I'm 66 with $3 Million: How Do I Pay Less Taxes in Retirement and Save Up to $600K

Casey Weade: Now, let's take a look at a hypothetical example to illustrate the benefits of doing some tax planning and how Social Security taxes really impact your bottom line in retirement. We're taking a look at a gentleman named Max. Max is a physician. Max is retiring at age 66 and had a pretty good income throughout most of his working life, so close to those maximum Social Security benefits. He's filing at age 66. He's going to receive $3,500 a month in Social Security. He's saved around $3 million in various retirement accounts. I think this is an important thing for us to recognize too. I'm talking about some numbers. You may think they're small. You may think they're big. That's really irrelevant.

What I want you to get from this is really the concept and then this concept will still apply as you're going through your planning with us. He's spending about $8,500 a month and we're inflating that at close to 3.5% per year. Let's check out what retirement looks like. We're looking at the year 2024.

Let's take a look at what retirement looks like. We're going to take a look at 2025. We're about a year into retirement, and his provisional income is getting calculated this way. He has account distributions. He has account distributions of about $78,000 a year. In addition, they're taking half of his Social Security benefits giving us a provisional income of $99,934. The first $25,000 of Social Security, not taxable. 50%, now, we have the next $25,000 to $34,000. That's $9,000. He's in that area. He's still going to have to pay taxes on $9,000 in benefits, but then he's earning well over that limit.

Over the $34,000 limit, there's another $37,858 in Social Security benefits that are calculating a total taxable Social Security of $36,679, meaning that that's 85% of his benefits. 85% of his benefits are being taxed. He's at that maximum taxable Social Security benefit there at $36,679. Now, let's go a little bit further into the future. Let's go down to age 75. At age 75, now he's finding himself at required minimum distribution age.

His gross income is now $146,000. 50% of his benefits calculated into the provisional income number gives us $173,000 roughly in provisional income, meaning that now 45,000 of his benefits are taxable. It's still 85%. It's just that he has had those Social Security benefits grow a little bit over time due to cost of living adjustments, and we use the 2.75% inflation number on the Social Security benefits.

His ordinary income now is $192,000. Why is that? In large part, it's due to this required minimum distribution, which at 73 now, because the SECURE Act pushed that age out at 73 currently, you are forced to start taking required minimum distributions from your IRA. If you have a large IRA like we have here with Max, those RMDs can get extraordinarily large. He only needs $77,000 of the $146,000 to satisfy his income needs, so he has forced withdrawals of about $68,000, forced withdrawal taxes of about $15,000, and then this RMD is getting reinvested in a taxable account. When we reinvest those dollars into a taxable account, now there's probably going to be some ongoing taxation of the taxable account because it's probably going to be generating some 1099s in the way of capital gains or dividends along the way.

Now, what we want to do is go a little bit further out on the road. If we go all the way out to age 85, we can see now that that required minimum distribution is about $230,000. He has some really large amounts coming out of that IRA today giving him a federal gross income of about $300,000. That's important for us to recognize. Now, what we want to do is start to put together a strategy to change that to reduce some of those taxes.

Look at taxes over time. Over time, his provisional income is always at max. Like we said, he's always going to be paying 85% of his Social Security. He's always going to have that be taxable. Now, his brackets change a little bit over time and go up quite significantly. In those early years of retirement, his federal tax bracket is 22%. Then it goes to 24%. Then it goes to 32%. Then it goes up all the way to 35%, almost putting him into the highest federal tax bracket. His annual taxes only increase over time. His cumulative taxes only increase over time.

Now, let's take a look at some strategy here. Part of that strategy is to fill up those lower brackets. He is already filling up the 10% and 12% bracket in the early years of retirement. He's starting to fill up the 22%. Then he's starting to fill up the 24% and very quickly gets into the 32% bracket and beyond. Now, we want to implement a strategy. We're going to say, now he's 66. He wants to do conversions for seven years and stop when he gets to RMD age. Our software is going to tell us, in order to optimize the tax efficiency of his overall strategy, we should convert about $310,000 every year from his traditional IRA over to a Roth IRA. Now, where it was, his maximum RMD without any of these conversions or planning would have peaked out at about $300,000.

His lifetime taxes would have been almost $2.6 million. I think what's really interesting about that and often gets overlooked is, over your lifetime, if he's got a $3 million IRA, almost all of that will go to taxes over his lifetime, so projected lifetime taxes of $2.5 million. Now, let's also mention that he has taxes that are coming from his Social Security benefits as well. After we do this conversion, now his high RMD is only $15,000 and his projected lifetime taxes are only $1.2 million. That's a massive reduction. The legacy he's leaving behind is also significantly increased, and we know this is all Roth IRA as well versus being largely traditional IRA prior to the planning. Let's go ahead and apply this scenario and start to see--

Let's go back and look at those specific dates and same charts, and then we can see what the impact of this planning has been. We looked at the second year of retirement before we did any of the planning. We're going to go ahead and look at that year again. Now, his federal gross income is about $425,000. He's still paying taxes on 85% of his benefits. Now, if we go out a little bit further, we're going out again to age 75. At age 75, his federal gross income is $900. He has a little bit of his Social Security benefits that are taxable. Other than that, he is pretty much in a tax-free zone for the rest of his life because, after standard deductions, he's not going to be paying any taxes.

We could go down to age 85, and we're going to see the same thing. We have very little in the way of taxable income as we get down the line. Federal gross income of $5,500. We're going to have deductions of $16,000. We're getting to that tax-free happy land here for Max. What that look like from our tax chart perspective? Our tax chart looks like this. We're going to max out some brackets in those first few years, and then it's going to drop out significantly. Provisional income is very low.

After we get through the conversion amounts, provisional income starts going back up, and that's okay. Because of our standard deductions, we're still going to get him into that 0% tax bracket for the majority of his retirement. His annual taxes will peak, and then they'll go down to zero. His cumulative taxes will level out in 2032. What's the overall impact been? Let's summarize this. The overall impact of this work is this. At age 85, the assets that Max had before tax was about $4 million. Now, $3.6 million of that was in a traditional IRA still. About $420,000 was in a taxable account due to the reinvesting of those required minimum distributions. There's no Roth IRA.

Now at age 85, after our strategy, we actually have less in assets. We have $3.5 million instead of $4 million. You might go, "Oh, that's not a good thing. We have less in assets." Well, Let's keep in mind now that it's all Roth IRA. Now, we want to take this a step further because, after the SECURE Act 2.0, we found that we could no longer stretch our IRAs out over our lifetime for our beneficiaries, our heirs.

Now, let's say that Max passes away at 85, leaves behind this $3.6 million IRA. If he leaves behind that $3.6 million IRA, they're going to have to distribute that out over 10 years. It could be done under current law. It could be $362,000 a year. It could be done all in one year, but we know that that's going to result in a lot of taxation. I think we're being generous here by saying that those taxes would only be 30% on that IRA to the heirs. That means the net value of that IRA going to the heirs is about $2.5 million plus the $423,000 that's taxable. Now, the heirs, which isn't much different than for Max. Whether it's for Max or whether it's for the heirs, now he still has about $3 million versus having about $3.5 million after we implemented the strategy. The impact of doing this work added about a $500,000 in total asset increase for Max and his family. Now, what I want to also emphasize is that this is a fairly simple approach. We didn't do any strategizing around the actual Social Security strategy. This is simply implementing a tax strategy for Max.

Now, we want to get into Social Security filing strategies. Since the Bipartisan Budget Act of 2015 went through, it has greatly simplified the strategies that can be implemented for someone that is filing for Social Security. Now, it used to be, prior to 2015, the core strategy that we would always talk about was file and suspend. You had the opportunity that you could actually file for your spouse's benefit, suspend your own benefit, and let that grow into the future and then you could switch over to your benefit after it increased. Now, that's gone away.

For single individuals, for married individuals, it's really largely going to come down to life expectancy, but we can still implement file and suspend strategies if you're divorced or if you've been widowed. Now, we don't have time to go into those strategies today. I just want you to know if you're widowed or if you're divorced like my mother-in-law as well as my mother, you have even more planning strategies here, but we're going to focus today on a married couple. We're going to take a look at an example.

Now, let's take a look at a different example of a married couple where we're actually implementing a Social Security optimization strategy. For this couple, we're leveraging our Social Security planning software here. For the male, we're going to call them Big and Small Bucket. For Big Bucket over here, Big is about $2,500 a month full retirement age benefit. Then we have Small. Small is about $1,100 a month as Small Bucket's full retirement age benefit. Now, let's go ahead and implement our strategy.

Now, this couple, what they originally wanted to do was file for Social Security at age 62, but we're going to take a look at Social Security maximization strategies. Now, our software is showing us that if we, instead of filing at age 62 for a couple that are going to be with a life expectancy here of age 85 for the male, age 90 for the female, what we should really be implementing is we should be filing for benefits at age 67 for Small Bucket over here. We want to file for Small Bucket's benefit at age 67. Then we want to go ahead and file for Big Bucket's strategy over here at age 70, so deferring that benefit into the future.

Now, what happens here, I think it's important to point out, at age 85, we have Big Bucket passing away. When Big Bucket passes away, they're going to lose the smaller of those two Social Security benefits, and Small Bucket is going to retain the larger of those two benefits. That's why we see this reduction. Just this little bit of planning we did here added cumulative lifetime benefits of around $365,000 over their lifetime.

Let's take a look at what would have happened if they filed at age 62. Had they filed at age 62, now we have benefits again, about $1,800 a month, $880 a month. If they filed at age 62 because of those reductions, they have a 401(k), got about $1 million in a 401(k), about $100,000 in after-tax funds. They are spending $5,000 per month here and we're giving it a 3% inflation rate. Now, we could just look at the retirement tab and say, for this couple, they're in a great position. They have about $2,700 a month in Social Security, and they have to fill in a gap of about $30,000 a year leveraging the retirement savings, but we always want to look at the worst-case scenario.

Let's jump over here to our market tab, and let's just say, hey, they've got everything at risk in the market, but what if we hit the worst period of time we could really imagine, at least in recent memory when it comes to market returns, and we go through a lost decade? Again, we're looking at worst worst-case scenario. We always want to under-promise and over-deliver here at Howard Bailey, but we're not done yet. Now, that is Social Security maximization. They're really maximizing their Social Security benefits, but we still know that we can do some tax optimization like we did over there with Max. If we do that same thing here with Big and Small, we want to see what the impact would be.

If we did a five-year conversion, let's say they want to do a five-year conversion. We're converting about $60,000 a year from their traditional IRA over to the Roth IRA. Lifetime taxes are about cut in half. $1.2 million goes down to $600,000. Legacy increases quite significantly as well. Let's go back and look at that market tab and see what the impact is of those conversions. Now, the impact of those conversions results in them never running out of money all the way to age 100 and beyond.

What have we done? We've really just done a couple of things. We just scratched the surface on planning here. We did a little bit of Social Security planning, and we did a little bit of tax planning, and now we ensure that they're never going to run out of money the rest of their lives. In a hypothetical scenario here, using some hypothetical market returns, using an average conservative return of 6% per year, of course, there's still planning we can do here.

We haven't even done any investment planning. I think that's one of the neat things for us to recognize is that we often just spend all of our time with a financial advisor worrying about doing our investment planning, but a lot of the value can be added, and some good majority of the value can be added around the things you can actually control, your tax strategy, and your Social Security strategy.

Let's take a look at the overall impact. We're going to look at age 90 for Big and Small Bucket here because, as a joint life expectancy, it's pretty likely that one of the two of them will live to age 90. Before any optimization, they would have had about $2.2 million in assets at age 90 with 67% of those assets being in a traditional IRA. Now, after we just implemented the Social Security strategy, they increased that amount by about $100,000, and now they only have 52% that's traditional IRA.

Now, let's not just optimize the Social Security, but let's also implement our tax strategy. Now, that number goes to $2.4 million, and it's about 58% Roth IRA. Still a little bit of traditional IRA, but a lot of Roth IRA. Go through our same scenario here for the net tax and net distribution to the heirs. They have a $1.5 million IRA before any of the planning. That means the beneficiaries are at least going to see $150,000 a year if they take that out evenly over 10 years, and we don't even grow that $1.5 million while they're taking distributions.

Again, a conservative tax rate, I think, at 30% means that their net IRA value is about $1 million, $737,000 in taxable dollars. Net value to the heirs is about $1.8 million. Not $2.2 million, but $1.8 million. The net value of the IRA, now that we've implemented the strategy, we've done all of our strategizing here, there's only $269,000 of net dollars going to the heirs in the IRA, $1.4 million in Roth, and $1 million in taxable accounts. The heirs are getting about $2.7 million instead of $1.7 million. It's an $891,803 increase to the heirs. That's a lot of value for just a little bit of planning that we're doing here to just scratch the surface.

What are the strategies that we're talking about here? Strategies for optimization. We want to consider maybe waiting until full retirement age to claim. You can get more of those benefits, continue to compound, benefit from those delayed retirement credits, all the way to age 70 really. If you're going to earn, it might make sense to wait till full retirement age to claim. You have that higher dollar amount. We could be doing Roth conversions like we've illustrated. We didn't even talk about here stashing excess cash.

In those years, when you know that 85% of your benefit is going to be taxed, you could take excess distributions from your IRAs. It might be smarter to do Roth conversions during those years, but let's say you just took excess distributions, then that would give you the ability in the future to have some more flexibility and take a blended approach, blending some of your non-taxable funds with your taxable funds in order to stand under certain thresholds. Of course, run a Social Security analysis. If you're in a situation where you can file and suspend, you're divorced, you're widowed, then make sure you're taking a look at those strategies as well.

In closing, what I want you to know is that there's opportunities for you to do planning. We're giving you an opportunity today to do some of this planning. You've worked your whole life to accumulate that Social Security benefit to create your nest egg. It could make sense to spend half an hour to an hour of your time to take a look at that Social Security strategy, take a look at that tax strategy. We're offering you a complimentary personal financial review along with a Social Security analysis and tax analysis right now. All you have to do to take advantage of that free offer is give us a call at the number on your screen, or you can also text to the number on your screen. I look forward to seeing you soon.