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Welcome to How to Retire on Time, a show that answers your questions about all things retirement, including income, taxes, Social Security, healthcare, and more. This show is an extension of the book How to Retire on Time, which you can grab today on Amazon or by going to www.howtoretireontime.com.
This show is intended for those within 10 years of their target retirement date or for those are are currently retired and are concerned about their ability to stay retired.
Welcome to How to Retire On Time, a show that answers your retirement questions. We're here to move past that oversimplified advice you've heard hundreds of times. Instead, we want to dive into the nitty gritty because, well, frankly, there there's no such thing as a perfect investment product or strategy. There are certain things you just need to know, so we wanna dive into that. As always, text your questions to (913) 363-1234.
Mike:And remember, this is not financial advice. This is just a show, so do research. David, what do we got today?
David:Hey, Mike. How much does tax planning really play a role in a retirement plan?
Mike:More than you realize. That's my quick answer.
David:Well, because I was just thinking about this, like, right now as a working person, I do very little tax planning. Yeah. Maybe others do more, but so how is that gonna change?
Mike:Well, I don't wanna share your specific financials. Sure. But let's talk about that generally speaking, just So for a you make an income. I do. That's why you're here.
David:Yeah. Yeah. I like it. I like my income.
Mike:So your income is rather structured to where any tax planning you're really doing is, how much do you wanna contribute to a four zero one k or not? Is there company matches? They're not a company match? Does it make sense to put funds there or not. And then if not in a four zero one k, or maybe max out your four zero one k, you've got extra money, maybe you put it into something else, another investment.
David:Okay.
Mike:That's kind of the simplest version of it, but it actually gets more complicated. And you know these things, so thank you for setting me up on the question. Yeah. But what do you invest in? So let's say you invested in Verizon.
Mike:So you've paid income, taxes. It's now in your savings account. You're like, I got a little extra savings here. I I don't want this much emergency cash. Let's put it in the market.
Mike:And you bought Verizon stock. K. Verizon's a great dividend stock, but what's it doing? Every time it pays a dividend, you're paying income tax on it. Whereas if you're just trying to grow your money, you might think, well, you know, it's a brokerage account.
Mike:I really don't want maybe you buy Berkshire Hathaway. They don't pay a dividend. So you're now focused on growth without creating a tax inefficient issue. See, if you buy a bunch of Verizon stock, and I'm not dogging Verizon. I'm just using it as an example.
Mike:Everyone knows who Verizon is. Then if you reinvest that dividend every single year, your Verizon position gets bigger and bigger and bigger, and you're paying income tax on every time it's reinvested. How is that efficient?
David:And that's a capital gain. Right? Is that what we're saying?
Mike:No. It's yeah. Thank you for clarifying. It's ordinary income.
David:Oh, wow. Yes.
Mike:Yep. Okay. This is important. So what if you did Berkshire Hathaway? Maybe you did put it in the S and P 500, which historically has a lower overall dividend.
Mike:Maybe you were more deliberate about your research, and you found an ETF that's specifically like PKW, for example, that specifically buys large companies that have a historical pattern of buying back their shares as opposed to paying a dividend. Now you've got something that can grow, but is not paying your dividend because you don't need it. You've got an income. So tax planning, even when you're 20 years old and starting to work or 24, whatever you end up college or or technical school, whatever. When you start investing, tax planning starts, because you're either creating tax issues or you're not creating tax issues.
David:I see.
Mike:And then there's other things too, like, if you are gonna have tax issues, how do you get out of it? You could just pay the taxes. Could you separate certain things like here's a quick example. Let's go to retirement. So let's say you're 60 years old and you wanna retire.
Mike:Great. What are you gonna do? Well, you know, take a little bit from my IRA. I've got these stocks. I need to kind of slowly lower the positions.
Mike:Too much concentration there, so I'll take a little bit over there and, you know, a little bit from everywhere. That's so inefficient. Mhmm. And the reason is when you take income from your IRA, that's ordinary income.
David:Alright.
Mike:Ordinary income, adjusted gross income, that's taxed first. So all of your long term stock positions that you're selling, that starts at the end of your ordinary income. So if you have a 100,000 in ordinary income from your IRA, let's say, and then you start selling out some shares, you're paying 15% in taxes. Because that starts above the efficiency of long term capital gains. Or what if you just pushed out your IRA distributions from 60 maybe you didn't touch it until 63 or 64 years old.
Mike:And the first couple of years, you only took income from your brokerage account because you just had extra money there. It was growing tax efficiently. It was great. Uh-huh. But you're on affordable care act, insurance.
Mike:So health care, you want the premiums. Right? Yeah. You've also got these positions you wanna get rid of. Right?
Mike:So that you maybe sell some of those as well. So you can enjoy if you're married filing jointly. I think it's, like, around 96,000, if I remember right, as of today's recording. So the first 96,000 of gains gains. Okay.
Mike:Right? Not the basis. Not what you put into the market.
David:Okay.
Mike:But the profits. 96,000, not taxed. Because? Because of long term capital gains.
David:Oh, alright.
Mike:So when you understand that you can separate and diversify based on tax strategy, you've got seasons of where you're gonna take income from here, then income over there, and you were deliberate about what you were investing in to then get to that point, you're saving yourself thousands of dollars. Thousands. So it's not tens of thousands. For some people over the lifetime, it's hundreds. I mean, sometimes there's a lot of money, potentially even a million.
Mike:I mean, it depends how much money you have. It's all perspective. A lot of savings, not based on the investments, the tax planning and the investments. They go hand in hand. You cannot separate one without the other.
David:So you should really start early then thinking about your future self taking income and how to take income efficiently, what age should you start, like, thinking about 16. 16.
Mike:Yeah. No one's gonna do that. But 16 years old when you start, here's why.
David:Yes.
Mike:Don't get the nice car. And if your parents give you the nice car, sell it and buy whatever equivalent to they have the Geometro, because I don't think they make Geometros anymore.
David:No. But what a great car. Oh, the Geometro. I loved it.
Mike:Yeah. I drove a Chevy Auveo for a long time. Oh. And and it was ugly yellow. Then I had a Mazda that like lasted two years.
Mike:Then there was a Taurus I had. Wow. Just garbage cars. They all lasted two years, but it was cheap and it got me where I needed to go. Yeah.
Mike:No one expects you to be successful at the age of 16. So why are you trying to drive a nice car? Yeah.
David:Agreed. Don't need to give up appearances. Just have it get you to where you need to go.
Mike:Yeah. And as long as it plays music, that's good enough. Yes. If it plays music and it drives. But the point being is if you're 16 years old and you max out so you have to have income.
Mike:Mhmm. You have to generate income, but then you max out your Roth 16, 17, 18 years old, there's a good chance that half of your retirement is now paid for.
David:That's a sobering, like, woah.
Mike:Now there's a lot of variability there with market patterns and growth and what's gonna happen there. But based on thirty year historical averages and expectations, you put it all in equities. This is not financial advice. Remember, this is just a show. This is an example.
Mike:Yeah. Put it all in equities. Maybe you blend it with the S and P 500 and the Nasdaq 100. That's it. And you it's in the Roth, and it grows.
Mike:Yeah. There's a good chance maybe around half of your retirement is now paid for, and you didn't even start college. So when I say, yeah, start early, as soon as you can. Stop going to get the fancy coffee in the morning, and just drink the crap that's at the office. Maybe you got a fancy machine.
Mike:I don't know. But Right. These little differences alleviate significant financial stresses along the way. I can't tell you how many 40 year olds are barely making ends meet and have no idea at this point. I was on the phone with one yesterday.
Mike:He says, we're having a hard time saving. In fact, they're struggling. They're having to sell the little they have saved just to take care of some kids things that were unexpected. Yeah. And he's like, how am I supposed to catch up with this?
Mike:It's a lot easier if you give up a couple of fancy meals. You don't need $80 appetizers at the age of 18 years old. No. But that 80, I don't know. Layton, would you just look up the compounding interest?
Mike:Let's say, 9% compounding interest from the age of 18 to 60 years old. So you didn't buy the $80 appetizer. You put it in the market, and it's average, let's say, 9%. Just just do a quick calculation because that's not what I can do in my head at the age of 60 years old. 9% compounding interest because we're doing the equities.
Mike:We're hoping it's 9%. You're going more risk, but you don't need the money till 60 years old. What's the value at 60 years old? Need a drum roll here. That $80 appetizer's now around $3,000.
Mike:So now at that point later on, that might seem insignificant, but that's now buying 37 appetizers when you retired at $80. The point is, that's just one little bit, Wasn't a big sacrifice. Yeah. Now how many times could you do that in the year? Do it 10 times in the year.
Mike:Wait. Got 30,000? Yeah. Do it a 100 times in the year? Got 300,000?
Mike:Oh. I mean, these are things that matter. You've got to create the system to where you're saving. Now the question was about tax planning as well.
David:Let's Tax planning.
Mike:Let's dive into that a little bit deeper. So when it comes to tax planning, k, you've got to keep in mind your ten forty. What do I mean by that? When I say the ten forty, the 1040 is the scorecard. Let me give you an idea, and I can tell you right now, I would be willing to bet most financial advisers don't have a clue what I'm about to say or even look at this on an annual basis.
Mike:Okay? So on lines two and three, let me break that down for you real quick. Line two a, that's your tax free interest. That's where it's gonna be recorded there. It doesn't affect your adjusted gross income Oh.
Mike:But it affects your modified adjusted gross income. So think of your municipal bonds. That's gonna affect your Social Security planning. That's gonna affect if you qualify for Trump's new senior standard deduction planning and so on. Did you really do yourself a favor for all these municipal bonds to, quote, unquote, not pay income tax when it could be affecting other parts of your plan?
Mike:Also, keep in mind that your municipal bond interest, you need to account for the comparable difference of taking the municipal bond interest versus some other fixed income. That's what they call bonds. Fixed income offer and pay taxes because the fixed income that's not a municipal bond might pay you more than the municipal bond. Municipal bonds give you less because they know it's tax free.
David:Oh, I see.
Mike:So you have to do a after tax calculation. And do you need or want the Social Security tax efficiency or not? Do you want the extra 6,000 per person deduction that's gonna be from 2025 to 2030 or not? You've gotta keep in mind that there's no get out of jail free card if you're getting money in one way or the other. It's showing up on your tax return, typically speaking.
Mike:So two way, tax exempt interest. Be aware of that. Now it affects other parts of your plan. Also, adjusted gross income, that tax free interest, that's gonna affect your Medicare. So IRMA and surcharges there.
Mike:So be mindful of these things. What if you don't need this tax free interest? You're just trying to grow your assets. Pick something else that doesn't pay a dividend or an interest rate. It's just growing.
Mike:You could create unintentional inefficiencies because you didn't pay attention to the tax free bank because it's not on your adjusted gross income, but it shows up elsewhere. You gotta pay attention to these things. Look at two b. K? Two b is the taxable interest.
Mike:So this is kind of a surprise for some people as it bumps up their bits. You know you got your high yield savings or other things that are paying you interest. Be aware of that. You've got then three a. Three a, these are qualified dividends.
Mike:These don't show up as much based on my experience, but you've got your qualified dividend, which is paid as a long term capital gains rate, but it's like for foreign companies or corporate payouts, things like that. Very specific they they qualify very specifically. Like, it's not as easy. Then you've got two or three b, which is your ordinary income. This is where people get hurt.
Mike:Because they've got so much ordinary income coming from because they're dividend investors, and it's in their brokerage accounts, and they keep reinvesting it. So then the issue gets bigger and bigger and bigger. This is when they typically come to me and say, how do we fix this? See, only the way to get out of it is to either do nothing and keep paying the taxes, do nothing and spend this money, or sell with long term capital gains rates to coordinate that usually over a couple of years to then move money into something that's not paying as much dividends so the problem doesn't get bigger and bigger and bigger. Anyone that actively avoids paying taxes oftentimes pays more in taxes.
Mike:Oh. They create tax efficiencies they have to deal with later on because they're not being proactive, And the specific scorecard for brokerage accounts I have found is to be on lines two and three. So two a, two b, three a, three b. And then also keep in mind line seven. Line seven is where you're keeping the scorecard of your capital gains.
Mike:Are you or your adviser actively trading in your portfolio to try and beat the market? Let's put that into context. For easy math, let's say that the market's averaging 10%, because ten's an easy number. Mhmm. K?
Mike:And let's say your effective tax rate is 20%. If the market's doing 10% and you're actively trading and you got 10% performance, you have to account for taxes. That's 20% you're paying in taxes. So really, you didn't get 10%. You got 8%.
Mike:Because you had to pay taxes. It's a headwind against your performance.
David:Okay.
Mike:And for what? I love active trading, but I think it should be done more appropriately in a qualified account like an IRA or Roth
David:Yeah.
Mike:Not a brokerage account.
David:Yeah. Because the brokerage account for, like, just sort of buy and hold or
Mike:In my opinion. Yeah. Yeah. Yeah. Now, I mean, you can get fancy and do holding companies and c corps and things like that.
Mike:There's double taxation, which is an argument. But if you're looking for long term growth Mhmm. You're gonna get taxed at a different rate than income tax, but most people don't do that kind of thing. But then think, okay. Well, I need to get 12% just to match the 10% growth net of taxes.
Mike:So now that's really hard to do, but it doesn't stop there. You have to then rationalize the fees. Let's say you're paying 1%. So you've gotta do 13% average annual returns to match roughly net of tax performance, the 10%, and just ignore how it affects all the other parts of your plan.
David:So how do we put a bow on this whole we we started off with how does tax planning really play a role in my retirement plan? We've talked a lot about lines two and three and two a and three a.
Mike:When I got started in the industry, I was taught to tell people, if you're paying taxes, you should be thanking me because I'm making you money. And how ignorant is that?
David:Yes. It fails to consider all the scorecards as you call it.
Mike:Yeah. Another way of looking at it is I don't think you can give proper investment advice unless you also can give tax advice. So if you ask someone, can you give me tax advice? No. That's a red flag.
Mike:Mhmm. Because the way you build a portfolio must acknowledge how it's going to affect your tax return and the performance and the other parts of your Social Security taxes, your modified adjusted gross income, how that affects the standard deductions that you may or may not qualify, how that affects your IRMA if you're 65 years older. It all plays a role. And so many people miss it because they put blinders on and say, okay. What was my performance?
Mike:They look at a percent, and they forget how it affects the taxes. Or they might realize it, but they don't fully connect the dots. It's not about how many times your adviser trades. If you hire an adviser, the purpose is to help guide you through the complexities of your ability to create and sustain your wealth. The growth of your assets that they're used for your lifestyle and legacy goals.
Mike:Don't get upset if adviser doesn't trade frequently. Are they keeping my best interest at heart? Are they a fiduciary that can also do taxes? By the way, fiduciary doesn't mean they can give you tax advice. Fiduciary means that they have a securities license, and they're supposed to put your interest ahead of their own.
Mike:And it
David:seems like everybody should follow that what you just described.
Mike:Well, the insurance companies have their own word. It's called best interest. That's their version of a fiduciary. They couldn't use the same word though for No. I don't know, probably legal reasons.
Mike:Yeah. But they're also supposed to put your interest ahead of their own in their own way of wording it. It is confusing, but unless you have someone that can do both, tax and investment advice, you may be creating unnecessary resistance towards your growth and your goals. That's all the time we've got for the show today. If you enjoyed the show, consider subscribing to it wherever you get your podcasts.
Mike:Just search for how to retire on time. Discover if your portfolio is built to weather flat market cycles or if you're missing tax minimization opportunities that you may not even know exist. Explore strategies that may be able to help you lower your overall risk while potentially increasing your overall growth and lifestyle flexibility. This is not your ordinary financial analysis. Learn more about Your Wealth Analysis and what it could do for you regardless of your age, asset, or target retirement date, go to www.yourwealthanalysis.com today to learn more and get started.