The $100,000 Tax Mistake: Are You Making It Right Now?

It’s easy to avoid paying any taxes! Just donate every penny you make to the IRS to pay down the national debt. This is a completely legal way to not pay a dollar in taxes!

Assuming you are not going to donate all of your hard-earned money to pay down the national debt, what else can you do about taxes?

I’d like you to consider Dave. He is a mid-career aviation engineer in Wichita. He has been consistently contributing to his 401k, diligently saving for retirement, and has tried to keep his portfolio well diversified.

Dave is also a great unintentional philanthropist. He has been consistently donating money to the IRS. And in the future (unknown to him) he is planning on donating tens of thousands of dollars more to the government.

How?

Through a combination of small tax inefficiencies, lack of withdrawal strategies, and poor proactive planning. On their own, none of these are big mistakes. However, combined they have a compounding effect. They multiple into a very large donation to the IRS!

Dave has two options…

1. He can say, “I wish there was some way to lower my lifetime tax bill!" And then continue to do the same thing he’s always done (this is what most people do).

2. He can begin to proactively plan his tax strategy.

Let’s assume Dave picks the second strategy. The first thing to do is look at his assumptions that got him here in the first place.

Assumption 1: Taxes will be lower in retirement. There is some nuance here. Often what I see is investor’s tax brackets are lower for a few years before shooting up due to RMDs (money you are forced to withdrawn from your tax-deferred accounts), as well as Social Security kicking in.

The savvy investor will take advantage of this nuance to dramatically lower their lifetime tax liability.

Assumption 2: Dave assumed his 401k will be his tax-efficient golden ticket. It certainly seems this way when you are making contributions. In Dave’s case his combined marginal tax bracket (federal plus state) was roughly 27%. This meant that for every $1 Dave contributed to his 401k, he got $0.27 back from the government!

This seemed great until Dave realized he may be paying more than $0.27 for every dollar he pulled out of his 401k when he retired.

So, with these assumptions in mind, what strategies can Dave use to avoid such a costly mistake?

First, he needs to evaluate his Roth options. If he is still working, he needs to analyze whether he should contribute some of his 401k contributions to his Roth option. This seems painful because it means he doesn’t get that $0.27 back for every dollar he contributes. Which is why he needs to analyze where his tax brackets will likely be in the future to see if this makes sense. Then, he needs to put together a Strategic Roth Conversion Plan. Whether or not he is retired, he needs to look at conversions every year to see if they make sense.

Some questions to ask regarding whether conversions make sense include…

• What will my RMDs be like in the future? Will paying a little in taxes now and conversions save me a lot in the future on RMDs?

• Am I in a lower or higher tax bracket now compared to where I think I will be in the future?

• Are tax brackets set to increase in the future? (The tax code is written in pencil so it is always subject to change, but this is still an important question to ask?)

• Will my heirs be better off with money in an inherited IRA or an inherited Roth?

• If I’m about to tip over into the next tax bracket, do I have other pools of tax-free money I can use to smooth out my taxable income?

  
  

Depending on how Dave answers these questions Roth conversions may or may not make sense for him. But he should be asking these questions every year.

Second, pay attention to tax brackets. Most people have two to three tax brackets to be concerned about while they are working. These include federal, state, and capital gains tax brackets. When they retire, this now includes the Medicare IRMAA threshold and the Social Security brackets that Dave has to keep track of. Sadly, most people don’t pay attention to these. But this is especially important when doing Roth conversions. You may not increase your marginal tax rate, but you could certainly go up an IRMAA or Social Security bracket.

Third, Dave should evaluate whether the traditional withdrawal order, which is taxable, then tax-deferred accounts then Roth accounts, makes sense of him. This is a good rule of thumb but that’s all it is: a rule of thumb. If he does not carefully evaluate his withdrawal strategy based on his tax brackets, he could easily use the wrong withdrawal order and grossly overpaying the IRS!

This is getting long, but we haven’t even touched on charitable giving strategies or tax-efficient investments or asset location!

Biggest Lesson Here: Don’t Be Like Dave

• Tax mistakes are expensive, but avoidable with the right strategy.

• If you’re not proactively planning, you’re probably going to pay more than you have to over your lifetime.

• Want to see if you can reduce your lifetime tax burden? Let’s run the numbers—before the IRS thanks you for another “donation.”

  
  

I Can Help You!