‘Three-year window’ planning can save big on taxes

From Retirement Daily on the Street — By Joe DiSalvo & Marie Madarasz —

If we were to take a poll asking, “Who has an issue with the amount of taxes we pay?” we’re sure many hands would go up. However, if we had a time machine and were to travel back several decades, it would provide us with a very different perspective.

From a top marginal tax bracket of 91% in 1960 (yes, you read that right!!) to a 70% top bracket in 1970 to a 50% bracket in 1980, taxes in much of the last century were significantly higher than we have today. Since 2018 our top federal bracket has been 37%, which means that even Bill Gates, in theory, will top out at 37%.

Why taxes are going up

However, when we wake up on January 1, 2026, the highest tax bracket will revert to 39%, and the amount of money that will be taxed in each bracket will become tighter, which means that more people will find themselves in a higher bracket than they were before.

Why? Because this is the way the 2017 Tax Cut and Jobs Act (TCJA) law was written: it is set to sunset at the end of 2025, with rates returning to those in place before its passing. All Congress must do is nothing (and how good are they at doing that??), and rates will increase. We can also make the case that they will go significantly higher than before TCJA, considering our country’s debt of $31 trillion and growing.

Although it may not feel as if we are in a low-tax environment, the math says we are. And inflation has given us the most significant percentage increase in decades for a few key metrics. For example, if you are over 65 in 2023, your standard deduction has risen to $15,700 for single filers or $30,700 if married filing jointly.

Although tax rates remain the same, 10% and tiering to 37%, the brackets have widened by approximately 7%, meaning that the income taxed at each rate is higher. For example, in 2023, a Single Tax filer with a taxable income of $95,000 will hit the top of the 22% bracket, down from the 24% bracket in 2022.

Why is this so important? Because our current environment provides us an excellent opportunity to get money out of our IRAs, 401(k)s, etc., at today’s historically low tax rates, which can help set us up for a future with less taxable income. Not less income, less taxable income, which is a crucial distinction!

And here is where the sense of urgency comes in: We most likely have only three tax years left, 2023, 2024, and 2025 before tax rates go up!

What is your plan to take advantage of this timeframe?

Planning for the total tax, not just the bracket

Most people who have yet to do tax planning or receive tax guidance tend to focus solely on their current tax bracket. However, you must understand where your future bracket(s) may likely be. Those who have been good savers and saved most of our wealth in pre-tax retirement accounts have unknowingly built a significant tax liability.

Once Social Security comes online and Required Minimum Distributions get rolling, we often find our clients (who tend to be those millionaires next door: live a modest life, saved well, and ended up with over a million, or several million, dollars in their retirement accounts) will be pushed into a higher bracket by their late seventies or early eighties than they were in during their accumulation years.

And all those nice deductions, the good things, on their tax returns have gone away — no more deductions for retirement savings, exemptions for kids, or paying for college, etc. Even worse, some new taxes have come on board: IRMAA surcharges, Provisional Income calculations, and the shock of the Widow’s Penalty.

In retirement, your highest marginal “bracket” only determines the top tax rate you may pay. It is often a misleading number as you must look at your “total tax” incorporating all the new “phantom” taxes. For example, it’s not unusual for someone technically in the 12% top marginal bracket to experience an over 40% tax on an IRA withdrawal once the total tax is calculated. (Often referred to as the Tax Torpedo!)

If tax rates double, where will you be?

The reality of getting money out of your pre-tax accounts now is that you must pay the tax due. There’s no getting around that, and we have been taught to put off paying taxes as long as possible. Many of our conversations with our clients’ CPAs and tax-preparers follow this theme — us trying to explain why doing forward-looking tax planning makes sense, and them pushing back on paying the tax before you must.

Often, the tax preparer is not aware or focused on how much you have saved in your retirement accounts. These accounts do not generate any year-end tax forms unless you have taken a distribution — so unless they ask or you tell them the dollar amount, they remain in the dark.

However, when we speak to them on our client’s behalf, we make it clear, it is not the current value of the 401(k) that concerns us; it’s what the future value may be. With Congress moving the age at which RMDs begin (via The SECURE Act 2.0), there may be close to a decade after retirement for these account balances to keep growing — along with the tax liability. More significant balances mean larger RMDs, which means higher tax bills.

Tax planning can drastically reduce your taxes — even to ZERO!

We want to walk you through a case study to illustrate why forward tax planning is so impactful. Take Bill and Sarah, our clients for many years. They are married and both aged 73.

We have been thoughtfully and strategically shifting money from their traditional IRAs to their Roth IRAs for nearly a decade, filling their 22% bracket. They have amassed a sizeable balance in their Roth IRAs ($920K, part conversions and part tax-free growth) and will have whittled their traditional IRAs down to where their RMDs will be low enough to stay under their Standard Deduction amount.

This means our client can generate an income of $120,496 and pay 0% in federal income tax. How is that possible? Through good planning and having the wisdom to know what you can and can’t control.

For Bill and Sarah, their $120,496 income worked out like this:

• Total Social Security $56,496
• Traditional IRA distributions $20,000 (2023 RMDs)
• Qualified & Ordinary Dividends $4,000
• Capital Loss carry-forward $2,300
• Roth IRA distributions $40,000

So, how did they end up paying 0% in tax? The $20,000 IRA distribution and the $4,000 in dividends were handled by the 2023 Standard Deduction of $30,700. Then, add the $2,300 carry-loss forward (from tax-loss harvesting in non-retirement accounts) to offset like income.

Many people are unaware that Social Security is not taxable unless in the presence of other income. So, although their total Social Security was $56,496, the taxable amount of their Social Security was just $11,409 due to the provisional income calculation.

And the $40,000 Roth IRA distribution was tax-free. So, their adjusted gross income equaled $33,524, total taxable income equaled $2,755, and total tax due: $0. No IRMAA surcharges. Total spendable income: $120,496.

Who wouldn’t like a 0% tax bill? In his book, The Power of Zero, David McKnight says: “Why is the 0% tax bracket so powerful? Because of that four-letter word: math. If you’re in the 0% tax bracket and tax rates double, two times zero is still zero!”

To understand how to strategically think through Roth Conversions, download our whitepaper: The Consumer’s Guide to Partial Roth Conversions.

Act now before the ‘three-year window’ closes!

The point here is that forward-looking tax planning can be very impactful, and taxes are on sale for the next three years. So, whether you can get your tax rate to 0% or lower it by a bracket or two, done correctly, tax planning can help your wealth last longer and benefit the next generation.

David McKnight also says, “The decision boils down to this: You can pay those taxes now on your terms and at historically low tax rates, or you can pay them on the IRS’s terms at some unknown point (and tax rate) in the future.”

How will you use this three-year, low-tax environment window to your advantage? We recommend seeking qualified help to develop a plan that will incorporate the three prongs needed to create tax-efficient retirement income: income planning, investment planning, and tax planning in a coordinated, holistic strategy.

Contact Kleshinski, Morris & Morrison CPAs