No matter if you are a dyed-in-the-wool Democrat or a Reagan Republican, when it comes tax time everyone wants to pay less. Sure we might vote for some bonds and other future programs we believe will improve our city, our safety, or our way of life in November, but when you sit down with your accountant or try to hack your way through Turbo Tax, suddenly no one wants to pay.
It is human nature and I’m not here to debate that. What I am here to discuss are solid ways to defer or divest yourself of tax burden. As you accumulate wealth by whatever means, there will be some doors that close such as Roth IRAs above a certain income level, but then other doors will open, such as Permanent Life Insurance. My father-in-law is in his 80s and currently going through required minimum distributions, which he doesn’t fully understand and certainly doesn’t full grasp how to best manage what is required by law. I’ll start there.
Required Minimum Distributions – RMDs
After you reach age 70.5, you are (please listen here) required by law to pull a minimum amount out of your retirement vehicles, such as 401k, 403b, Roth, etc. Here is the IRS table on minimum distributions. This table gives you the keys to factor how much you will need to pull out at a minimum (there is no max). The shorthand here is that the minimums increase every year up to 115 (then I guess you get a break). The way all of this is set up is that you can fund these vehicles with tax-deferred dollars (except for Roth), but then you pay the tax on the way out. No big deal. Certainly taxes are constantly trending up, so it will cost you more later, but you can also stack up in the meantime.
So then you pull your minimum out, pay some taxes, and now you have these dollars. Now here is the catch. If you already have a pension or some form of non-self-funded retirement, these extra dollars need to just sit there. If you have things you need to buy–retirement home slots, health care costs, etc–then this is perfect, but if you don’t then things can get weird. Many people waste this and end up distributing out of their retirement. Others put it back into the market and end up paying even MORE taxes on those dollars when they cash out. Others fund some non-profits or scholarships to get a break on the taxes, but they still are giving up money.
Everyone’s situation is a little different, but please do a couple things. Meet with a financial advisor and see what options they suggest. Then do the same with your accountant. They should have all of your various context in mind and can help steer your specific situation rightly. But for some advice today…
I would look to stack up some expenses right as you retire out, such as a balloon mortgage payment or buy-in to some sort of retirement home. This will allow you to pay taxes at the smallest (read: earliest) rate, and it will bring down the numerator in your RMD calculation, which will reduce the amount you must pull out each year, which just makes things less stressful and reduces long term errors.
Please Please Please Meet with an Accountant
I’m not an accountant. I don’t work for an accounting lobby or Turbo Tax> or anything like that. But just do it. They know things you don’t and more importantly, they know things in your context. If you are a teacher or a government employee or have an inheritance or a small business or the like, there are tons of different options that are designed for your specific case to help you not overpay taxes. ESPECIALLY if you are a small business or self-employed business. You can even pay quarterly taxes online now which didn’t used to exist a few cycles ago. Pay a little to save a lot.
There are lots of good accounting software and even some very cheap payroll software options out there (as low as $129), and I would encourage you to use them for your small business or household accounting, but make sure you are being guided by a professional.
Here’s my very specific example from when I was a young lad. When I first became self-employed, we were living pretty cheaply and my wife was covering everything. What little I made, just sat in a money market account that whole year mainly because we didn’t know if we could spend it. Seriously. That’s how dumb we were. We knew we were going to have to pay taxes and it was going to be a big number, but because of the penalties for not paying quarterly business taxes, we ended up paying $5000 extra at tax time. Our account, who was our first, was furious at us. We were mad at ourselves. But that is one of the points where we started educating ourselves and getting pretty serious about personal finance. Because it had been so costly. Had we gone to an accounting professional the year before, and paid $400 for his help (which is pretty high but we were in DC), we still save $4600. So just pay a few hundred just to make sure you aren’t missing anything. Please.