Many retirees don’t know an important fact. (No, not the fact that “Pickleball resulted in about 67,000 trips to the ER in 2023.”)1
This fact: When it comes to taxes, seven specific years are more consequential than the rest.
It’s true. And if you know those years are coming, it’s possible to do some advance planning that can save you thousands of dollars and untold stress and regret.
Understanding tax rates
When we think about future tax years, there are a couple of things to keep in mind:
1. In some years you’ll want to show higher income; in other years you’ll need to show lower income (I’ll explain more about this shortly).
2. You need to understand tax rates. Let’s spell out the difference between an effective tax rate and a marginal tax rate.
Your effective tax rate is only known after the fact. Some income gets taxed at 10%, and some at 12%. If your income climbs higher, you may pay 22% on some of your money. Your effective rate is the average tax you paid. To calculate this rate, you simply divide the amount of tax you paid by your income.
Your marginal tax rate is the tax rate you’ll pay on your next dollar of income. If you’re in the middle of the 22% bracket, and you decide to do a Roth conversion, you’ll pay 22% on your next dollar of income. So, your marginal rate is 22%, but your effective rate might only be 17%.
When we plan for retirement, we use your marginal tax rate. If you do a $20,000 Roth conversion, you’ll pay at the marginal rate. You won’t pay the effective rate. So, we look at your marginal tax rate now. What tax bracket are you in? And what will your marginal tax rates look like in the future? What tax bracket will you be in later?
Understanding these basics, let’s look at those seven years that are critical to consider in your retirement and tax planning.
Critical Year #1: Your last year working
We need to determine what income tax bracket you’re in going into your last year of work. If you are needing to do a large Roth conversion, but your income is already high during your last year of work, it may make sense to postpone that Roth conversion.
Or maybe, you want to take a large distribution at retirement, and your retirement date is set for December. It might make sense to wait and take the distribution in January since you’ve been working all year and your income will climb even more if you take the distribution in December.
Critical Year #2: Your first year of retirement
During the first year of retirement some employees get an unused annual leave payout. That would increase your income, and it could adversely affect your tax situation. Or, it could be that you worked for part of the year and were retired for part of the year. Knowing your projected income for your first year of retirement can help you avoid potential tax surprises.
Critical Year #3: A large income year
Maybe there’s a certain year looming in which you know you’ll have higher income from taking a large distribution. That’s good information to know in advance.
For many of the people we work with, we develop a Roth conversion strategy designed to move money out of their TSP or traditional IRA. If you know you already have more income in a certain year, that may mean you can’t do a significant Roth conversion that year. Knowing this in advance can help us with the planning.
Let’s say, for example, you have a million-dollar traditional TSP balance. You decide you want to have that money fully converted over to Roth in 10 years.
At first, you might think, “I need to convert $100,000 a year for 10 straight years because that equals a million dollars.” But remember, your account will likely keep growing during that decade of conversions. So, you’ll actually have to convert more than $100,000 each year, or you’ll have to do conversions for a longer period than 10 years.
Another example: If you know at retirement that you want to take a large distribution and pay off your house, that probably means you can’t do a Roth conversion that year too. In short, if you’re working with a 10-year timeline, but then discover you can’t do Roth conversions one of those years due to higher income, you’ll need to adjust your planning.
Critical Year #4: Two years prior to turning on Medicare.
Remember: Your Medicare premiums are based on your income. Now, as a federal employee, you get to choose whether to turn on Medicare. If you decide to carry your federal employee healthcare (FEHB) into retirement, you don’t have to switch to Medicare. Your federal healthcare will act the same way in retirement it did while working.
But let’s say you choose to turn on Medicare. What’s so special about your income two years before turning it on? That’s the number your Medicare premiums are based on. If you turn on Medicare at age 65, your taxable income at age 63 will be used to determine the Medicare premium you pay.
So, let’s say we’ve worked up a Roth conversion schedule to move your traditional money to Roth. And let’s say our plan requires us to do rather large Roth conversions, which will cause your income to be higher than normal. If that income is too high, it will exceed certain thresholds and cause your Medicare premiums to rise. Knowing this in advance helps.
If you have a million-dollar balance (or more) in your TSP, it will take some large Roth conversions to shift that taxable money to a tax-free Roth account. Those large conversions could cause your income to be so high that your Medicare premiums go up.
One fix would be “don’t turn on Medicare.” If you keep your federal healthcare, you don’t have to worry about Medicare income limits. You can Roth convert to your heart’s content (with the only worry being the tax bracket you want to stay in). That’s one solution.
The other solution is Roth converting up to the 22% bracket, but no higher. (A Medicare surcharge threshold is just beyond that 22% bracket).
However, if you have a healthy pension, two Social Security benefit checks, and a million plus TSP balance, Roth converting to the top of the 22% bracket may not allow you to convert much traditional money. It may not move the needle at all.
At that point, you’ll have to decide which is more important in the long run. Would you rather pay more in taxes or higher Medicare premiums? If you work with us, we can help you find the best solution. But regardless, several years before you turn on Medicare, you’ll want to think through all this in detail.
Critical Year #5: The year you start drawing Social Security
Working on that same thesis–that we want to move money from your traditional accounts to Roth accounts by filling up the tax bracket you’re comfortable with–if you decide to turn on Social Security, we need to know about it. That extra income will affect other things.
Again, if our strategy says “Let’s convert $100,000 to Roth every year,” but then you turn on Social Security, that Social Security income will fill up part of that tax bracket. That likely means you’ll have to lower the amount of Roth conversions you do.
I hope by now you’re seeing that every decision has a consequence.
Turning on Medicare may limit the amount you can convert. Turning on Social Security may reduce the amount you can convert. All of these decisions have consequences.
This doesn’t mean that you shouldn’t turn on Social Security. It just means you should think about this in advance–and have a strategy built to accommodate your plan.
Critical Year #6: The year you start taking RMDs
RMD stands for required minimum distribution. These are withdrawals from your traditional retirement accounts that are mandated by the government when you reach a certain age.
Whether we’re talking about a traditional TSP or a traditional IRA, RMDs force you to take out a minimum amount of your account balance. Depending on your birth date, your RMD age may be 72, 73, or 75.
These withdrawals are not optional. And each distribution is fully taxable. When we work with a client, one of the things we look at is how much will your RMDs be? What will that “income” do to your tax bracket situation? If you have a large TSP balance at age 60, you’ll likely have a really large balance by your RMD age.
We met with someone last week whose RMD is going to be $127,000 in the first year. Imagine the tax implications of an extra $127,000 of income! In this person’s case, they don’t need to take the distribution to fund their lifestyle, but they’re being required to take it, and all that money is taxable. In this individual’s case, the distribution will bump them into a higher tax bracket.
One of our goals of doing Roth conversions with clients is to get your traditional balance low enough so that when you arrive at RMD age, either you don’t have an RMD at all, or you have an RMD that’s small enough that it helps fund your lifestyle and doesn’t create an unpleasant tax consequence.
Naively showing up at RMD age only to discover that you have a $127,000 RMD…and you’re getting kicked up into the next tax bracket is NOT what we want. Identifying such potential problems in advance gives us time to fix them.
Critical Year #7: The year of your death (or your spouse’s death)
If you’re married and your tax status is “married filing jointly,” you’re in a certain tax bracket. If either you or your spouse dies, the surviving spouse suddenly gets bumped to the single tax bracket, where the allowable income is half as much.
It’s true that at the death of a spouse, the lower Social Security benefit goes away. Depending on whether it’s the federal retiree who dies or the spouse, the pension may shrink too, but large RMDs will still be mandated for the surviving spouse.
Being moved into the single tax bracket often acts like a tax increase because you run through the tax brackets more quickly. Your income may dip some, but it usually does not go down by half. However, the tax bracket does go down by half. So if you don’t do proper planning, you could end up paying even more taxes on your traditional TSP all because the RMD kicked in and your grieving spouse got moved up to the higher tax bracket.
This is avoidable if you do some planning and pay taxes now at the friendlier “married, filing jointly” rate.
We talked earlier about what your marginal tax rate looks like now and what it might look like in the future? Just know that if huge RMDs kick in, your marginal rate could look worse. If you get bumped to the single tax bracket, your marginal tax rate could be higher.
If your unwillingness to pay more on Medicare premiums causes you to not Roth convert as heavily, that decision may cause you to pay higher taxes later when your RMDs kick in. The best fix to all these tax issues is to figure out whether you’re going to have them or not.
Assuming that you keep your money just like it is (for most people, that’s in a traditional TSP or IRA), will you have tax issues later? Diagnosing that problem early is key. That will give you more time to fix it.
Discovering that you’ll be facing a huge RMD problem one year before your RMD kicks in is not helpful. Finding out you have serious tax issues while grieving a spouse is not helpful. These financial issues can be identified and addressed in advance. Now is the time to come up with a strategy to fix these tax issues.
For the record, this is what we help our clients with all day everyday. It’s our view that no one should overpay the government. We should all pay the government everything we legally owe, but we shouldn’t be giving Uncle Sam a big tip every year. We shouldn’t overpay our taxes simply because we didn’t do the proper planning. That’s easily avoidable.
If you have $800,000 or more in your TSP, and you’re 59 and a half (or over), you could be facing some serious tax issues later–unless you deal with them now. Reach out to us. Let’s talk about your situation so we can recommend some solutions for you.
If it sounds like we’re pro-Roth, that’s because we are. But check out this video right here [need link]. It discusses some good reasons NOT to do Roth.
Meanwhile, if you have questions about any of the subjects I’ve talked about here, visit our website, christycapital.com. There–in the top right corner of the page–you’ll see a green TALK WITH AN ADVISOR button. Click it, and leave us a short message. We’ll be in touch right away.
At Christy Capital Management, we help clients take the mystery out of retirement. We’d love to help you too.
