October 1, 2019
When planning for retirement, most people think they need to put away as much money as they can while they are working. However, will that really get you to where you need to be? You may have heard it said before—‘it’s not what you make; it’s what you keep’. Today I want to talk about provisional income. Most people have not heard of this term, but will be affected by it throughout retirement.
How Can the National Debt Affect Your Retirement Savings?
As you know, we have A LOT of national debt, and it’s not going down. We also have a shortfall of taxes being collected to meet all our financial obligations. Both of these significant factors cause most professionals to believe that tax rates will be going up in the not so distant future, and not by a small amount.
The government understands these issues, so they have planned ways to collect extra money from many people who had believed they had planned really well. Did you know that if you build a lot of savings in tax deferred vehicles, like 401k or traditional IRA, it could cause your social security to be taxed? Yes, that’s correct! Just because you’ve saved well does not mean you are tax efficient. I would argue that if taxes are not addressed, no financial professional could create a reasonable financial plan. How can you really plan ahead if you don’t know how much someone is going to pay; 0% tax rate or 50% tax rate in the future?
What Can You Do About It?
There are ways to strategize for keeping more of the money you earn in retirement.
Traditional thinking says, contribute to your 401k and get a tax deduction in your working years, and then withdraw income from those savings in retirement when you’re in a lower tax bracket.
But wait, we are in a historically low tax environment right now. We also tend to have more tax deductions in general when we are working. For example, let’s say you have a mortgage, are paying off student loans, and have children at home in your working years. Right there you have tax deductions for the kids, the student loan interest, and the mortgage interest.
If you saved into a 401k, you’d see that once you got to retirement, you would likely have the mortgage paid off, the student loan balances paid, and the children out of the house. So you not only have more money in the account, but you have less tax deductions to offset the withdrawals you take.
This is just the tip of the iceberg when it comes to provisional income. I want to make sure you understand; I am NOT saying 401k plans are bad. What I’m saying is you should understand why you’d use a 401k and that it should be PART of the plan, not the plan itself.
Provisional Income Explained
So what is this provisional income we keep mentioning? Provisional income is a calculation created by the IRS to dictate how much of your retirement income will be taxable. The basic provisional income calculation looks like this: gross income (not including social security) + tax-free interest from municipal bonds + 50% of your social security amount + pension + long term capital gains & dividends = provisional income.
Let’s take a look at a simple example. Let’s say your gross income is $22,000 and you earned $2,000 in municipal bond interest. Add those amounts together to arrive at $24,000. Now let’s assume you receive $24,000 in Social Security benefits. Divide that in half to arrive at $12,000. Add $24,000 and $12,000, and your provisional income is $36,000. At $36,000 of provisional income, a single or head of household could be taxed on up to 85% of their social security benefit.
If this were for a household that is married filing jointly, the $36,000 of provisional income would mean up to 50% of the social security benefit getting taxed. Quick question, what’s the only way to increase the amount of social security benefit you take home after you have started receiving your social security benefit? Answer: To reduce the taxes you pay on your overall income.
Look at the Big Picture
I don’t want to go into detail of how to minimize taxes because it’s different for every person. The biggest factor to understand is there is no simple tool to accomplish this task. You must create a strategy that addresses taxes now and as they rise in the future. According to Jim Cramer’s website ‘The Street’, an article on new tax laws say that tax deferred accounts are the most affected by the rise in tax rates overtime. Don’t put all your eggs in one basket. You want flexibility and control over your income in retirement. And keep in mind that if your money is not tax efficient, it could negatively affect your heir’s tax situation when those assets are passed on.
Don’t solely rely on someone without doing any research on your own. At the same time, know that if you don’t deal with these issues on an ongoing basis, you should seek out help to check your progress if nothing more. Taxes and all the laws that dictate your income can change, so be sure you can talk with someone that is staying abreast of any new changes. Finally, there is a major difference between a tax advisor and a financial advisor when it comes to retirement income planning, and you’ll likely want advice from both. To help you better understand your retirement plan and learn ways to strategically plan for your financial future, contact us today.