Small Business Taxes & Management^TM--Copyright 2021, A/N Group, Inc.

Introduction

One of the most important principles of tax saving is to defer income from when you're in a high tax bracket to when you'll be in a low tax bracket. Generally, that means deferring income until retirement. But too much of a good thing can be a bad thing. Here's how one taxpayer ended up on the wrong side of the curve. Here's a real-life example.

Fred and Sue weren't high earners, making the equivalent of about $120,000 a year. The couple always deferred as much of their income as possible through a Keogh plan for Sue and a 401(k) for Fred. That reduced their reported income significantly. In addition, rental properties created losses of between $15,000 and $25,000 each year. As a result their taxable income averaged around $50,000, putting them in the 12 percent bracket. They disposed of rental properties, but always used a 1031 exchange, avoiding any capital gains.

Fred continued to work until he was almost 75 and continued to defer as much income as possible. But when the couple reached 72 their income climbed as a result of social security benefits and required minimum distributions from IRAs. Once Fred retired distributions from his 401(k) kicked in. They were more than the taxable portion of his salary. As a result of all the changes his income was well over $100,000 and the couple were unable to take any of their rental losses. They're now in the 22 percent bracket for a significant portion of their income.

An outlier? There's no question this isn't the usual situation, But it's also far from unique. More and more retirees are encountering something similar. Keep in mind that taxes are only part of the equation. Putting money in IRAs and 401(k)s and other plans is a smart move because you save taxes up front and the money grows tax free. But you can overdo it. Here are some thoughts.

Traps and Loopholes

Retirement Fantasy Where will you be at retirement? This is the first step in analyzing your finances. Some people want to retire at 65 and start booking cruises the next day. Some out of necessity or desire will continue working well into their 70s and often 80. Some people can work; some can't. Retirement may be mandatory at some age, required skills might change, physically unable to work, etc. But business owners, professionals, etc. may be able to continue working. You may not know your fantasy or limitations until you're 50, but that's still time to switch gears. Many financial planners don't take this into account.

Tax Deferred Accounts Produce Ordinary Income That includes IRAs, 401(k)s, and a variety of other plans. They save taxes up front, but you'll owe in retirement when you take it out. In addition, withdrawals are taxed at ordinary income rates. You bought Madison Inc. at $10 a share 30 years ago and it's now worth $300 when you're taking your RMD (required minimum distribution). In your own name that would be capital gain income taxed at maybe 15 percent. Coming out of an IRA or 401(k) it's taxed at, say 22 percent. Stocks or other investments that can be held for the long term might fare better in your personal rather than a tax deferred account. Assets that are likely to be traded regularly should be in a tax deferred account.

Divide Assets Between Taxable and Deferred Accounts While even when you're young you should be investing in your own name to provide funds for emergencies and other purposes but concentrating on deferred accounts. As the accounts build and you have a better idea of both your finances and your retirement aspirations, you may want to adjust the mix depending on what you project you'll need. Remember, assets in your own name don't have to be distributed.

What You'll Need in Retirement There's simple answer such as 70 percent of your working income. Some retirees may sell a house, move to a less expensive area and may find living expenses much less than when they were working. For some the reverse is true. The free time can result in expensive activities. And some individuals never fully retire. After 40 years in a profession you may make a fair amount as a consultant. You may also have other sources of income such as the sale of a business or rental property, and you may have a substantial inheritance. Both may not only reduce the funds you need but could also generate additional income, further increasing your tax bracket.

Roth Accounts Roth IRAs have two advantages. One, if held for the requisite time and you're over 59-1/2 distributions are tax free. Two, you can leave the funds in the indefinitely. If you think you might be in a higher bracket at retirement, Roth accounts make considerable sense. The drawback is that contributions to the account may be restricted by your adjusted gross income.

Higher income taxpayers have another option, converting a traditional IRA to a Roth. The downside here is that you'll have to pay tax on the amount distributed from the traditional IRA. The tax penalty means you'll have to run the numbers carefully before converting and you'll have to be pretty sure the investments in the traditional IRA will appreciate and/or produce income. The worst situation could be where you convert a $100,000 in IRA assets, pay, say $25,000 on the conversion only to see the assets in the Roth decrease.

There are some ways to mitigate the tax consequences of the conversion. The first, and most obvious, is to make the conversion when the portfolio is down, i.e., in a bear market. That could save a considerable amount. Second, if you have a business or your income varies (e.g., commission salesman) do a conversion when your income is low and you're in a lower tax bracket. Some business owners have carefully estimated their income near the end of the year and converted just enough to keep them in a low bracket. You may even be able to structure your business income (e.g., large depreciation deduction) to achieve that goal. Get good advice from a tax professional. The tax dollars involved could be substantial.

Passing It On While your spouse essentially treats your IRA as hers (or his) on your death, that's not true for other heirs. Distributions can no longer be spread over the beneficiary's life, but must be distributed within 10 years. In the case of a large account that can result in a substantial tax bill if the individual is in a high bracket. On the other hand, assets in your own name get a stepped up basis, potentially avoiding years of accumulated gains. Of course, like any part of tax law this could change, but it's an important consideration if your beneficiaries are doing particularly well.

Tax Brackets Not Only Factor Finding yourself in a higher tax bracket isn't the only way your taxes can go up. Once you pass $100,000 you start to lose your $25,000 exemption for the deduction for rental losses. At $250,000 the net investment income tax kicks in. That's a modest 3.8 percent and the effect depends on your investment income (interest, dividends, capital gains, etc.). There are a number of other phaseouts, but fortunately a number of them aren't generally applicable to retirees.

A big change can occur if your spouse dies. You'll no longer be entitled to the lower tax rates of married filing jointly. Instead you'll have to file as single (unless you have a dependent). Your rates would just about double. The effect would likely be tempered by lower income since there would only be one social security check and the higher basis in investment assets held by your spouse would result in lower capital gains.

Best Approach

It's unlikely you can optimize your tax and investment situation. There are too many variables that you won't be able to quantify. Depending on your projected working income, your retirement plans, and how much income you'll generate in retirement, you should be able to come up with a mix of total investment assets held in your own name and investment assets in tax deferred accounts. But even if the analysis suggests putting as much as possible into deferred accounts, you should put away some money personally so you won't have to tap the retirement accounts prematurely and pay the 10 percent penalty should you encounter an emergency situation or need funds for a large discretionary expenditure.

This is one area where you should seek professional advice, at least in the initial planning. And don't forget to recheck the mix of personally owned and deferred accounts at least annually. Your personal situation as well as tax law and the investment environment is subject to change.

--Last Update 02/04/21