The tax code is a confusing maze of rules and regulations that very few people understand. All of these rules often make it difficult to understand what is true and what is not.
This leads to people creating rules of thumb that are generalizations to simplify the complexity of the tax code. Unfortunately, as with most complex topics, this can create popular beliefs that may not be true.
Here are five of the most common tax myths we hear from clients:
1) I’ll be in a lower tax bracket once I’m retired.
Naturally, if you are no longer working and earning wages it is reasonable to assume you will be in a lower tax bracket. Unfortunately, the formulas that determine how much of your Social Security, qualified dividends and capital gains are taxed, along with mandatory withdrawals from your 401k/IRA at age 72, can lead to paying a lot higher tax rate than you expect.
Retirement tax specialists often refer to this problem as the “tax torpedo.” It’s where a middle income household can quickly approach a marginal tax rate of up to 49% despite being well below the top tax brackets. This happens when 1 additional dollar of income results in more Social Security and capital gains/qualified dividends being taxed.
The tax torpedo isn’t even the worst of it. The Medicare IRMAA (income-related monthly adjustment amount) surcharges are built in a way where one additional dollar of income over the limit results in hundreds or thousands of dollar more in annual Medicare premiums. That equates to a marginal tax rate of well in excess of 100%!
2) I should pay as little tax as possible every year.
This myth makes one giant assumption that is by no way guaranteed; that your future tax rate will be lower or the same as your current tax rate. We described two ways that may not be true in myth number one. Also, it’s possible the tax rates themselves for each bracket go up as Congress changes the rules all the time. In fact, tax rates are scheduled to revert back to the higher 2017 rates starting in 2026, if Congress doesn’t act before then to stop it.
Also, there is an additional reason tax rates may go up in the future for a married couple. If one spouse outlives the other for an extended period of time they may face what is called the “widow’s tax.” This is the result of having similar or only slightly lower income, but filing as a single taxpayer as opposed to a married couple. Often times this situation can be anticipated if, for instance, one spouse is significantly older than the other or one spouse has a medical condition while the other is in perfect health. It could be very valuable to take advantage of tax rates as a married couple to avoid the surviving spouse having to pay higher tax rates in the future.
3) Paying $0 in taxes is always a good thing.
It feels very strange to say it out loud but $0 in federal taxes may not actually be a good thing. Consider this scenario: a married couple age 65 has $50,000 of long term capital gains as they live off of their savings in the bank and taxable brokerage account. They also have $500,000 in a traditional IRA they don’t touch and they haven’t started receiving their Social Security benefits yet.
This couple would pay $0 in federal taxes because of how the tax code treats long term capital gains for someone with income in that range. The problem is they could have taken out $27,800 from their traditional IRA and still paid $0 in federal taxes! On top of that, they also will very likely find themselves in the 12% federal tax bracket or higher once they started required IRA distributions and start their Social Security.
This means they also wasted their chance to get money out of the IRA and “fill up” the 10% tax bracket, which would be better than paying tax on those same dollars in the future at 12% or higher.
4) I don’t have to pay tax on my Social Security benefits.
This may be true if your only income is Social Security or if you have very little other income. For most people though, somewhere between 0% and 85% of their Social Security benefits will be consider taxable income. How much depends on how much your benefits are and how much your other income is.
This complex formula is difficult to quickly calculate, which is why it’s so often misunderstood. You simply can’t have a rule of thumb for it and that’s why having a retirement tax specialist evaluate how your retirement income coincides with your Social Security benefits is so important. Once you understand how they will interact you can strategize to save money on taxes.
5) My accountant will help me with a long term tax strategy.
In our experience, accountants have neither the time nor the information needed to create a long term tax strategy for their clients. We all know how time crunched accountants are during the busy tax season; and Congress is doing them no favors by continually tweaking the tax code last minute. They simply must focus on looking backwards and ensuring an accurate tax return for the previous year.
Along with preparing last year’s tax return, they almost never have the information needed to strategize about tax opportunities. How often has your accountant asked about your 401k/IRA balances and future Social Security benefits? Have they calculated the amount of your future required minimum distributions? What about your annual living expenses, planned gifts to your kids, or charitable donations in the future? Without this information they aren’t able to take advantage of opportunities.
If you find yourself dazed and confused over all the moving pieces of your taxes in retirement and would like one of our advisors to help review your situation, please don’t hesitate to contact us at 716-634-6113.
These type of issues for retirees are exactly what we specialize in because we know how big of a difference it can make. Plus, every tax dollar saved is another dollar available to get the most of out your retirement!
Steven Elwell, CFP®
Partner, Chief Investment Officer