avoid last few years?” It made him stop and think for a moment, and his grin slowly fell to a neutral position. I continued, “do you suppose you might have converted some of your pretax accounts to a never taxed account by filling up the lower tax brackets? If you don’t use it, you lose it, right?” I finished. 

His financial advisor had never suggested it. His CPA, it appears, had never thought beyond saving taxes over the previous year, or anticipating the tax traps he and his wife were potentially setting for themselves by continuing to defer taxes on all of their pre-tax accounts. 

Taxes Are Remain On Sale!

Are you a "Tax Cuts & Jobs Act" beneficiary? The TCJA is in its 3rd year. There are still several years to take advantage of historically low tax rates. Strategic Roth conversions are likely an opportunity to buy out the federal government from your retirement accounts forever, and you might be able to do it all while taxes are on sale. However, it doesn’t make sense for everyone, and it may not be right for you. 

How might you begin assessing whether you should convert some of your pre-tax money now? One thing you might consider is your likelihood of falling into higher tax rates and brackets in the future. If you think that it is likely that tax rates will go up in the future, or that you might end up in a higher tax bracket down the road when you’re forced to take required minimum distributions beginning at age 72, it may make sense to convert some of your pre-tax money to a Roth IRA now.

How much should you convert? The answer is different for everyone depending on their circumstances. However, one thing to consider is how much capacity you have in the lower tax brackets. Do you have capacity to stuff the lowest tax brackets without crossing into the higher brackets? 

Take my friend for example. Let’s imagine he is so tax efficient today because he and his wife have prioritized the consumption of after-tax money first that they end up in the 12% bracket. The 12% bracket tops out at $80,250 for a married couple, and then progresses to the 22% bracket, and then the 24% bracket and so on. The standard deduction for a married couple filing jointly in 2020 is $24,800. Folks over the age of 65 enjoy an additional $1,650, or $3,300 for a couple both over age 65. We’ll say my friend’s income was $70,000. Knock off the Standard deduction of $24,800, and that means he’s into the 12% bracket at $45,200.

He and his wife have another $35,050 of capacity in the 12% bracket. Do you suppose they might want to consider converting some of their money from a pre-tax traditional IRA to a never-taxed Roth IRA? It might be a very good idea considering the 12% bracket was 15% before the Tax Cuts and Jobs Act, and that the rates are set to revert back after 2025. They have several years to pay off the federal government while Roth conversion taxes are on sale, thereby forever removing the tax man’s future claim over at least a portion of their retirement accounts. 

Balancing The Scales By Stuffing The Brackets&nbsp

Stuffing the tax brackets may or may not make sense for you. Everyone’s circumstances are different. However, doing so can be an effective way to create tax equilibrium in your retirement plan. 

Imagine an old-fashioned scale. If you add weight to one side it drops, and the scale becomes lopsided. Now imagine the side that falls to the floor is your effective tax rate early in retirement. You intentionally do what you can to be so tax efficient that you lower your effective tax rate early on in retirement. Perhaps you delay drawing on your IRAs and your 401k in order to defer taxes. Meanwhile, you use your after-tax accounts and Roth IRA money to supplement your income from social security. You feel great about paying so little in taxes. 

However, you’re likely tipping the scale. You’re potentially setting yourself up for a real shock later in retirement when you begin drawing from IRAs and your 401k to supplement your now inflated lifestyle. Perhaps you’ll thrust into yet a higher tax bracket and a higher effective tax rate when you are forced to begin making distributions from your pretax accounts at age 72.

What happens if tax rates increase? What happens when your inflation adjusted lifestyle’s appetite for income increases to feed the rising cost of goods and services? Oh no! You’re out of balance and the cost may be too much to bear. 

There’s good news. Now that you know that it is possible to be too tax efficient early in retirement you can begin to assess your own personal circumstances and adjust as needed. It would be advised to consult with a fiduciary financial advisor who is well educated on the concept of creating tax equilibrium in retirement by stuffing tax brackets when it makes sense. You may also consider seeking tax advice from a forward-thinking CPA. Find a CPA who thinks about taxes very differently, always striving to reduce taxes not only today, but in the future as well.  

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