SHOW NOTES: 2018-02-22 Money in Motion

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Last Week’s Question of the Week: Approximately how many ETFs trade globally today? ANSWER: Interesting fact about ETFs, according to research firm ETFGI, as of July 2017, there were 5,024 ETFs trading globally.

HOST: There are three words on our show that you discuss quite a bit: Remind us of those?

KLAAS FINANCIAL: Yes, we do! SIMPLIFY, CONSOLIDATE, and DIVERSIFY. This is very important and we really do encourage our listeners to follow these steps as they get closer to retirement.

  1. Begin to simplify your investment holdings.
  2. Begin to consolidate IRA’s, old 401k’s.
  3. Diversify them with an appropriate asset allocation.

HOST: So, today you are talking about tax strategies in retirement when looking at your future potential income distribution?

KLAAS FINANCIAL: Yes, we do spend time a lot of time looking at income for our clients in their pre-retirement years, and then what it can look like in retirement. And, we have said that most people will probably need somewhere between 70-80% of their pre-retirement income, recreated in retirement. So, as we look at where we will derive our future income from and how much we will need, we, need to consider taxation during retirement years is important. Which tax bracket will you be in?

  1. Remember, that although you may not be collecting wages when you retire, just know that the IRS is still waiting for their tax money.
  2. Retirees will likely draw their income from a variety of sources- some income may be exempt from federal taxes, some will be fully taxable, and others may be taxed in part.
  3. First of all, what about your Social Security income? Some people don’t realize that for many people, they will likely pay taxes on up to 85% of their social security benefit. This comes as a surprise to people who remember that SS was previously not taxed. Beginning in 1984, the IRS began taxing Social Security income to help with the financing crisis of Social Security.
  4. If your combined income is more than $34,000, up to 85% of your benefits could be subject to tax. And, if your combined income is less than $25,000, your benefits are not taxable at all. Married couples with combined income of less than $32,000 don’t pay taxes on their Social Security benefits.

However: Social security and railroad retirement benefits are not taxable for Wisconsin.

HOST: What if you have a pension in retirement? Or IRA income? What is going to be taxable?

KLAAS FINANCIAL: First of all, if you have a pension coming to you, you are in a narrowing and lucky group of people!

  1. Pension income: Most pensions are taxable, and if you are collecting a pension in Wisconsin, your pension will be both state and federally taxable; however, some types of military pensions or disability pensions may be partially or entirely tax-free. The provider of your pension will send you a 1099 form at the beginning of each year that shows you how much of your pension is taxable. If you live in Illinois, your pension is NOT taxable by the state, just federally.
  2. Withdrawals from retirement plans: If a plan was funded with pre-tax dollars, whether by you or your employer, it will result in taxable retirement income when withdrawn. Expect pretty much all withdrawals from IRAs, 401(k)s, 403(b)s, SEPS, SIMPLES and other similar types of plans to be taxable. If you are under 59 ½, distribution of these monies from these plans will be charged a 10% penalty.
  3. What rate will you pay taxes? Depends on how much income you are taking. The more you take, or have to take as a result of your Social Security or pension, or to live your life, will determine the tax bracket that you will be paying taxes on as this is considered ordinary income tax. 10-39.5%.

HOST: What about investment income in non-retirement accounts?

KLAAS FINANCIAL: You can expect that all of the following types of retirement income will be taxable at your ordinary income tax rates.

  1. Interest, dividends and capital gains that occur in non-retirement accounts will be reported to you on a 1099 form each year and you will pay tax on most of this type of investment income as it is earned. The exception would be any capital gains that fall into the zero percent tax rate – you don’t pay tax on that portion of capital gains. So, if it is an investment account, you will pay capital gains tax if your account has grown and if you take a distribution but never a penalty since these are not retirement accounts.
  2. Remember that capital gains rates are more favorable today than income tax rates. For most people, cap gain rates are either 0% or 15% but can go as high as 20% for people in the highest tax category.
  3. You will never pay a penalty on taking money out of an after-tax account unless it is an annuity. Distributions from after-tax annuities can cause a penalty if you are under 59 ½, and remember that they are income taxable, instead of capital gains taxable.

HOST: When I turn 70 ½ and have to begin taking my RMD’s from my retirement accounts, will I pay tax then? Can I avoid this?

KLAAS FINANCIAL: Yes, again according to your tax bracket, and the balance of the account from the previous year end close, you will be required to begin drawing out a percentage of your pre-tax monies from your IRA’s or 401ks (unless you are still working where the 401k plan is) and graciously pay the taxes due. Avoiding these taxes legally? You can currently donate your RMD’s to a charity and avoid the taxes paid by you, and charity pays nothing as well. OR: You can consider beginning to complete Roth Conversions, sometimes known as “backdoor Roth IRAs”, no age limit or income considerations prior to this. You are not required to take RMD’s from ROTH IRAs at any age, so they can stay invested or taken as income without taxation. ROTH 401k’s at old employers are a different story.

  • Distributions from Roth accounts are basically the opposite of a tax-deferred account. Assuming you paid tax when you put the money into a Roth, and you are 59 ½, and the account has been established for 5 years, you will not pay taxes on the growth when you take a distribution.

HOST: How much are you allowed to convert every year? And is there a deadline?

KLAAS FINANCIAL: There is no limit, you just have to pay the income taxes on however much you convert. And yes, there is a deadline of December 31st to complete a Roth Conversion. Why would a sane person choose to pay more taxes now, vs. deferring this to a later date?

  • Perhaps between your pension income and SS, you will not be needing much of your income in retirement, and when/if you do, does it make sense to be forced to withdraw at age 70?

HOST: So, if I decide to do a Roth conversion what do I need to know?

KLAAS FINANCIAL: Well, there are a few rules to be aware of.

  1. Five-Year Rule for Penalty-Free Distributions of Converted Funds. If you convert your traditional IRA to a Roth IRA, any pre-tax funds in the traditional IRA that you convert are taxable to you in the year of the conversion.
  2. No matter what age you are when you convert, the 10% early distribution penalty does not apply. If you then take a distribution of the converted funds from your Roth IRA, that distribution will always be tax-free. This makes sense because you already paid taxes when you converted your Traditional IRA.
  3. However, if you are under age 59 ½ and take a distribution within five years of your conversion, your distribution will be subject to the 10% early distribution penalty, unless an exception such as disability applies. This rule was put in place to close a loophole in the rules, where traditional IRA owners, under age 59 ½, would have been able to convert to Roth IRA and then take a Roth IRA distribution to evade the early distribution penalty that would have applied if they took the distribution directly from their traditional IRA.
  4. The five-year period starts January 1 of the year you convert, regardless of the date of the actual conversion. It applies separately to each conversion you do, if you do more than one.
  5. After-tax dollars converted from a traditional IRA are never subject to the penalty. If you are over age 59 ½, no worries, you can access converted funds in your Roth IRA whenever you want without penalty.

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Catch C.J. Klaas and Maleeah Cuevas on Money in Motion every Thursday on Madison's 1310 WIBA from 8:05-8:35am.