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Taxes: Mandatory vs. Optional...

Live happily

Death and taxes - 2 truths we all know about! Both are mandatory, but at least with taxes, there are actually some that with proper education and planning can actually be optional! Let’s explain…

Mandatory taxes in retirement refer to taxes that you must pay by law, regardless of your retirement status. These include:

Social Security taxes:

If you receive Social Security benefits in retirement, a portion of your benefits may be subject to federal income tax. The amount of tax you pay depends on your income and filing status.

Medicare taxes:

If you enroll in Medicare, you'll be subject to Medicare taxes, which are deducted from your paycheck if you're still working. If you're retired and receiving Social Security benefits, your Medicare premiums will be deducted from your benefits.

Optional taxes in retirement refer to taxes that you may choose to pay, based on your financial situation and tax strategy. These include:

Income taxes:

If you have taxable income in retirement, such as income from a part-time job or rental property, you'll be subject to income taxes. However, you may be able to reduce your taxable income through deductions and credits.

Estate taxes:

If you have a large estate, your heirs may be subject to estate taxes after you pass away. However, there are strategies you can use to minimize the impact of estate taxes, such as setting up a trust or making annual gifts to your heirs.

All of the money you’ve put away in your IRA has been racking up for years and years due to the hard work you’ve put in over your career. But while it’s technically your account, the IRS has basically been lurking in the corner as a silent partner on this sort of ‘joint account’ with the government. In fact, as soon as you pull money out of your IRA, the IRS is going to get paid first! The tax that comes out is mandatory.

But here’s the difference between taxes: mandatory vs. optional...

Let’s walk through a little scenario - say you have a $500k IRA account, how do you approach taking this money out?

You could…take money out all in one year to use as you see fit or even do a Roth conversion and put it in a tax free account, but then you’d have to declare $500k in one day which would leave you with sky-high taxes because you’d be considered to be in a higher tax bracket 🤔

Doesn’t sound like that great of an option, does it?

The strategy we would employ and recommend in this scenario would be to do a conversion to a Roth IRA over 5 years instead of 1 year. Now, we’re only taking $100k per year for 5 years. In this scenario, you’d be in the 25% bracket... and this means you’d have to write a check for $25k each of those 5 years. That still doesn’t sound great, we know, but now that you’ve moved your money over to a Roth IRA, all future growth and earnings are tax free and you’ve knocked out paying the IRS their mandatory tax.

Running from excessive taxes

We speak to plenty of folks about their retirement plans and we hear from some that despite hitting age 59 ½ (when you are eligible to pull out from your retirement account), they are choosing not to. Why not? Well, they say it’s taxable and they want to put off paying those taxes. While we can appreciate that sentiment, that approach is almost like trying to fill a bucket with water that has a hole in it. You’re going to keep adding more and more water (your money) but the part leaking out is going to also keep amounting to more water spilled out (again, your money) and that water spilling out is going to the government!

If you choose to take the money out of this retirement account over your lifetime, using the Required Minimum Distributions strategy (RMD), it’s actually going to equate to significantly more money taxed in the long run. And don't forget, at age 73, the RMD must be withdrawn based on the balance in the account the previous December 31st. The difference between what you would pay in a quick conversion strategy, versus this RMD strategy is the difference between mandatory and optional. Anything beyond the quick conversion approach is option tax. Which means, you are choosing to pay more!

We want you to keep as much as you possibly can of your hard earned income. It's important to work with a financial advisor or tax professional to understand the tax implications of your retirement income sources and develop a tax-efficient strategy that meets your financial goals.

Book a strategy session with us by clicking the link below if you’re interested in paying the least amount of taxes possible 😉

Compass Financial Founders - Karen & Sam


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