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David Muhlbaum: You’ve been told by plenty of people, us built-in, that saving for retirement is vital. You’ve doubtless also heard that step one is putting aside salary in a 401(k) plot, if one is void to you, or some other retirement vehicle. But there’s a catch. Saving for your retirement is a excellent thing, but in small, if you keep deferring the taxes, they’ll likely bite you in the end. We’ll talk to an expert in defusing what’s now and again called the retirement tax bomb. Also, more checks from the regime? Well, maybe. All coming up in this episode of Your Money’s Worth. Stick around.
David Muhlbaum: Welcome to Your Money’s Worth. I’m Kiplinger.com senior editor David Muhlbaum, joined by my co-host, senior editor Sandy Block. How are you doing, Sandy?
Sandy Block: Oh, I’m doing fantastic.
David Muhlbaum: Excellent for you. Well, you know as well as I do that one of the most well loved things we’ve ever written about were the endemic-era spur checks, because, you know, money from the regime, whee!
Sandy Block: You got a check, I got a check, nearly every person got a check.
David Muhlbaum: Yeah. Excellent times. Excellent times, until the bill comes due for ancient Uncle Sam. But we’re just going to slide right by that biased hot potato. Anyway, you gave me a heads-up that some of us are going to get more checks from the regime, and that is related in a way to the endemic, but it’s more limited, even if it’s related. So that’s my hype. What’s the reality, Sandy?
Sandy Block: Well, filing your taxes is never fun, but it was above all nerve-racking during the endemic. You were more likely to win the Powerball than get someone from the IRS on the phone, and I can speak to that in person. And on top of that, various changes in the tax code complicated the process, which is why people tried to get someone from the IRS on the phone. So the IRS gave taxpayers more time to file and pay in 2020 and 2021. But even with those extensions, some taxpayers and businesses failed to meet the deadlines and they were charged a penalty.
So here’s where the checks come in. Some of those taxpayers will get that penalty money back. The IRS is sending out more than $1.2 billion in tax refunds to about 1.6 million taxpayers who paid penalties for late tax returns. So by now, you’re doubtless wondering, “What do I need to do to get this money?” And the answer, according to the IRS and our colleague, Rocky Mengle, is nothing. The IRS says that most tax refunds will be sent out by the end of September and you don’t have to do no matter what thing at all.
David Muhlbaum: Okay. What if you filed late but you didn’t in fact pay the penalty?
Sandy Block: Well, there’s excellent news for you too, because if you were hit with a qualifying penalty but didn’t in fact pay it, you won’t receive a refund from the IRS because you didn’t pay the penalty, but the unpaid penalty will go away. Now, note that I said qualifying penalty. The refunds will only be sent to taxpayers who were penalized for filing their late tax returns for the 2019 and 2020 tax years that were due in 2020 and 2021 correspondingly. Second, only certain types of returns are eligible for a penalty refund. We’ll publish the link with the entire list in the show notes, but for party taxpayers, it pretty much covers Form 1040 and variations.
One more thing: The type of penalty matters too. There’s in fact several uncommon types of penalties you get for not only filing late but paying late, and these refunds are only void for the late filing penalty, which is 5% of the tax due for each month or part of a month your return was late up to a maximum penalty of 25%. And as a side note, that’s why we always tell people even if they can’t pay their taxes, go ahead and file your taxes because these late filing penalties really pile up in a rush.
David Muhlbaum: It’s not for late payment, it’s for filing late.
Sandy Block: Right. So paying late doesn’t get you off the hook. And if you pay late, then you have appeal on the amount that you should have paid. That’s not covered by this. And just finally, that you won’t get a refund if the IRS thinks your late return was falsified, which is kind of how they roll.
David Muhlbaum: Oh, come on. Oh, come on now. Really?
Sandy Block: No refunds for fraud.
David Muhlbaum: Yeah. Geez. Okay, Well, how about people who are late filing their 2021 tax return? It wasn’t a whole lot simpler getting the IRS on the phone this year. Asking for a friend.
Sandy Block: Okay. Sorry, your friend is out of luck. The penalty relief doesn’t extend to 2021 tax returns. And that’s an vital thing to dredge up, that if you filed for an additional room on your 2021 tax return back in April, you have until October 15th to file to avoid a late filing penalty. And like Halloween and pumpkin lattes, it will be here before you know it.
David Muhlbaum: Yeah. And late payment penalties could still be piling up too.
Sandy Block: Right. That’s right. If you owed money back in April and you haven’t paid it yet, then yeah.
David Muhlbaum: Just bringing that small honor back into it. Okay. So all right. Thank you, Sandy. Checks for some, not for all, but if you get one, excellent for you. Coming up, we will talk to an expert about how to organize retirement savings so that you can sock away plenty of money without getting whacked by a giant tax bill. Stick around.
Defusing the Retirement “Tax Bomb” with David McClellan
Welcome back to Your Money’s Worth. We are going to talk about a topic that we’ve broached before, how to lessen taxes on retirement savings, but with a new guest who’s going to take us a bit deeper into some of these angles. And even though optimizing retirement savings is pretty dry stuff, we know it’s well loved based in part on the traffic we’ve been getting to the articles that our guest, David McClellan, has written for Kiplinger.
So at the core, David is a partner at Forum Fiscal Management, a fiscal advisory firm in Austin, Texas, but he’s also VP and head of wealth management solutions at AiVante, a company using machine culture to forecast healthcare costs for the party. Now, that second bit sounds fascinating, but not at once germane to the retirement tax burden. But healthcare does get dragged into these calculations, and with a bit of luck we’ll get to that too. Welcome David. Thank you for joining us on moderately small notice.
David McClellan: Yeah. Well, thanks for having me. Excited to be here.
Sandy Block: So David, I be with you that last night you were deep into your fantasy football draft, and I hope that went well for you.
David McClellan: I reckon so. I geek out on fantasy football, mainly the auction format. I’m very questioning and I’ve urban custom spreadsheets to help me draft well, but I’m unendingly the bridesmaid and coming in second place. I’ve never in fact won my fantasy league. So there’s a lot of luck caught up, more so than what I hope people have with the retirement schooling.
David Muhlbaum: Well, you bring your analytics skills to the table there too. So Sandy handles sportsball around here, and she also knows more than I do about retirement tax bombs. But I have been educating myself in part by reading the articles you’ve been contributing to our Construction Wealth channel. And these, well, they have a lot to say. You wrote over 5,000 words. But what I want to note for viewers, who really should check these out because we’re only going to be able to scrape the surface in 25 minutes or so, is that David and his editor have divided those 5,000 words into a seven part series so you can both see the overarching opinion and have it broken into tasty chunks.
Now, David, you clearly go deep here, and we do want to get into some of the finer, less obvious points so that people who are already deeply committed to retirement savings, maybe about to retire, maybe even drawing on their retirement savings, can come away with some useful guidance, maybe a touch that’s new to them. But I reckon it would be helpful if we start with the test case, the sample couple you use in your articles, because that was very vivid in showing how people who are making excellent money, not yet really rich, can end up on a track that could cost them millions of dollars in taxes that they didn’t have to pay down the road. So can you tell us a bit about this John and Jane Doe model?
David McClellan: So in the article, I used a case study of a working couple who was age 40 who have already saved $500,000 collective in pre-tax 401(k) fiscal proclamation, and they’re in the end maxing out their donations every year at $20,500 a year and then also getting a $6,000 employer match. Now, that is a very common circumstances. This is a couple who are saving really well and later the square wisdom that the diligence has, that they should be saving all they can in tax-late fiscal proclamation. Now if they keep doing that, by retirement at age 65, they will have saved $7.3 million tax-late, which sounds like they’re in fantastic shape. I mean, who wouldn’t want to go into retirement with $7.3 million?
And the problem is that that tax-late savings also represents a growing tax liability, because tax-late savings is not tax-free savings, and now and again investors forget that. When you start taking withdrawals from a tax-late account like a 401(k) or a habitual IRA, all of that income, the entire withdrawal, is taxed as run of the mill income. And for this couple, when they first started taking vital minimum distributions at age 72, when the regime in the end is forcing them to start making withdrawals so that they can be paid the tax bill, their first RMD is going to be $435,000, and that will take up again to grow as they get older, success, for example, $739,000 in taxable income just from their vital minimum delivery by age 80. So do you reckon they have a tax problem in retirement?
David Muhlbaum: Yes.
Sandy Block: They sure do. And I want to back up a small bit, because in reading your article, you go into a lot of strategies, but it seems like one of the simplest ways, and perhaps not used enough, for a couple to avoid this scenario is going back to when they’re in their 40s and diverting some of those donations to a Roth 401(k) instead of a regular 401(k). My appreciative is a lot of people don’t do that because they reckon, “Well, I’m missing out on a tax break,” but maybe I’m not asking for another breakdown. But how would that help them?
David McClellan: Yeah. It’s a very common thing for people to do is to say on a pre-tax basis to their 401(k), and there’s a lot of reasons for that. The square wisdom, the fiscal press, other fiscal advisors, CPAs, in the end, they’re all reinforcing the point save every dollar you can in tax-late fiscal proclamation, and that’s often the default setting in most 401(k) plans. So people, when they enroll in their 401(k), they in the end start contributing on a pre-tax basis and never reckon twice about it.
Five or six years ago, I reckon there was a touch like maybe 30% of 401(k) plans even supported a Roth option, but I reckon now that number is maybe as high as 70 or 80%. So it’s much more common now, but people don’t know about it because they have to do a small bit of legwork on their 401(k) platform to investigate it and find out if that’s an option. But it’s the simplest way to get rid of this tax liability over a long period of time, and above all impactful for younger savers. If you’re 40, you got 25 years in which your donations can either grow in a tax-late way if you’re contributing on pre-tax basis, or it can grow in a tax-free way if you’re contributing on an after-tax Roth basis.
So that makes a huge alteration as to the growing pool of retirement savings that you have. Do you want that pool to be pre-tax and you’re going to have to pay taxes on it at some point, or do you want it to be tax-free Roth? The other thing about this is that investors often say, “Well I’m not eligible to say to Roth in a 401(k) because my income is too high,” and that’s a common misnomer. What they’re referring to is income limits on wealth IRAs, which do exist, and many people make too much money to be eligible to say to a Roth IRA. But inside a 401(k), there is no income limit. So if your plot offers a Roth option, you can start contributing to it in any case of what your income is.
David Muhlbaum: So William Roth has entered the chat, so to speak. I’m referring here to the late senator who helped launch the very well loved and often financially advantageous deal with of prepaying the taxes on money you’re putting aside for retirement. So we just talked about the Roth 401(k), which allows people to place money they make on the job aside in a retirement plot on a post-tax basis so that the growth they hope to delight in in the years ahead will be tax-free.
Sandy Block: As long as their employer offers it.
David Muhlbaum: Yes, as long as their employer offers it. Yes. Excellent point, Sandy. But there’s more to Roth than the 401(k). Senator Roth left quite a legacy. We sure do say his name a lot. So David, in your articles, you bring Roth up a lot because there are other solutions for people at other stages of the retirement path. I was hoping you could walk us through a couple of the other strategies for prepaying taxes, I’m thought Roth IRAs and Roth conversions.
David McClellan: Yeah. Surely. Well, each shareholder’s circumstances is unique and so the strategies that are going to be most commanding are going to vary for people. But oftentimes, you need to pursue all of the three strategies which I outlined in this series. So briefly, the first one, which we’ve already talked about, is in the end shifting your tax-late savings to Roth fiscal proclamation from pre-tax fiscal proclamation. And because most things don’t have a free lunch, the drawback of that is that you no longer get the tax deduction in the current year, so you’re choosing to pay higher taxes in the current year with the reward that your taxes in retirement are likely to be much, much lower. So that’s approach one.
Approach two is a concept called asset place, which we can talk about in more detail in a minute. But the third one that you referenced is Roth conversions. And Roth conversions are going to typically play a larger role for people who are older and perhaps already retired. And it is if you are, say, 60 and you’re retired and you have this really huge tax-late account balance, then you have a window of time in which you can start to whittle away that tax liability by every year doing Roth conversions. So let me departure for a second to clarify how a Roth conversion works.
So in a Roth conversion, you’re in effect moving money from a pre-tax account like a 401(k) or habitual IRA into a Roth IRA, and every dollar that you go is thorough taxable income. So if you did $100,000 Roth conversion, that’s $100,000 of income that you’re in effect adding on for that tax year to all of your other sources of income. So Roth conversions typically don’t make sense for people who are saving a lot who are now earning a lot. If you wait until your income is low, such as in retirement, then you have an chance to do Roth conversions every single year. And with many of my clients, that’s exactly what we’re doing. We’re doing much sized Roth conversions every year early in retirement trying to whittle away that tax bomb because you can’t solve it in a single year.
David Muhlbaum: But there’s a window, because you’ve got to get it done before the RMDs kick in.
David McClellan: Yeah. So the huge closing of that window is at age 72 when your vital minimum distributions come into play, because at that point, you don’t want to be doing Roth conversions on top of your RMDs because both of those are thorough taxable income. An earlier window is once you start to take Medicare at age 65, because if you have noteworthy income from any other source, then you will face Medicare means testing surcharges, which is another major focus point of this article.
So the ideal time period, if you retire early, is up through age 63, because Medicare means testing in fact has a two year look-back, meaning your premiums when you are 65 are based off of your income when you were 63, so that’s the prime window to do huge Roth conversions. And then as you start to hit Medicare, maybe you’re doing smaller Roth conversions and you’re doubtless stopping them when all’s said and done by the time your RMDs kick in at 72. So it’s an ongoing approach to try to bleed away this tax liability and smooth out the taxes that you’re paying right through retirement.
David Muhlbaum: Well, Sandy warned me against bringing up the Medicare means testing. “Too complicated,” she said, but, well, David said it first.
Sandy Block: David did a really excellent job of amplification the two year look-back. That’s what I was worried about. I reckon he makes a really excellent point there. But maybe, David, you could just briefly as doable clarify what the debt Medicare addendum means and how high your premiums could potentially go if you’re hit by it.
David McClellan: Yeah. So I first stumbled on this topic in 2019 when I was doing some investigate around medical expenses in retirement for the equipment firm AiVante that I work for, and I was shocked by what I exposed and finished up in fact writing a white paper in 2019, which is referenced in my Kiplinger article for anyone that wants to go into the details, because I really clarify the workings of how Medicare premiums work and what happens with Medicare means testing. And it is usually a touch that is absolutely shocking to people.
Most people, for starters, reckon that Medicare is free. You’re paying into the Medicare system through payroll taxes right through your whole life, and then you find out in retirement, once you start taking Medicare at 65 or so, that you in fact have to pay premiums for Part B, which is in the end the doctor air force, and Part D, which is drug. Part B is by far the larger element of that. And what I came to learn is that in 2007, Medicare means testing was implemented for the first time. And what that means, it’s also referred to as IRMAA surcharges, which is just a really complicated acronym, but in the end, Medicare means testing.
David Muhlbaum: Yes. But it’s memorable because it sounds like your fantastic-aunt.
Sandy Block: Yeah, your mean fantastic-aunt.
David Muhlbaum: Your mean grandma, beyond doubt, because she’s coming for your wallet. So the Medicare means testing surcharges, if you take a step back to the huge picture of Medicare, you may be aware that Medicare has some noteworthy solvency issues. In many cases it’s in worse fiscal circumstances than even Social Wellbeing.
Sandy Block: And harder to solve.
David McClellan: And harder to solve. There are no simple solutions, and no politician really wants to touch this with a 100 foot pole because it’s going to be very politically unpopular. But one of the things that they can do, and they first implemented in 2007, is means testing. And in the end, what that means is if you have high income, then you are going to pay more for Part B and Part D Medicare premiums, potentially as much as four times as much. And that comes as quite a shock to people. So as an example, the premiums are $2,041 for Part B in 2022 if you are in the base income bracket, which has in the end an adjusted yucky income of under $182,000. So most people who are inflowing retirement reckon, “Well, this isn’t noteworthy to me because I’m retired. I don’t have a job. I don’t have any income. So I’m just going to pay the base premium like anyone else.”
Well, what about vital minimum distributions? Recall back to that case study, the couple that was going to have hundreds of thousands of dollars of vital minimum distributions. Well, at the highest means testing tier, that base Part B premium goes from $2,041 a year to $6,939 a year. Now, that’s an boost of nearly $5,000 a year. And if you reckon about that’s just for a single party, so if you’re a married couple, that’s $10,000 more every single year that you’re going to be paying in Medicare means testing surcharges, or you surely have the the makings for that. Now, that’s a very high income bracket, but if you’re doing that every year over a 20, 30 year retirement, it starts to add up to real money, hundreds of thousands of dollars in surcharges. And in the end, surcharges is just another word for tax. So these are taxes which I reckon can be largely avoided or minimized with proper schooling.
David Muhlbaum: I mean, it’s appealing because with time, we turned this four figure charge into an annual five figure charge, and then over duration, we’re into six figures or more. And I guess this is in part where you’re experiencing the actuarial and long-term Medicare costs comes into play in forecasting. Sorry, I didn’t mean to say Medicare costs. Healthcare costs.
David McClellan: Yeah. Well, underlying the Medicare means testing is the basic problem that medical expenses keep rising at a much higher rate than inflation does. So if you look back at the period from 2007 to 2019, premiums for higher earners in Medicare augmented from 5.0% to 8.6% annually depending on which Medicare means testing tier you are in. And inflation, which I reckon every person has on the front spot of their minds now, any high inflation rate compounded over a long period of time can be categorically devastating. So the masses, most people who are paying the base premium in Medicare, over that same period from 2007 to 2019, their premiums only augmented by 3.1% annually. But higher income people, it was 5%-8.6% annually. Medical costs and expenses keep rising, and they have to make the numbers work somehow, and so the people who are earning more income are going to be paying a lot more.
Sandy Block: And one other thing I wanted to mention, David, because I hear this a lot from readers, is that those addendum thresholds, there’s a real cliff there. If you just go over the threshold by a dollar, you could end up paying a whole lot more for your premiums. Isn’t that right?
David McClellan: Yeah, but only for a single year.
Sandy Block: Oh, is that right?
David McClellan: Yeah. So it’s not a stable cliff that you’ve fallen off of. So your premiums will get adjustments every single year, and that’s why the ongoing every year that the tax management decisions that you’re making are going to be really vital. And it may make sense, for example, one year to do a really huge Roth conversion, even though it’s going to trigger some Medicare means testing because you’re going to have some tax refund for the next 20 years after that. And in order to benefit from that, you’re okay eating the Medicare means testing surcharges in that one year.
David Muhlbaum: I’d like to come back to a term you brought up in this podcast earlier, and it’s one of the points in your pieces, but the words are a small hard to say on the air. I don’t mean that I can’t pronounce them, I just mean that this term sounds a lot like a touch that we often use in investing. You were talking about asset place, and that sounds a lot like asset allocation. So let’s break this down.
Asset allocation is the longstanding thought of buying some of one thing and some of another and so forth. Some stocks, some bonds, some cash, some MLPs, uncommon kinds of funds. Asset place, if I be with you this accurately, is picking where you place uncommon assets depending on the tax deal with of the vehicle that holds them. Some types of funds go in your pre-tax fiscal proclamation, some go in your post-tax Roth fiscal proclamation. I just threw a bunch of terms out there and I’m hoping you can tell us a bit more about asset place.
David McClellan: Yeah, sure. So backing up, asset allocation is, highest level, a declaration on what asset classes to invest in. So for example, a very common asset allocation for people in retirement at the highest level would be, say, a 60% stock, 40% bond allocation, conservative growth allocation, and the asset allocation is what defines the risk and probable return for the shareholder. And there’s not automatically a excellent or terrible, every shareholder circumstances is uncommon and their enthusiasm to take risks to earn a higher return is uncommon. So most people are habitual with asset allocation, at least in some level. Asset place is a term that even most fiscal advisors don’t know about and don’t apply. So asset place means what tax bucket are you placing uncommon asset classes into?
So there’s three basic tax buckets. There’s taxable fiscal proclamation, like a non-retirement brokerage account as an example, there’s tax-late fiscal proclamation, which we’ve talked a lot about, how to defer tax liability linked with them, and tax-free fiscal proclamation like Roth. So there’s three tax buckets that you have to work with. Now, a lot of investors and fiscal advisors will apply the exact same asset allocation, that 60% stock, 40% bond allocation, into each of those tax buckets, and that’s a mistake. So go back to the huge picture approach of what we’re trying to do, which is to limit the growth of tax-late fiscal proclamation.
So if I have a 60% stock, 40% bond allocation, and dredge up that stocks are riskier and have a higher probable return than bonds, so if I’m going to pursue that fastidious approach for a client with asset place, we would look to place all of the bond exposure into tax-late fiscal proclamation and then load up mainly the Roth fiscal proclamation with the riskier assets that have higher probable returns and potentially doing the same in a taxable account. So for the same risk reward dynamic, that overall 60/40 investment approach, you are in effect putting the bonds that are going to grow slower in the tax-late account and the riskier higher growth items, asset classes, into the Roth fiscal proclamation.
And the net result of that over, say, 20 years can be giant, because what you’re doing is restrictive the growth of the tax-late fiscal proclamation and maximizing the growth of the Roth fiscal proclamation. So this is a harder thing to apply. Oftentimes, you would benefit from working with a fiscal advisor to apply this, and the funds that you have, some lend themselves to asset place better than others. So one of the concepts here is you need asset class pure funds, meaning perhaps a global small-cap value fund would be a fantastic entrant, very focused high probable growth investment.
David Muhlbaum: And the inverse being a target-date fund.
David McClellan: Right. The inverse, a target date fund, would be a fantastic example, because it is in effect a blend, or growth and income fund would be another example, it’s a blend of both stocks and bonds. So when you have a product like a mutual fund or ETF that is amalgamation uncommon asset classes, you don’t have the ability to break the asset classes and place them into the right tax bucket to optimize the taxes. So asset place can make a huge alteration in terms of sinking this tax liability over time.
David Muhlbaum: Well, I look forward to our viewers going back to their advisors and saying, “I want to talk about asset place,” and those advisors going, “Yeah, asset allocation. No, we got that.” No, no, no. Asset place. So if we have one solid takeaway, it’s that honor in terms. But I reckon we’re going to have many more from what David has had to share with us. And again, as I warned, we’re just scratching the surface. You really should check out his pieces at kiplinger.com about the tax bomb and how to defuse it. I will include a link. Thank you again for joining us, David.
David McClellan: Okay. You’re welcome.
Sandy Block: Thank you, David.
David Muhlbaum: That will just about do it for this episode of Your Money’s Worth. If you like what you heard, please sign up for more at Apple Podcasts or where on earth you get your content. When you do, please give us a rating and a review. And if you’ve already subscribed, thanks. Please go back and add a rating or review if you haven’t already. To see the links we’ve mentioned in our show, along with other fantastic Kiplinger content on the topics we’ve discussed, go to kiplinger.com/podcast. The episodes, transcripts, and links are all in there by date. And if you’re still here because you want to give us a piece of your mind, you can stay collectively with us on Twitter, Facebook, Instagram, or by emailing us frankly at [email protected]. Thanks for listening.