Jan 10, 2022 By Harry Funk staff Writer hfunk@thealmanac.Net 12 min read

With retirement comes a whole new chapter of navigating the arcane universe of the Internal Revenue Service.

As founder, managing partner and senior wealth adviser for Pittsburgh-based Aptus Wealth Planning, Neal McGrath helps older adults unravel the inevitable mysteries.

“If you’re like a lot of folks, you’re a little confused about the current tax landscape,” he told a nearly full house of participants during a recent Taxes In Retirement workshop at the Upper St. Clair Community and Recreation Center.

Partnering with Enlighten567, an organization dedicated to providing credible and helpful information on a variety of finance-related topics, McGrath focused the workshop on leading participants toward a certain goal.

“You want to pay the least amount of taxes as you can, while you’re around,” he said.

Required minimum distributions

A major consideration is the requirement for distributions from most types of Individual Retirement Arrangements, 401(k)s and similar plans to start when a holder turns 72, which in turn increases his or her annual income.

“Essentially, the IRS says, we have allowed you to defer our tax money long enough,” McGrath said. “We want our taxes before you go see the angel.”

Distribution amounts are calculated using a Uniform Lifetime Table published by the IRS. The additional income has the potential of pushing the recipient into a higher tax bracket, and failure to take a required distribution carries the penalty of a 50% surcharge on the applicable year’s amount.

Investment firms send letters to retirees listing their required minimum distributions, but McGrath said the message could become lost in the shuffle.

“If you’re like a lot of the folks I speak with, you get so much mail from these investment companies that you might miss that letter,” he said. “Or they might, believe it or not, have your birthday wrong. I see that often.”

Also, having accounts with multiple firms can cause issues.

“You may have already satisfied your distribution from, let’s say, your Vanguard IRA, and your Merrill Lynch broker doesn’t know that. So you take out more than you need to,” McGrath said.

For those who want to pay taxes sooner and not have to worry about them later, other retirement options are available.

Established in 1997 and named after former U.S. Sen. William Roth of Delaware, Roth IRAs and 401(k)s are built on money that is taxable at the time of contribution but does not count as income when eventually withdrawn.

McGrath gave the example of a client who retired at age 61 and learned he faced a required minimum distribution of $150,000 when he turned 72.

“We created a gradual Roth conversion strategy, where over the next 10 years, we were going to convert roughly $50,000 a year at a very low effective tax rate,” McGrath said. “We reduced what he was forced to take out over his lifetime from required distributions by hundreds and hundreds of thousands of dollars, thus saving him over $100,000, at least, in income taxes.”

The course of action has another benefit.

“When that money passes to his children, presumably 30 years from now, instead of it being fully taxed as income,” McGrath reported, “they’ll pay $0 in income taxes.”

Capital gains

When stock shares or other taxable assets are sold, the profits are subject to their own type of levy.

“The government wants to incentivize us, as citizens, to invest money,” McGrath said. “And one of the ways, at least currently, they incentivize that behavior is by taxing those profits at a lower rate.”

For example, a married couple filing jointly with taxable income of less than $80,800 would pay nothing on capital gains. Couples in the range of $80,801 to $501,600 are taxed at 15%, and above that amount, 20%.

By comparison, the marginal tax rate for married couples filing jointly is 12% for income levels of between $19,901 and $81,050.

“If you’re projecting out the taxes ahead of time, often you can find that right level where you can capture some of those gains and pay nothing in taxes, or at least pay less than you thought you were going to pay,” McGrath said. “And I think that’s really important to look at right now, when the stock market is up 400% in 12 years, roughly.”

On the negative side, he described a phenomenon involving mutual funds that he calls “phantom capital gains.”

“When you own mutual funds, you own shares of that mutual fund. You don’t own the underlying stock,” he said. “Let’s say you bought XYZ Mutual Fund a couple of years ago, and maybe it’s flat this year, 2022. And you really haven’t made any money.”

Meanwhile, the individual stocks inside of the mutual funds have been sold for substantially more than the purchase amounts.

“Even though you didn’t participate in those profits, you’re going to get a capital gain distribution, which is a tax distribution, as if you made that 400%,” McGrath said. “It really hurts when your portfolio is flat or negative and you get a big tax bill.”

He said mutual fund companies publish estimated capital gains distributions each November, to be paid out the following month, and at that point investors may want to ask themselves a question.

“Should I actually own this in December, when those negative tax consequences come my way?” he said.

An alternative to mutual funds, he said, could be a growth strategy involving direct investment in stocks, a practice that allows for greater control of a portfolio’s contents and a better understanding of the tax implications.

Social Security benefits

For most people who are employed, 6.2% of gross income is siphoned off as Social Security withholding tax.

So when retirees start collecting Social Security benefits, they may be surprised to discover that what they receive could be subject to taxation, as well.

The determining factor is yearly provisional income. If the annual sum is below $25,000 for single filers or $32,000 for married couples filing jointly, none of it is taxable.

Higher totals, though, can result in taxes needing to be paid on certain percentages of benefits. McGrath gave the example of a couple exceeding $44,000 in provisional income.

“Let’s assume that you had a Social Security benefit of a thousand dollars a month,” he said. “Eight hundred and fifty dollars, 85% of that thousand dollars, would be subject to taxes at your tax rate.”

That would mean $10,200 being added to the year’s ordinary income, potentially bumping the couple into a higher bracket.

Under what officially is called the federal Old-Age, Survivors and Disability Insurance program, as enacted in 1935, the minimum age to collect Social Security retirement benefits is 62, for a partial amount.

Collecting full benefits starts at either age 66 or 67, depending on the year a retiree was born, and the amount can increase by delaying collection until the maximum age of 70.

Charitable giving

Until recently, a common practice among taxpayers was to list amounts they donated to charities as part of their itemized deductions to be subtracted from gross income.

Then came the signing into law of the Tax Cut and Jobs Act of 2017, provisions of which included substantial increases in standard deductions and new limitations on itemized deductions. As a result:

“The IRS actually estimates that 93% of us do not itemize anymore, because that standard deduction is so large,” McGrath reported. “If you give, let’s say, $5,000 to your church, prior to this Tax Cut and Jobs Act, you got a deduction for that charitable gift. Now, you may not.”

A possible alternative to writing checks to nonprofits is to participate in a donor-advised fund, which is administered by a public charity to manage donations on behalf of organizations, families or individuals.

“Let’s say that you’re planning on giving $10,000 a year to various charities over the next five years,” McGrath said. “We might say, ‘Hey, let’s take $50,000 of highly appreciated stock that you would have owed capital gains taxes on. Let’s transfer what’s called in-kind, without selling it, into this donor-advised fund. And let’s instruct that donor-advised fund to pay out $10,000 a year over the next five years to these various charities.”

The upshot, he explained, is a $50,000 deduction where one didn’t exist before, plus the benefit of avoiding capital gains taxes on the stocks.

“From the charities’ standpoint, there’s no difference,” he said. “They still get the money each year.”

Estate planning

Among other provisions, the federal Setting Every Community Up for Act of 2019 raised the starting age for taking required minimum distributions to 72 as of 2022, up from the traditional 70½.

While that was good news for plenty of taxpayers, it cut into at least one longtime practice of transferring wealth.

“What the IRS does is, they give you something with one hand, and they take away something even bigger with the other,” McGrath observed.

With the SECURE Act came the elimination of the so-called “stretch IRA,” which allowed members of younger generations to inherit the contents of accounts and reap certain tax benefits following the holder’s death.

McGrath spoke about a gentleman’s hypothetical bequest of an IRA with a $1 million balance to his daughter.

“Prior to the SECURE Act, she could take a required minimum distribution based on her age. Let’s assume she’s 45, so maybe that’s $30,000 a year over the next 30 years,” he said. “So yes, she’s going to owe money in taxes, but $30,000 might not be enough to knock her into another tax bracket or create a whole bunch of other tax issues.”

The scenario has changed considerably.

“That daughter is forced to take the full million dollars out over 10 years,” McGrath said. “So now – if we’re just doing simple math, and she’ going to take out 10% a year times 10 years – she’s taking out $100,000 a year.”

He recommended re-examining estate planning with regard to the ramifications of both the Tax Cut and Jobs Act of 2017 and SECURE Act.

“I have never, in my 25 years of doing this, seen so many impactful tax changes in such a short amount of time.”

For more information, visit www.aptuswealthplanning.com and enlighten567.com.

Basic retirement plans

• Individual Retirement Arrangements, or traditional IRAs, allow you to make tax-deferred investments to provide financial security when you retire.

• Roth IRA is a tax-advantaged personal savings plan in which contributions are not deductible, but qualified distributions may be tax-free.

• A 401(k) is a feature of a qualified profit-sharing plan that allows employees to contribute a portion of their wages to individual accounts.

• The term 403(b) plan refers to a retirement account designed for certain employees of public schools and other tax-exempt organizations.

• A Simplified Employee Pension Plan allows employers to contribute to traditional IRAs set up for employees. A business of any size, even self-employed, can establish an SEP.

• A profit-sharing plan accepts discretionary employer contributions. There is no set amount that the law requires you to contribute.

• Defined benefit plans provide a fixed, pre-established benefit for employees at retirement.

Capital gains

• A long-term capital gain or loss stems from the sale of a qualifying investment that has been owned for longer than 12 months at the time of the transaction. Short-term gains or losses pertain to investments that are disposed of in less than a year’s time.

• Long-term capital gains often are given more favorable tax treatment than short-term gains.

Marginal vs. effective rates

• The marginal tax rate is the rate of tax charged on a taxpayer’s last dollar of income. For example, a married couple filing jointly with a combined taxable income of $150,000 is taxed at a 22% marginal rate. The first $19,900 of income, though, is taxed at 10%, and between $19,901 and $81,050, 12%.

• The effective tax rate is the actual percentage of taxes you pay on all your taxable income.

Mutual funds

• A mutual fund is a company that pools money from many investors and invests the money in securities such as stocks, bonds and short-term debt. The combined holdings of the mutual fund are known as its portfolio.

• Investors buy shares in mutual funds. Each share represents an investor’s part ownership in the fund and the income it generates.

Provisional income

• Used to determine taxes on Social Security benefits, provisional income is the sum of 50% of the benefit plus other income, includes pensions, wages, interest, dividends and capital gains.

• For a single person whose total adds up to more than $25,000, 50% of the amount is taxable up to $34,000. Over $34,000, 85% percent of the benefits are taxable.

• For married couples filing jointly, 50% of the amount between $32,000 and $44,000 is taxable. Over $44,000, 85% percent of the benefits are taxable.

Standard deduction

• A dollar amount that reduces taxable income, the standard deduction that eliminates the need for many taxpayers to itemize actual deductions, such as medical expenses and charitable contributions.

• If your 2021 filing status is single or married filing separately, the standard deduction is $12,550.

• For head of household, the figure is $18,800.

• The standard deduction for married filing jointly or qualifying widow(er) is $25,100.

Sources: Internal Revenue Service, U.S. Securities and Exchange Commission, CNBC, Investopedia