Retirement Answers

Jacob: 00:00

Hey, everybody, and welcome back to this week's episode of Retirement Answers. My name is Jacob Duke. I'm a certified financial planner, and I help people just like you retire on a daily basis. And if you're listening to this the day that this comes out, then it is tax day 2023, meaning your taxes are due. It is 04/18/2023, and this is the final day to file and pay your taxes for 2022 unless you extend, which just to be clear, an extension is not an extension to pay.

Jacob: 00:30

It is simply an extension to file, meaning you still have to pay your estimated taxes by the end of today. So, that's our announcement for today. And by the look of the title on the episode, you're probably like, man, how is this possible? I wanna know more about this. But I wanted to share with you a real life example of how this couple, I'm gonna call them Bob and Sue just to make sure we keep them anonymous.

Jacob: 00:56

But I'm gonna show you how Bob and Sue have $100,000 a year of tax free income in retirement. And how this is possible goes into so many different things that I've talked about previously. So if this is your first time tuning into the show, please go back and listen to all the previous episodes because there are so many good things there for you around how you can build a more successful retirement. So I'm gonna lay a little bit of framework here and give you some of the facts around their situation, And then we're gonna dig into how they can have $100,000 a year of tax free income. So the first thing that we need to know is that Bob has $2,500 a month of social security, which comes out to be around 30,000 a year.

Jacob: 01:39

Sue has $2,000 a month, which comes out to $24,000 a year. So a total just from Social Security between Bob and Sue, their total Social Security income for the year combined is $54,000. So that's the first piece of their income for the year. And in addition to that, they have a few different accounts that have assets in them. The first is their combined IRA totals equals 600,000.

Jacob: 02:04

Their combined Roth IRAs equal 500,000. And their taxable investment account has $300,000 in it. And included in that taxable account is investments, but also we're including, some of their cash assets in that number as well. So they've got $1,400,000 total saved for retirement, and they also have $54,000 coming in, through Social Security each year, and they are both over age 65. Okay.

Jacob: 02:31

So those are the primary facts that you should know about whenever I begin explaining how this works. So the first thing that I come to as a retirement planner is I see, hey, we've got a big chunk of 100,000, which we're going to say that a 100,000 is how much they can take. It's not really how much they need, but just for hypothetical purposes, we're gonna say that they're gonna need, $100,000 a year. So the first thing I noticed is that 54,000, which is just north of half of their overall, annual need from an income stand standpoint is covered on, fixed assets. Like, it's not going anywhere.

Jacob: 03:08

In fact, it's gonna increase with inflation over time through the cost of living adjustments that Social Security benefits from. So $54,000 is already covered of the 100,000 they need, which leaves $46,000 left over. So whenever I, as a retirement planner, start thinking about this, I am trying to figure out, hey. How can we get the the most income for the least amount of tax burden or the least amount of taxes paid? So if they have different accounts like they do, they have an IRA, a Roth, and a taxable account, we can use those in such a way and distribute a little bit from each in such a way that we can lower their overall tax bill.

Jacob: 03:43

Okay. So let's walk through how this is possible. The first thing that we're gonna have to do to figure out how much they can distribute from each account without paying any taxes is you kinda have to back into that number. And the the account that we really wanna key in on is the IRA. And that's really what we're trying to figure out how much money we can distribute from the IRA and ultimately not pay taxes on any of their income.

Jacob: 04:06

So the first thing we have to do is back test that a little bit. And I've already done a lot of that work for us here, we don't have to go through it. But what it comes out to be is they can take $20,000 from their IRAs, which are taxable distributions, this year so they can avoid paying taxes on all of their income. So how did I come up with that? Well, I have to know how Social Security taxation works.

Jacob: 04:27

And the main thing you have to know is you have to file what's called your combined income. So what is a combined income? Well, you have to take one half of your Social Security benefit, and then you take all other income, which the 20,000 from your IRA will be included in this. Roth IRA distributions are not taxable income, and then we're gonna talk about why the taxable account distribution that we're gonna have is not gonna necessarily matter in this situation. But we have to take one half of Social Security.

Jacob: 04:53

We have to add in all their sources of income, and then we can figure out how much of the social security is taxable. So 54,000 of social security income, we divide that by two, that leaves us with 27,000. And I've already told you that we're going be taking 20,000 from their IRA. So we add that in, and that leaves us with $47,000 of a combined income. Now we have to run these through the married filing jointly social security taxation brackets, which the first bracket is zero to 32,000.

Jacob: 05:23

That $32,000 bracket says that none of the money that falls in that particular bucket is taxable in terms of how much of your social security is taxable. The next level is from 32,000 to 44,000. That means that $12,000 that that would fall into that bucket, only 50% of that amount is subject to taxation. And then any dollars that fall above 44,000, that amount would be 85% is subject to taxation. So just really quickly, the math on that is we have $47,000 of combined income.

Jacob: 05:58

If we know that the first 32,000, none of that is gonna be taxable, we can subtract out $32,000 from 47. That leaves us with 15. And remember, the next level is 32 to 44. And so we can say that's $12,000. So we subtract out 12,000, and that leaves us with 3,000.

Jacob: 06:17

So whenever we have 12,000 there in the middle bracket, only half of that is subject to taxation, which means that $6,000 of social security income is subject to taxation. So write that down, $6,000. And then since we had 15,000, we subtracted out the 12 that is left. That means that 3,000 is subject to 85% of that could be taxable. So 85% of 3,000 is $2,550.

Jacob: 06:46

So that's how much of that bracket is subject to taxation in terms of social security. So if we have 6,000 plus $2,550, that leaves us with $8,550 of our Social Security of Bob and Sue's Social Security is subject to taxation. So 8,550 out of their 54,000 total is subject to taxation. Now that we know that number, that's how much of their social security is taxable. We have to add that back to their other sources of income, which in their case, only $20,000 of their IRA distribution is their other income.

Jacob: 07:23

So we're gonna add 20,000 to that, and that leaves us with $28,550. So that is their total income that is subject to taxation. Okay? So remember this. They're gonna have a total amount of $100,000 coming to them to be able to spend this year, but only $28,550 of that is subject to taxation.

Jacob: 07:48

But we're not done yet because that's just their AGI. Well, we haven't even factored in their standard deduction. And remember, they're over age 65, so married filing jointly in 2023, their standard deduction is $28,700 Do you see what's happening here? Their total AGI is $28,550 and their standard deduction this year, because they're over age 65 is 28,700, they have a higher standard deduction than what their AGI even is. So when you subtract out the standard deduction, you're left with zero.

Jacob: 08:22

Right? And so right away, you can see, hey. They're not paying any taxes on any of their income because they have it structured in such a way, and it's from certain sources that makes basically all of their income tax free. So how does this work out? Well, you're probably wondering more, Jacob.

Jacob: 08:37

What about the distributions from their Roth IRAs and their taxable account? Well, it worked out in such a way that if we take $20,000 from their Roth IRAs, just like we did 20,000 from their IRA and an additional $6,000 from their taxable investment account, that's how we can get to a $0 tax bill on a $100,000 of income because we've got 54,000 coming from Social Security, their combined annual amounts. And then we have $46,000 coming from a combined 20,000 at their IRA, 20,000 at Roth, and then 6,000 from their taxable account. So that's a $100,000 of income that they're going to pay no taxes on in retirement. And this is completely possible for anybody, but you have to do a few things correctly both while you're working, but if you're already done working and you're thinking about retirement, you have to begin building out what I've called tax diversification.

Jacob: 09:32

If you go back and listen to previous episodes, you have to have tax diversification to have this even be possible. So what is tax diversification? Well, it's basically having your savings in different account types so that whenever you decide to distribute that money in the future, you can do so in a tax efficient manner, which goes back to having your money saved and invested in three different, what I call, tax buckets. The first being tax deferred, like an IRA or traditional four zero one k. The second being tax free, like a Roth IRA.

Jacob: 09:59

And then the third being what's called taxable, which is basically like your checking account, your savings account, or just a normal brokerage account. Those three different tax buckets, whenever you can have money invested and saved in those three different account types, you can have what's called tax diversification so that you can accomplish what Bob and Sue are accomplishing. You can distribute money from different accounts in such a way that you can lower your overall tax rate. This is the opposite of someone who comes to me and says, hey. I've got a million and 0.5, $2,000,000, and it's all tax deferred in an IRA or something.

Jacob: 10:31

Number one, we can create a plan to help navigate that, but I think it's crucial that you do create a plan because up until that point, there's been no work done to create tax diversification as opposed to someone who has done that throughout their career like Bob and Sue did. So tax diversification is probably the most important piece to being able to to have a $100,000 a year of tax free income in retirement. The other piece is that both Bob and Sue have healthy Social Security incomes. They both had great jobs and were able to, earn a decent living, and so their Social Security income reflects that. So that's another thing is is whenever you can have Social Security be a primary income source throughout your retirement, remember, because we already walked through it, but Social Security is not taxed the same way as normal income.

Jacob: 11:16

At any given point, at most, 85% of your Social Security income will be taxable, never 100% of it. So tax verification, having a large amount of your income being Social Security. And some of you might raise the question, hey, Jacob, what about that $6,000 from their taxable account that you took out? Well, the reason that that is not taxable, once again, is because they've been able to keep their overall income below a certain level. So whenever we're talking about income or distributions from a taxable or brokerage account, we have to do it in the framework of are they short term gains or are they long term gains?

Jacob: 11:53

Okay? And so whenever we can do that, and let's say $6,000 this year is is gonna be a long term capital gain. Well, whenever it's classified as a long term capital gain, meaning the security has been held for over one year and the type of security being a stock as opposed to a bond or a money market or a CD, because of the type of security, it qualifies as a long term capital gain and the investment has been held for over one year, those would receive long term capital gains treatments, which are always lower than normal income treatments. So whenever we look at this and we say, hey. Their their total adjusted gross income is 28,550, that's before, obviously, we took their standard deduction out, but that amount falls under the income brackets that they would need to be in for their long term capital gain rate to be 0%.

Jacob: 12:39

In fact, if they make under $83,000 in 2023 adjusted gross income, their long term capital gain rate is gonna be 0%. If they make over 83,000, this goes up to 517,000, then their long term gains will be taxed at a 15% rate, which is still lower than whatever the normal income rate would be because around 83,000, the 22% bracket begins. So regardless, they're saving a huge amount of taxes by having long term capital gains. And because their income is so low under that $83,000 mark, they're not gonna pay any taxes on their long term capital gains every single year. So that's that's how they can have that $6,000 come out of their taxable account, basically tax free because they're not paying any income taxes on that or long term capital gain tax on that because their other income sources are lower.

Jacob: 13:28

So this goal goes back to how can we be tax diversified? How can we minimize the amount of money we have in tax deferred accounts like an IRA or a four zero one k? Because doing so allows you to benefit from so many other distribution strategies. So now if you don't have tax diversification, let's say you are about to retire or already retired, Well, Roth conversions are gonna be one of the best ways for you to get tax diversified throughout the early years of your retirement. If you don't do it in the early years, then it's gonna kinda lose its value or potential over time, especially once you turn on social security, especially once you get to RMD age and so forth.

Jacob: 14:02

So Roth conversions, I've talked about them previously. Go back and listen to the episodes on that. But Roth conversions are gonna be one of the biggest benefits in terms of getting paying the tax now as opposed to throughout the rest of your retirement to get money from that tax deferred account over into your tax free account like a Roth IRA. So thank you so much for tuning into this week's episode of the Retirement Answers Show. I hope it's been very helpful and informative to you, but, I I wanted to illustrate this because this is a real life example of a couple who have done things the the right way.

Jacob: 14:31

They built over $1,000,000, $1,400,000 of total assets, and they have a really healthy Social Security income. And they don't need a whole lot of money, but they're able to take up to a $100,000 a year out of their accounts tax free. They're able to have a $100,000 of income each year completely tax free. So, I hope it's been helpful. If you have any questions around that, please do reach out.

Jacob: 14:53

Other than that, I appreciate you being here and listening to this week's episode of Retirement Answers. I look forward to talking with you again next week. Hey. Jacob here again. Really quickly before I let you go, just wanted to say that while I believe that these ideas and strategies are potentially really helpful to you as someone who's thinking about retirement, but these are purely ideas and thoughts.

Jacob: 15:12

They're not meant to taken as personal investment, tax, or legal advice. They are strictly ideas, and they're not meant to be personal financial advice for you specifically. Thank you so much, and I look forward to talking with you next week.