Episode 45: Why Paying More Taxes Now Can Be a Smart Move

Table of Contents

• Introduction with Madison and Mike
• Article Summary: Paying More Tax Can Be a Smart Play
• Why People Oppose Deferring Taxes Less?
• How Do I Know If This Strategy Is Right for Me?
• Impact of Required Minimum Distributions (RMDs)
• Minimizing Stealth Taxes Like Medicare Surcharges
• What Is a Roth Conversion?
• Considerations for Roth Conversions
• Using the 0% Capital Gains Tax Rate
• Final Thoughts from Mike
• Outro and Credits

Introduction with Madison and Mike

Madison: Hello everyone, and welcome to Not Just Numbers: Honest Conversations with a Financial Advisor and Lawyer. I am Madison Demora, and I am here with Mike Garry. Mike is a financial advisor and a CFP practitioner and the founder and the CEO of Yardley Wealth Management. He is also an estate planning lawyer, and his law firm is Yardley Estate Planning. Hey, Mike.

Mike: Hey, Maddie. How are you?

Madison: I’m good. How are you doing today?

Mike: Good. How about us recording not on a Monday.

Madison: Yeah, yeah. All right. So today we are going to discuss an article from the Wall Street Journal. It is titled “Paying More Tax Can Be a Smart Play” and this is by Laura Saunders. I will read a summary like always, ask Mike some questions.

Article Summary: Paying More Tax Can Be a Smart Play

Madison: All right. The article argues that sometimes paying more taxes in the short term can lead to lower lifetime tax burdens. Traditional tax planning encourages deferring income to delay taxes, but this strategy may backfire, particularly for retirees with large tax-deferred accounts like 401(k)s and IRAs. Required minimum distributions at age 73 can create significant taxable income, pushing retirees into higher tax brackets and triggering additional costs, such as Medicare premium surcharges and the 3.8% investment income surtax. To mitigate these effects, taxpayers can strategically accelerate income while in lower tax brackets. Spreading income, such as stock sales or bonuses, across multiple years can help avoid sudden jumps into higher tax brackets. Making Roth contributions or converting traditional retirement accounts to Roth accounts allows individuals to pay taxes upfront, benefiting from tax-free growth and withdrawals while also avoiding future required minimum distributions. For those inheriting traditional IRAs, withdrawing more than the required minimum each year can prevent a tax spike in the final year of the 10-year withdrawal period. Additionally, lower-income taxpayers may take advantage of the 0% capital gains tax rate by selling appreciated investments tax-free, though this requires careful planning to avoid unintended consequences, such as increased Social Security taxation. Overall, the article emphasizes the importance of proactive tax planning to minimize total lifetime taxes rather than simply deferring them. The article challenges the traditional idea of deferring taxes whenever possible. Why may people be opposed to this idea?

Why People Oppose Deferring Taxes Less?

Mike: So it’s long held, long established, right, that your first choice is to not pay the tax. And if you have to pay it, pay it in the future because the value of it in the future is less than it’s worth now. And so if forever, it has been the common assumption to not pay sooner than you have to. Right. And for a long time that probably made a lot of sense. I remember taking income tax 1 and 2 in law school in the 90s and Professor Carolyn Nakmius, it was something that you went over every day in class, right. You don’t want to pay it if you don’t have to pay this year, don’t pay it this year, pay it in the future. And it’s, you know, that probably is wise still in a lot of situations. But this kind of tax planning that the article references is what we do every day. And so I really thought it would be a good article for us to discuss because people have a lot of opportunities to look at their overall lifetime expected taxation and make some key moves, especially in their 60s and to a lesser extent, 50s and 70s, to bring these down. You know, we’re at a point now where CPAs are having a hard time. They’ve been so overworked and stressed since COVID. I think a lot of cases they’re not getting to do as much planning as they would like to do or they did in the past. And, and we are trying to help out in that regard and do a lot of planning. And I think that if you just go to, if you don’t do any planning and you bring everything to your tax guy or gal, they will do what they can to decrease your taxes for, you know, the, the prior year. Right. That makes sense. You go see your accountant next month and you bring all your stuff and they’ll go through everything, you know, they, they’ll do what they can. So you have to pay the lease that you can or get a, get a refund. But in some situations, especially in or around retirement, if you look at the broader picture of the available investments and income and Social Security and RMDs and things like that, it often makes sense, you know, to look out and not just pay your lowest amount of taxes. Right. So, you know, I don’t know if you’re aware or listeners are aware, there’s a 0% capital gains tax bracket that goes to like $100,000. And so if someone has no other income except for capital gains. If they were just doing the old school don’t pay or delay, they wouldn’t do anything in a year and they would lose out on that bucket. If instead they took 50 or $80,000 in gains and paid zero percent, like zero dollars in tax, that’s the right thing to do. Right? Like that makes sense. And in a lot of situations, even if they were paying at 10 or 12% or 15%, it still might make sense depending on what is coming up after in terms of Social Security and requirement on distributions.

How Do I Know If This Strategy Is Right for Me?

Madison: Okay, so referring to the strategy in the article, how do I know if this strategy is right for me?

Mike: Well, what you have to do is look to see what you have and do some tax planning. You know, we use some different tax software that maybe individuals don’t have, but there’s tax planning software out there. You need to take a look to see what it is, look at your situation and try to plan. Right. So when we get somebody’s, what we do is we get somebody’s prior year tax return, we ask them what changes there are to that. We plug the numbers in and so we see what the current tax rate is. And then knowing how old they are, we’ll know like how many years until they will take Social Security or how many years before they have to take their required minimum distributions. And if they’re in a low, and we could see like if we keep the status quo, if they’re in the 10% effective rate now, but in five years when they have to take Social Security and require minimum distributions, they’d be in a 20% effective rate. Then some of these strategies are probably worth pursuing. And then the question is like which ones and how do you do it? But, and that really changes based on the individual circumstances. We make all kinds of different recommendations and advice for this. It really is personalized.

Impact of Required Minimum Distributions (RMDs)

Madison: All right. How might required minimum distributions impact retirees who have diligently saved in tax-deferred accounts? And what are some potential consequences of large RMDs?

Mike: Sure. So if someone, and it’s not uncommon if someone like spends their life saving the max in a 401k and they invest it well, by the time they get to their RMDs, which is 73 for people now and 75 for people born in the 60s or later, you know, if you’re working for almost 60 years, you could save a lot of money in your 401k or your IRA. And then when you go to take that distribution, it could be a lot and it could be a lot on top of your Social Security which you’ll be taking by then and maybe your spouse’s Social Security and maybe your spouse’s requirement minimum distribution. And so we’ve run into people who haven’t done that planning and they’re at a part now where they are paying large Medicare surcharges because their income is so high. They’re paying a lot of tax on this income and they don’t need it all. So it’s really silly. So, yeah, it can really affect you. So if you’re in a position where you have a large pretax 401k and you’re getting close to retirement, it might make more sense to put that money in the Roth version. If you have Roth election in the 401k, if you have that or just in your brokerage account. Right. You really need to plan ahead and don’t be surprised you wind up being 75 and your tax system is worse than it’s been in 20 years.

Minimizing Stealth Taxes Like Medicare Surcharges

Madison: All right. The article mentions stealth taxes such as Medicare premium surcharges and the investment income surtax. How can strategic tax planning help minimize these additional costs?

Mike: Yeah. So if you do that strategic tax planning and you pay more in tax at the lower rates than you necessarily have to, it could greatly reduce either of those things. Right. By keeping your income lower at a time when you have to take your required minimum distributions. So and those are those are taxes people don’t think about at all until they pay them. The people paying the Medicare surcharges, sometimes it’s a lot of money and they don’t like it. But you just need a plan in advance.

Madison: Yep.

What Is a Roth Conversion?

Madison: All right. Roth conversions are presented as a way to reduce future tax burdens. What is a Roth conversion?

Mike: So it is taking your IRA, converting some part or all of it to a Roth and paying taxes now. And so. There are a number of reasons why you may or may not want to do that. Like if you’re in a really high tax bracket now, but don’t necessarily have a lot of assets, it might not make sense to do it because you’d be paying 37% tax on the conversion. But then, you know, and maybe it’s not worth it to you. But if you are in a lower bracket now, maybe you’ve stopped working and you’re not really taking a lot of money out of your accounts, your income’s not high. We have a lot of people in their 60s who do that, who aren’t necessarily living on a lot of money, but are making conversions every year of 25, 50, $75,000 a year. What it does is we’ll use numbers to make it simpler. Say somebody does a $50,000 conversion, they’re going to move money from their IRA to their Roth, they’re going to have $50,000 of extra income. They’re going to have to pay tax on that. And that tax money is going to have to come from a cash account, right? You don’t want to have to take it from your IRA and pay more tax on that. So if you move that 50 into the Roth and say you do it for 10 years, you’ll have $500,000 plus the growth all those years. So Maybe you’ll have $800,000 or a million dollars in that Roth at the time when you’re done. So that’s a million dollars that you aren’t going to have part of your IRA, right? So you’re not going to take out $40,000 a year based on that and pay income tax rate on that. And the conversion, when people inherit your Roth, they don’t have to, they have to take it out over 10 years just like a regular IRA, but it’s not taxable. So if you’re 75 and you pass and your, your kids are in their late 40s and early 50s and, and at their peak earnings, if what they’re getting is more Roth, it’s less extra tax you’re gonna have to pay on those distributions. So, you know, I mean, it’s a complicated decision sometimes. It’s not, this is not like, oh, this is a no brainer, everybody’s gonna go and, and convert their IRA to a Roth. But it makes sense in a lot of situations and it could be based on your taxation or something that you’re doing for your children, for their future taxation. You know, it could make sense for either of those reasons. It’s definitely something people should look at, especially once they’ve stopped working. If you’re still working and earning a good salary, it often doesn’t make sense to do it. But once you’re retired and not earning anything, it always makes sense to look at. And then for some people, it’s a great idea.

Considerations for Roth Conversions

Madison: Yeah. So what are some things that they should consider when making this decision?

Mike: Yeah. What their future taxes are expected to be, what their kids future taxes are expected to be, whether they have the money to do it. Like if you don’t have money to pay the tax now, then you really can’t do it. It doesn’t make sense to take more money out of your IRA and owe taxes on that to pay the tax bill for the conversion. So you need to have the money available. You need to I think be in a lower tax bracket than you’re afraid you’re going to be later in retirement. And often if you have kids, it often makes more sense to do it, right. If you’re going to leave your money to charity, it doesn’t make sense to do it because they won’t pay any tax on it. So yeah, there’s a bunch of different things and then again it really depends on like your mix of pre-tax, Roth, brokerage, savings to see what makes the most sense for you.

Madison: Great.

Using the 0% Capital Gains Tax Rate

Madison: The article discusses using the 0% capital gains tax rate for lower income taxpayers. What is that and are there potential risks or unintended consequences of this strategy?

Mike: Yeah, I think that the what is it is like your capital gains tax bracket is zero for the first somewhere around $100,000 of capital gains. Likewise like your income tax bracket, like the first one, zero. Right. You could earn some money that winds up being less than what the standard deduction is and you would owe no income on that. You’d get a refund if anything was withheld. And so if you are at a position right where you’re not earning a salary and you don’t have a pension and you’re retired and you are thinking about taking money out of your brokerage or your your IRA, your Roth. One of the things to consider is whether you can take any gains in the 0% tax bracket and if so it’s often a good idea. Again, it’s in context with whether you want to do Roth conversions to or instead. But then the possible downsides are like if you have too much income, maybe it’ll make your Social Security taxed more because at the lowest income level, Social Security is taxed much is not taxed, and then lightly taxed, you know, you get the higher earners, you know, 85% of it is taxed. When I say that it’s not like an 85% tax bracket, I mean, if you own, if you make $10,000 in Social Security payments, $8,500 of it will be income for tax purposes. So those stealth taxes are the ones you need to worry about if you are taking large gains based on the assumption you’re using a zero percent tax bracket.

Madison: Okay.

Final Thoughts from Mike

Madison: All right. Is there anything else you want to add, Mike?

Mike: No, really, the whole thing is people need to get away from the mindset of, like, I need to pay the lowest amount of taxes I can this year. And only that. Like, if you are thoughtful and you do some planning and look ahead, you can really save yourself and potentially your heirs a lot of money in potential taxes. And, you know, we have had relatively low income taxes, you know, in, like, in my adult lifetime. They’re among the lowest as a percent. And so Roth conversions might make more sense than they would have in other years. Also, like, the standard deduction is pretty high and that 0% bracket for capital gains tax is pretty high. So, you know, we have this landscape that we wouldn’t have anticipated 20 or 30 years ago, right, where people can do all this planning, right before and into retirement to really reduce the amount that they’ll pay or potentially their children will pay. And it just makes a lot of sense to pay attention to it and, and look into it, explore it, maybe do some planning. Thanks so much, Maddie. This has been great.

Outro and Credits

Madison: Yes, thank you, Mike. For more information on Yardley Wealth Management or Yardley Estate Planning, you can visit our websites at yardleywealth.net and yardleyestate.net. you can also follow us on socials at Yardley Wealth Management. Don’t forget to smash the like button if you enjoyed this episode, this podcast has been produced by Madison Demora and Mike Garry with technical and artistic help from Poe Productions.