Carlsbad CA Estate Planning

Social Security and Medicare and the Impact on Retiree Taxes

 

“Medicare has a series of income limits that trigger increasingly higher payments for retirees. And it’s not just the rich who are affected.”

 

A 70% increase in Medicare premiums to $559 was a complete surprise to a woman who became a single taxpayer when her husband died. She felt like she was being punished for being a widow, she said in a recent article titled “Retirees, Beware These Tax Torpedoes” from Barron’s. With a 2018 modified adjusted gross income of $163,414, a combination of required minimum distributions, Social Security and her husband’s pensions, she went from being in the third-highest Medicare bracket into the second highest Medicare bracket. All it took was $414 dollars to exceed the $163,000 limit.

This is not the only tax trap awaiting unwary retirees. Lower- and middle-income taxpayers get hit by what’s commonly referred to as “tax torpedoes,” as rising income during retirement triggers new taxes. That includes Social Security income, which is taxed after reaching a certain limit. The resulting marginal tax rate—as high as 40.8%—is made worse by a Medicare surtax of 0.9% on couples with taxable income exceeding $250,000. Capital gains taxes also increase, as income rises.

There are a few steps that retirees can take to avoid or minimize these taxes for next year. The simplest one: delay spending from one year to the next and be extra careful about taking funds from after-tax accounts.

What hurts most is if you’re on the borderline of a bracket. Just one wrong move, like selling a stock or taking a distribution, puts you into the next bracket. You need to plan carefully.

One thing that won’t be a concern for 2020 taxes: required minimum distributions. While many retirees get pushed into tax traps because of taking large RMDs, the emergency legislation passed in response to the coronavirus crisis (the CARES Act) eliminated RMDs for this year.

However, the RMDs will be back in 2021, so now is a good time to start thinking about how to avoid any of the typical tax torpedoes. RMDs used to start at age 70½; the SECURE Act changed that to 72.

If you don’t need the money from an RMD in 2021, one workaround is to take it as a qualified charitable distribution. That avoids triggering higher taxes or higher future Medicare premiums. The administrator of the tax-deferred account needs to be instructed to make a donation directly to a charity.

An even better strategy: take steps long before Medicare income limits or tax torpedoes hit. If you can, live on after-tax savings, Roth IRA accounts or inherited money. Spend that money first, before tapping into tax-deferred accounts. You can then take advantage of being in a lower tax bracket to convert money from tax-deferred money to convert to Roth IRAs.

Another story of a tax hit that was avoided: a man with an income of about $80,000 prepared to take $4,000 from a tax-deferred account for a vacation. The couple’s normal top tax bracket was 12%, but they hit the income limit on Social Security taxes. The $4,000 in additional income would have caused $3,400 in Social Security income to be taxed, making his marginal tax rate 22.2% instead of 12%. With the help of a good advisor, the couple instead took $3,000 from a Roth IRA and sold a stock position for $1,000, where there were practically no capital gains generated.

Incomes at all levels can be hit by these tax and Medicare torpedoes. A skilled advisor can help protect your retirement and Social Security funds.

Reference: Barron’s (July 6, 2020) “Retirees, Beware These Tax Torpedoes”

Using Retirement Funds in a Financial Crisis

“U.S. has been making it easier for people to access long-term savings for emergencies, trading future financial security to stay afloat.”

For generations, the tax code has been a public policy tool, used to encourage people to save for retirement and what used to be called “old age.” However, the COVID-19 pandemic has created financial emergencies for so many households that lawmakers have responded by making it easier to tap these accounts. The article “Should You Tap Retirement Funds in a Crisis? Increasingly, People Say Yes” from The Wall Street Journal asks if this is really a good idea.

This shift in thinking actually coincides with trends that began to emerge before the last recession. People were living and working longer. Unemployment and career changes later in life were becoming more commonplace, and fewer and fewer people devoted four decades to working for a single employer, before retiring with an employer-funded pension.

For those who have been affected by the economic downturns of the COVID-19, withdrawals up to $100,000 from retirement savings accounts are now allowed, with no early-withdrawal penalty. That includes IRAs (Individual Retirement Accounts) or employment-linked 401(k) plans. In addition, $100,000 may be borrowed from 401(k) plans.

Americans are not alone in this. Australia and Malaysia are also allowing citizens to take money from retirement accounts.

Lawmakers are hoping that putting money into pockets now may help households prevent foreclosures, evictions and bankruptcies, with less of an impact on government spending. With trillions in retirement accounts in the U.S., these accounts are where legislators frequently look when resources are threatened.

However, there’s a trade-off. If you take out money from accounts that have lost value because of the market’s volatility, those losses are not likely to be recouped. And if money is taken out and not replaced when the world returns to work, there will be less money during retirement. Not only will you miss out on the money you took out, but on the return, it might have made through years of tax-advantaged investments.

The danger is that if retirement accounts are widely seen as accessible and necessary now, a return to saving for retirement or the possibility of putting money back into these accounts when the economy returns to normal may not happen.

IRA and 401(k) accounts began to supplant pensions in the 1970s as a way to encourage people to save for retirement, by deferring income tax on money that was saved. By the end of 2019, IRAs and 401(k) types of accounts held about $20 trillion in the US.

Boston College’s Center for Retirement Research has estimated that even before COVID-19, early withdrawals were reducing retirement accounts by a quarter over 30 years, taking into account the lost returns on savings that were no longer in the accounts. For many people, taking retirement funds now may be their only choice, but the risk to their financial future and retirement is very real.

Reference: The Wall Street Journal (June 4, 2020) “Should You Tap Retirement Funds in a Crisis? Increasingly, People Say Yes”

Can You Save on Taxes in Retirement?

It's frustrating when you’ve been responsible and saved diligently for your retirement throughout your working career, but the tax bites keep on coming. Over the course of time, those accounts most likely grew substantially, observes the Citizen Times in its article “Try this strategy to save on taxes in retirement.” The growth comes from maximizing annual contributions and the power of compounding interest, which is what 20^th century genius Albert Einstein is quoted as saying is the most powerful force in the universe.

Now that you’re retired, or near to retirement, you’ll want to use tax-efficient ways to withdraw money from your investment accounts. There was a rule of thumb from the financial investment community that said just leave those tax-deferred accounts alone and use the money from your taxable accounts until you reach age 70½. You can then start taking Required Minimum Distributions, or RMDs.

Here’s the problem: that equation assumes that your income has decreased in retirement and that simply may not be true.

RMDs are taxed as ordinary income at the time of withdrawal, so they could push you into a higher federal tax bracket than you expected. Let’s say a 63-year-old married woman born in 1953 has $1 million in tax deferred accounts. An example may be taking an RMD of nearly $47,000 at the age of 70½, combining it with $47,000 from Social Security or a pension or rental property income, and you could be bumped into a higher rate tax bracket.

Another impact could be the reduction of individual income tax rates that went into effect this year, because of the Tax Cuts and Jobs Act, which expires in 2025. Those tax cuts may not be extended or may be changed, so future tax rates might go up again in 2026. When that tax cut expires, you’ll need to review your tax burden again.

So, what can you do?

If you are a retiree between 59½ and 70½, consider a Roth conversion. Proactively convert a portion of your tax-deferred accounts into a Roth IRA on an annual basis. You’ll have to pay federal income tax on the amount you convert every year. However, you’re taking advantage of lower rates before those provisions mentioned above expire and before the RMDs begin. The goal is to convert just what you need to keep you in your current tax bracket.

Be mindful that you must do this right. Work out the numbers so you don’t trigger a higher Medicare premium or the 3.8% Medicare surtax. There are a lot of moving parts. However, this could save you a huge amount in taxes. Make sure it aligns with your estate plan—check with your estate planning attorney to make sure the entire plan works.

Resource: Citizen Times (July 29, 2018) “Try this strategy to save on taxes in retirement”

Think 61 is Your Golden Retirement Number? Think Again

If you work for a living, chances are good you like to daydream about what your life will be like during retirement. We all do it and so do younger workers who have yet to pay their dues.  However, according to a survey from Bankrate, as reported in The Motley Fool’s article titled “Americans’ Ideal Retirement Age–and Why It’s Not Realistic,” adults across the board think that 61 is the ideal age to retire.  Is that realistic?

Unless you can live without Social Security during retirement, 61 is not your magic number. Most American retirees can’t live on Social Security alone and those benefits have a major impact on the ability of most retirees to keep up with their bills.  However, eligibility doesn’t start until age 62. The people in the survey either didn’t know they can’t collect Social Security until they turn 62 or they are assuming they can get by without it.

The average Social Security benefit check is just more than $1,400, which adds up to about $17,000 a year. If you are among those who have little or no money set aside for retirement, that’s a lifeline.

A large number of working Americans are way behind in their retirement savings. It’s estimated that around 42% have fewer than $10,000 set aside for the future. How will they retire at all, much less retire at age 61?

Even if you can manage to keep working until age 62, filing at that age has its own issues. Today’s workers need to wait until their Full Retirement Age, or FRA, in Social Security’s terms, to receive their full monthly benefit. The difference is large enough to make it worth the wait.

Assume that your full retirement age is 67, but you retire at age 62. Instead of $1,400, your monthly benefit would be $980.

However, what if you are among those who really want to retire at 61? You’ll need to have started with saving and investing for retirement at a relatively young age and have been willing to take a very aggressive position in your investments. If you started at age 26, with a goal of retiring at age 61, and you are employed by a company with an employee sponsored 401(k), you’d have had to contribute $1,500 a month for thirty-five years to amass enough money—if your investments were earning a steady 7%.

If retirement is around the corner, one thing you can do is make sure your estate plan is in place. Therefore, whatever assets you have, will be distributed according to your wishes. Make sure you have also taken care of having a power of attorney and healthcare directive in place. Speak with an estate planning attorney to make sure these documents are prepared correctly.

 

Reference: The Motley Fool (July 18, 2018) “Americans’ Ideal Retirement Age–and Why It’s Not Realistic”

Hidden Fees in Retirement–Beware!

Talk about a rude awakening—you’re happily planning your retirement, reviewing your accounts as you start working the numbers, and wham—the fees have taken a bite out of your future. Be aware of these fees, advises US News & World Report in a useful article titled “10 Hidden Fees to Be Aware of in Retirement.”

Annuities. When you buy an annuity, the sales person receives a commission. There are also underwriting and management expenses. Annuities are generally understood to have higher fees than typical mutual funds, so be aware of the cost and the benefits before making a purchase.

Advisory Fees. In a non-fiduciary managed account, typically with a broker who is not a registered investment advisor or CFP, it may not be easy to discern the fees. Ask questions and make sure that you understand how much of your money is being invested and how money is being used on fees.

Inactivity Fees from Brokerage Accounts. Here’s money tossed away. Check the fine print on your online brokerage accounts to be sure you are not spending money because the account is not active.

RMD Penalties. Anyone over age 70 ½ is required to take a minimum distribution from their IRA and other retirement accounts. If you take the money by Dec.ember31st, you are fine.  However, if you forget, the penalty is steep:  it can be up to 50% of the required withdrawal amount. That is an expensive mistake.

Mutual Fund Expense Ratios. These are fees charged to cover a fund’s annual expenses. If you don’t know what they are, find out what you are spending on an annual basis.

Home Costs. If your retirement includes aging in place, make plans to ensure that your home remains safe.  This can include changing out a tub for a walk-in shower, adding a downstairs bedroom or repairs.

Car Costs. If you’ve got two cars but only use one, you should consider becoming a one-car household.

Travel in Retirement. Make the most out of your travel budget and be more aware of additional costs in organized trips. If you’re savvier about spending, you’ll likely be able to take more trips.

Inflation. This basic economic occurrence has been historically low in recent years.  However, it does not go away. Make sure that you’re prepared if and when it returns with a bang.

Smart financial planning can make your retirement dollars go further. Your planning should also include a visit with an estate planning attorney.

Reference: US News & World Report (July 18, 2018) “10 Hidden Fees to Be Aware of in Retirement.”

Determining an IRA Beneficiary

For many people, deciding who should be the beneficiary of their retirement accounts is something that is not thought about for too long. The decision is made quickly and the person chosen is usually a close relative.

When filling out the paperwork, most married people instinctively write down their spouses.

Parents who are not married will write down their children.

Younger people might just write down their parents or a sibling.

However, if an IRA is consistently paid into and wisely invested, it can grow to be of tremendous value. It is often one of the biggest assets that people have when they pass away.

That means IRA beneficiaries should be carefully considered and chosen wisely, as Morningstar discusses in "Who Should Inherit Your IRA?"

The bottom line is that the beneficiary of your IRA should be chosen based upon where the money will do the most good.

 Since there are different tax implications for different types of beneficiaries, you should consult with an estate planning attorney.

Doing so will help ensure that your IRA and the rest of your estate can be distributed to heirs in a way that is fair for everybody and has the fewest negative tax implications for everyone.

Beneficiary designations should be done as part of your overall estate planning. Therefore, you should seek professional advice.

Reference: Morningstar (Sep. 10, 2017) "Who Should Inherit Your IRA?"

When to Change Beneficiary Designations

Estate planning today is not just about going to an estate attorney to have a will or a trust drawn up. It also includes making plans for your own end-of-life care and deciding who should get your retirement accounts and life insurance policies, if something happens to you.

The beneficiaries of your accounts will get the assets by operation of law. If you have done everything correctly, then you have factored those accounts into your overall estate plan with the assistance of your estate planning attorney. Sometimes you need to review and change those designations.

Recently, the Aiken Standard listed some appropriate times to do that in "On the Money: Don't disinherit your loved ones," including:

• If you get divorced or remarried, then review your accounts to make sure you are not leaving things to an ex-spouse or that your new spouse is included.
• If you get a new employer and roll over your old account, then make sure that the new account accurately reflects your wishes.
• If the primary beneficiary on your accounts passes away, then you obviously need to make changes.
• If the financial institutions you have the accounts with change ownership, review your beneficiary designations to make sure the new company has everything recorded properly.
• If you have a new child or grandchild, consult your estate attorney about including them and whether they should be named as beneficiaries.
• If a beneficiary becomes disabled, you should talk to an attorney about creating a special needs trust. Keeping them as a beneficiary could make them ineligible for some needed government benefits.

Reference: Aiken Standard (Dec. 10, 2016) "On the Money: Don't disinherit your loved ones."

Naming Your Trust the Beneficiary of Your IRA

When people get trusts, one of the first things they are told is that they should put all of their important assets into the trust. They are often told that they can designate their trusts as beneficiaries of their life insurance policies and retirement accounts, and that they should consider doing so.

However, for tax purposes, it is not always a good idea to designate a trust as the beneficiary of your IRA, as Financial Advisor explains in "Is Naming A Trust As Beneficiary Of A Client's IRA A Good Idea?"

The biggest and most important issue is that IRA beneficiaries must take required minimum distributions or face tax consequences. This requirement does not go away when the beneficiary is a trust and not an individual.

Satisfying the requirement with a trust can get technical.

Every beneficiary of the trust must be identifiable and must be an individual. While that might seem easy to accomplish, it is not always the case. Every successive beneficiary must be an identifiable individual. Therefore, the beneficiaries who would automatically receive the trust assets when a previous beneficiary passes away, must be an identifiable individual.

This can be an issue if a residual clause in the trust includes giving assets to a charity, for example.

That is not the only complication with designating a trust as the beneficiary of an IRA. There are other potential problems, which is why you should consult with an estate planning attorney before doing so.

Reference: Financial Advisor (Dec. 2, 2016) "Is Naming A Trust As Beneficiary Of A Client's IRA A Good Idea?"