# Smart Tax Planning Beginning at Age 50

August 26, 2021

Smart Tax Planning Beginning at Age 50

Are you surprised at the size of your retirement accounts?

Have you projected what their balance will be when you turn seventy-two, the year you must begin withdrawals? Compound growth calculators available online or a financial calculator make this easy. The SEC (Securities & Exchange commission) even provides one: https://www.investor.gov/.../compound-interest-calculator.

Choosing a growth rate to use is harder. U.S. investment grade (high quality) bonds have a historical growth rate of 3% and the S&P 500 index (large US stocks) had an annual compound growth rate of 12% from 2011 to 2021 and a 7% rate from 2001 to 2020. Your portfolio allocation to stocks vs bonds can help you arrive at a number for yourself. If we assume a 50-year-old has a \$1,000,000 retirement portfolio and chooses a 5% compound growth rate their portfolio is projected to be \$2,925,260 in 22 years.

While a good problem to have, the projected RMD’s (Required Minimum Distributions) may have significant tax consequences.

The IRS uses an age-based formula based on the value of your retirement accounts on December 31st of the prior year. Simplifying the formula, if your retirement accounts have a value of \$2,925,260 on December 31, 2020 and you are seventy-two then you multiple the 2,925,260 x 3.59%. The result is an annual RMD of \$105,016 for the first year. The percentage rate increases each year until age ninety. Here is a link to the IRS worksheet https://www.irs.gov/pub/irs-tege/uniform_rmd_wksht.pdf for calculating your RMD. There is more than one worksheet depending on the age of your spouse.

In 2021 a married couple filing jointly with annual taxable income of \$105,016 are in the 22% Federal tax bracket before deductions and the 8% bracket for California state taxes. Your social security and other income may permanently push you into higher tax brackets. You can download your projected social security amount at SSA.gov.

Adding up your projected social security, RMD and other income you realize the RMD amount is more than you need and will lock you into a high tax rate starting at age seventy-two. You followed the rules to be financially successful, but now find yourself looking at a large tax bill when your tax rates were supposed to be low.

A couple of other looming surprises may be the high- income surcharge for Medicare parts B and D and the inherited IRA rules effective January 1, 2020.

You pay Medicare tax of 1.45% on 100% of your earned income during your working career and your employer also pays 1.45%. The self- employed pay the entire 2.9%. In the past few years, if your earned income was more than \$200,000 as a single filer or \$250,000 as joint filers you paid an added .9% on earned income and 3.8% on investment income. You become eligible for Medicare at age 65 and will start paying your monthly Medicare premium. If your 2019 income was greater than \$88,000 as a single filer or \$176,000 as a joint filer you will pay a surcharge in addition to the base Medicare premium. The income tier is updated annually, but Medicare uses a 2-year lookback at your earned income. This means a Roth conversion at age 63 or 64 could create a Medicare premium surcharge.

After January 1, 2020, a non-spouse who inherits an IRA, must remove the balance within 10 years. Previously the balance could be paid over the beneficiary’s lifetime. If your children are high wage earners, your retirement account assets may be taxed at rates up to 50.3% (37% federal and 13.3% CA) when passed to them. In other words, your children may only receive ½ of your IRA balance.

Typically, starting at age 50 you have opportunities to change your future income tax exposure. You may even change your work life balance plans. For example, you may start working part time before you retire or change to a career/job which will give you more fulfillment but less income. You may even decide to take your Social Security earlier or withdraw some funds from your IRA (after 59 ½) so you can travel more.

Before you begin making early retirement plans, the other half of the equation is expenses. Projecting what your expenses will be in 20 years is typically done with the help of a financial planner or advisor. The cash flow based financial planning software available today can be immensely helpful in projecting future expenses. It is superior to a spreadsheet, so please consult with an advisor. After you have a clear picture of your projected expenses and income, you can begin exploring strategies to reduce your future taxes. Below are five strategies to explore. If you have cash outside of your retirement accounts and will have some low-income years, the Roth-IRA conversion strategy may be the most beneficial to you.

1. A Roth-IRA conversion strategy allows you to convert all or part of your traditional retirement accounts to a Roth-IRA. The amounts you withdraw from your traditional retirement accounts is added to your taxable income for the year. The benefit is funds in a Roth -IRA grow tax free and are not subject to RMD’s. If the funds are held for 5 years, they can be withdrawn tax free. An example is at age 65 you reduce your income by retiring or changing jobs and your pension starts. You know your income will be its lowest from age 65 to 69. Your Social Security starts at age 70 and your RMD’s start at 72. Near the end of each year, you calculate your income and then calculate how much of your IRA you can convert to a Roth IRA without pushing yourself into a higher tax bracket. Done over 5 years (65 to 69) this can reduce your future RMD amounts. In addition, it adds to the funds you can transfer to your children tax free. One thing to keep in mind when planning a Roth conversion, is the high- income surcharge for Medicare parts B and D.

1. Converting part of your IRA into a charitable trust may be of value to you. Withdrawing some of the funds from your IRA will likely create a large tax bill which may be partially offset by the charitable contribution in that year and future years. Your heirs may receive a benefit because your smaller IRA may reduce the tax rate on the IRA assets you pass to your heirs. In addition, the charitable Trust creates opportunity for passing income or assets to your heirs before you pass. You should contact a Trust attorney experienced with this approach to see if it is a workable solution for you. If you do not have a Trust attorney, please contact us for a referral.

1. Defer part of your RMD’s until age 85 with a Qualified Lifetime Annuity Contract (QLAC) or longevity contract. The amount invested in the contract is excluded from your RMD calculation until you reach the age specified in the contract. You can invest up to \$135,000 from your IRA or up to 25% of the balance whichever is less and add a death benefit with a joint tenant. If a 60- year- old single male invested \$125,000 today and defers the first payment until age 85, he could receive \$46,294 per year until he passes. If he lives to age 95 the annualized return is 4.4% or 5.4% if he lives to 100. If you expect to live well into your ninety’s and are concerned you will deplete your IRA, the annuity could be helpful. For comparison, a Deferred Charitable Gift Annuity (DCGA) bought with non-retirement account funds currently has a 4.3% annual compound growth rate and you get a tax deduction. To put these rates in perspective, the S&P 500 index, from 2011 to 2020 had an average annual return of 12% and from 2001 to 2020 an average annual return of 7%.

1. Under a quirk in the IRA rules, you can contribute (up to \$100,000 a year) directly to a 501C-3 charity starting at age 70 ½ even though RMD’s now start at age 72. If you are already giving to charities, contributing at 70 ½ allows you to reduce your age 72 balance calculation by up to \$100,000. This assumes your retirement accounts do not grow after the withdrawal. Giving to charities from your retirement accounts can be a much better choice than giving cash or highly appreciated stock/mutual funds from your non-retirement accounts. Besides keeping the after -tax dollars until you need them, you will be giving the charities pre- tax dollars from your retirement accounts. In addition, when you pass, your non-retirement account assets will receive a “step up” in cost basis and pass to your heirs without being taxed. This assumes you are not subject to estate taxes which currently do not tax individual estates less than \$11.7 million.  Your retirement account assets may be taxed at rates up to 50.3% (37% federal and 13.3% CA) when passed to your children (non-spouse heirs). In other words, non-retirement account assets pass to your heirs on a dollar-for-dollar basis and retirement account assets pass at potentially fifty cents on the dollar.

1. If you plan to work for your employer past age 72, you do not have to take RMD’s from your employers 401k until you retire. If you have 401k’s or rollover IRAs from former employers, RMD’s will be required from these accounts unless you are able to roll these accounts into your current employers 401k. Some employer 401k plans allow this, others do not.