In my last column, I described a number of mistakes I saw retirees make. But these were specific to 2020.
I received a number of e-mails from readers lamenting other mistakes they see frequently. These can largely be placed in three categories. I share them here with examples I have encountered recently.
Ignoring Taxes
While reviewing a new client’s tax return, I noticed a small IRA distribution. The client and his wife were in their mid-60s. They had retired and were living off a buyout from his former employer in 2018. He needed some money in 2019 for a cruise. Instead of using buyout money, he took from his IRA.
With his bills covered by withdrawals from the buyout cash and Social Security, he didn’t think the taxes would be high. He knew wages could affect his Social Security, but he wasn’t working.
Unfortunately, being new to retiree taxes, he didn’t know about the notorious Social Security tax “torpedo”—when additional income changes the taxation of the benefit.
The tax rate on that cruise distribution turned out to be roughly 40%.
Managing taxes in retirement is a completely different challenge than managing them while you’re accumulating funds. Too many people think that since they are retired, their tax situation is simple. But then they are shocked when they find out how complex the tax code actually is, even at lower levels of income. The Social Security tax torpedo is just one example. Two additional wrinkles clients can easily miss are taxes triggered by Medicare and capital gains.
How much one pays for Medicare Part B is also a function of income. The income related monthly adjustment amount (IRMAA) increases Part B premiums as income reaches certain thresholds. The higher premiums start two years after the income threshold is reached. I see many retirees paying higher premiums because their income was barely over one of these thresholds. In most cases, they could have opted to do something just a little different and avoid the extra Part B cost—they could have, for example, taken a little less from their retirement accounts or sold a smaller number of shares for a gain.
One thing people can take advantage of is the zero percent rate on long-term capital gains for lower income households. That’s a great opportunity that is often overlooked. People miss nuances, not realizing, for instance, the effect of adding more taxable income to a return that has tax-free gains on it.
Capital gains are stacked on top of other income. When those gains are roughly filling up the 12% and lower tax brackets, they are not taxed. When the gains exceed the threshold, however, they’re taxed at 15%. It’s easy for a retired client to pull money from a retirement account thinking it will get taxed at 12%, but then income from a distribution pushes the gains into the 15% bucket. The 15% additional tax imposed on the now-taxable gains makes the marginal rate on the distribution 27%, not 12%.
Obsession Over Taxes
Last year, I spoke with a 66-year-old man who didn’t ignore taxes but instead obsessed about them. He had a sizable nest egg divided into various types of accounts. His No. 1 goal was to keep as much money as possible away from the government and keep it in the hands of his family. He was married with one child. The son was a successful surgeon making a seven-figure income who shared his dad’s hatred of the taxman. The son had no family of his own and intended to keep it that way.
The father thought putting the assets in his taxable accounts in a variable annuity was a great way to reduce his taxes. He had done this before and owned several contracts because of it. He was going to receive proceeds from the sale of some land and called me to see if any annuity we could put him into was better than the ones he already had.
It was a classic case of the tax tail wagging the investment dog. He was very proud of the fact that he was keeping his tax bills low by stuffing money into the annuities. He was keeping Uncle Sam at bay. But he was dramatically failing at his goal of letting his family keep more of what they had.