Episode 216: The Retirement Tax Mistake That Costs Thousands

Expenses and Taxes: Not the Same

Alex Murguia 00:08

If my current expenses and my future expenses will be the same due to vacation home purchase, what is the best strategy with over 80% of my investments locked up in tax deferred accounts?

Wade Pfau 00:24

Yeah, so I thought this was an interesting question to add because we can't just equate expenses with taxes. This kind of comes up with like safe withdrawal rate questions and things. Just because you're spending the same amount every year, it doesn't mean you're going to have the same tax bill every year. Whether your composition of different account types matters, ⁓ phase out.

Well, the social security tax torpedo, the IRMA surcharges, all that stuff has to be considered. So I think that kind of the embedded assumption here was if my expenses are going to be the same now and in the future, probably my tax rates are going to be the same now and in the future. And that's not necessarily true. And so then what's the best strategy with over 80% of my investments locked up in tax deferred accounts? Well, that's you have to kind of look at the situation, but that might be a candidate where at least thinking about Roth conversions to get some of those funds transitioned over to a Roth IRA could be worthwhile to look at. But you can't just say because my expenses are going to be the same now and in the future, my tax rates are probably going to be the same now and in the future. That doesn't necessarily follow, especially if those required minimum distributions are going to be binding, which by binding I mean the RMDs are going to force you to take out more than you actually want to spend. Then you might be taxed at a much higher rate, even though your expenses are the same. So that's what you want to be thinking about. And that could really be the main motivation to consider Roth conversions.

Roth Conversions and IRMA Surcharges

Alex Murguia 02:05

If you are under 65, single and retired and do Roth conversions, will the conversions impact possible IRMA for Medicare when you turn 65? Or is there some way to have the conversion amount excluded from considering as income for IRMA?

Wade Pfau 02:24

Yeah. So a few questions came up about this, that when you hit Medicare eligibility, there is the SSA form 44, which has a list of six reasons to petition for not having to pay an IRMA surcharge, changing life events, including work stoppage or reduction of salary and so forth. Roth conversions are not on the list. So just because I did a Roth conversion, I can't file form SSA 44 and say, hey, I did this Roth conversion, but I'm not doing it this year. So please don't charge me more for IRMA. So a strict interpretation of this is, no, you can't get around paying IRMA surcharges because of a Roth conversion. But where this could get a little bit more in the weeds, people having the experience of saying, well, I did a Roth conversion and I also retired. So I filed the form because I retired and I'm trying to sneak the Roth conversions under the, ⁓ kind of sneaking that into it. There may be cases where people were successful with that sort of thing. I would be cautious about that because they do want evidence of, okay, if your salary increased by this much, well, if they know this is the reduction in your salary, they're not gonna let you add the Roth conversion above and beyond that to the consideration.

At the end of the day with humans reviewing the forms, I don't know if people have been successful in sneaking a Roth conversion in through their form by saying they had retired. Maybe somebody's been successful with that. It's just, I don't think generally going to be the best operating practice for how to think about IRMA surcharges. Generally it's safe to assume any IRMA surcharges triggered by a Roth conversion will need to be paid. But again, maybe user experience could vary.

Finding Your EMR Target

Alex Murguia 04:23

Results vary. All right. It seems the goal is to stay below certain EMR levels for long-term tax efficiency. How should you find what is the target EMR for someone?

Wade Pfau 04:37

You know, so this is the million dollar question. What's the EMR target to use? And well, there's the CovaSum software out there that developed this whole concept. And that's, based my own analysis in the book on that. It's very hard to program where you do a lifetime optimization to find the EMR target. I don't think in practice folks are going to have access to that, but really what I've been finding, and these are all just general rules of thumb.

Talk about in the book now. This general rule of thumb, if you have investable assets somewhere in the ballpark of under $3 million, and of course a significant chunk of that being in the IRA, I think a 12% EMR target for ordinary income is pretty reasonable in those circumstances. You don't need to overdo it. The goal is not to get your IRA down to zero. You least always want to fill your standard deduction. Any money that you might eventually contribute to charity, you don't want to Roth convert. It's much more tax efficient to either do a qualified charitable distribution or leave the charity as a beneficiary of your IRA. So you don't want to Roth convert money going to charity. And also you might want something to later in life if you have deductible medical expenses, you need to have income to offset those to get any tax benefit. And so that could be another reason. You don't necessarily need to overdo the whole Roth conversion conversation and you certainly don't necessarily need to target zero for your your IRA balance.

So I think 12% can be a reasonable starting point and then as your wealth levels increase as you're getting above three million dollars eventually, you might start targeting higher EMR levels, but just for the average person who doesn't have tons saved up by by tons. I mean like under three million dollars ⁓ 12% is probably a reasonable starting point for an EMR target. And otherwise, to get any more detailed than that, you really have to do the lifetime optimization where you're assuming a planning age, annual spending, future tax law, rate of return on your investments when you assume all that, which is what I do with the programs I've written and what the CovaSum software does. Once you assume all those things, you can answer the question, what's the target that's going to give me the most after-tax spending and legacy?

But to the extent that those assumptions may not hold, the answer wouldn't necessarily hold either. It's just with all the different iterations and case studies and things that I've done, 12% really seems to be landing. And if you're reading an older edition of my book, it used to be 15% because of this, what we talked about earlier. Originally in 2026, the 12% bracket was meant to revert back to 15%. But now that the 12% bracket is permanent, 12% is the new 15%.

Monitoring Income Throughout the Year

Alex Murguia 07:42

How do people keep track of how much income they have during the year when sometimes the final statements are not available until the next year? How do you know if to sell some stock for example at the end of the year if you can't tell how much income you've had?

Wade Pfau 07:59

Well, so that it would make it hard. If you have no idea what your income is, it's very hard to then target how much final income you want to have after a Roth conversion. So to answer it, you really need to be monitoring these things. You want to know how much income's coming in. Now, where that can get tricky is with investments. A lot of your investments may have end of year distributions. And the estimates for what those will be don't come out until say November. So that the Roth conversion game really is typically a December event because you can't really fine tune anything until you know what your income is going to be for the year. And so, yes, it's very important to monitor what your income is going to be and then to also account for those end of year investment distributions. And then once you have those, then you can start to fine tune and target what your overall income will be after a Roth conversion.

But absolutely, without that information, you can't really do much because if you're trying to target a specific income level, you need to know what your income is going to be to do that.

Long-Term Capital Gains Harvesting at 0%

Alex Murguia 09:07

And to take us home here, if only income is Social Security, let's say $100,000 a year, and we want to sell stocks with long-term capital gains, filing jointly, how much long-term capital gains can we claim and stay in the 0% bracket? All of our other income is Roth.

Wade Pfau 09:31

Mm-hmm. Well, and so it's just the ⁓ long-term capital gains the end of the 0% bracket is 98,900 dollars, so that's after the below the line deduction, so you add your below the line deduction to that which is now more complicated with this age 65 plus bonus deduction if you've got two people over age 65.

Your below the line deduction is now $47,500. If nobody's over age 65, your below the line deduction this year is $32,200, I believe. And so either of those numbers, whichever, I mean, whatever your below the line deduction is, you add it to 98,900. And then that becomes the threshold. As you subtract your ordinary income from that number, and then the remainder there is what you have available to come to.

Gains harvest at 0%. Now, the only complication with the way this question was worded, they said their only income source is Social Security. So they may be dealing with the Social Security tax torpedo, which preferential income is also hit by that. That's one of the new features of the third edition of the Retirement Planning Guidebook is we do look at preferential income tax maps in addition to ordinary income tax maps. You can have that Social Security tax torpedo coming in with an 8.5% effective marginal rate.

As you're generating long-term capital gains since they count as part of the provisional income measure for how Social Security is taxed. So caveat being, you may not have access to a full true 0% rate if you're dealing with the Social Security tax torpedo, but otherwise, except for that, what I said holds was you can get yourself up to, again, if you're both over 65, somewhere close to a little bit less than but close to a hundred and fifty thousand dollars would be where that cutoff is. So that would be the amount of capacity you had at a zero percent rate with your long-term capital gains.

Alex Murguia 11:40

Interesting play. How many times do you... Can you use the text maps for that one?

Wade Pfau 11:48

Yeah, now ⁓ we do have with the tax map calculator at the Retirement Researcher Academy and in the book, we have both the ordinary income tax maps and preferential income tax maps. And the preferential income tax maps you can use for capital gains harvesting, long-term capital gains harvesting. Yes, it's a different map, but it's the same concept. So absolutely.

Why Tax Code Complexity Matters

Alex Murguia 12:12

Okay, and just the concept since everyone, we were talking about like losses, why would somebody want to do long-term capital gains harvesting?

Wade Pfau 12:21

To raise the cost basis of their taxable accounts. Now, it may not always be helpful at the end of the day, because if you get the step up in basis at death anyway, so you don't need a higher cost basis if these are money that are going to go to beneficiaries, or otherwise you might always just be in 0% or you might always be in 15%. So there may not ultimately be a benefit from capital gains harvesting, but it becomes relevant if in the future.

You have to sell taxable assets to meet expenses. The long-term gains, the first question we talked about was how much of that is cost basis, how much of that is gains, taxable gains? Well, if you do gains harvesting, you raise your cost basis so that in the future when you need to sell those shares to meet expenses, after another year holding to keep it as long-term capital gains, ⁓ you'd have a lower tax bill in the future.

Alex Murguia 13:19

So, just for, why would you do that is because your rate is such right now that it makes sense to just take on those gains.

Wade Pfau 13:28

Yeah. And if, if you're not dealing with the social security tax torpedo, if you can truly realize gains at 0%, that's one of the big no brainers out there. You know, why not do that? It might never have any benefit to you, especially like I said, if you never really have to sell shares to meet expenses. And if all that money goes to your beneficiaries anyway, there may not be any tax benefit from it, but hey, why not pay taxes at 0% when you can. Maybe that I'll give you opportunities in the future where you can pay less tax at 15%.

Alex Murguia 14:02

There it is. Any other questions Wade that may be answering the spark that you thought,

Wade Pfau 14:07

Well, we still have a lot more questions. Are you thinking to save these for a different episode?

Alex Murguia 14:13

No, I was just curious how, you know, I thought of that, you know, the gains one, and so just a little pause, like anything's there, but if not, we can keep on keeping on. Why doesn't Congress change the tax code so income tax is more gradual based on income and not sudden torpedo points like IRMA brackets and long-term capital gains? What's that acronym for? I can't make that one out.

Wade Pfau 14:43

Well, the Affordable Care Act is now going to be the big one. I don't know what LTCC is actually. I didn't read that carefully enough.

Alex Murguia 14:51

Well, the point is, why don't we do this gradually as opposed to having torpedo points for certain items?

Wade Pfau 14:58

Great, and it's a great question. I think over the past hundred years, the tax code just gets more and more complicated and it seems like they could streamline and simplify things. I don't know why we have all these cliffs and tax torpedoes and IRMA charges and now with the Affordable Care Act, you could lose $23,000 of subsidies if your income is $1 too high. I don't know why any of that exists. It just really complicates things. And it'd be great to simplify the tax code. So I'm all for supporting ⁓ the sentiment of this question.

Roth Conversion Break-Even Ages

Alex Murguia 15:35

Will you be running for office in 2028?

Wade Pfau 15:39

Yes, simplified taxes. And a chicken in every pot.

Alex Murguia 15:43

One. There you go. So, you're running on two. Your platform has two, three legs. You need two more. Yeah, you need two more. Do I have to have a good? All right. How long would my break even on Roth conversions be at age 78, 71, if able to predict?

Wade Pfau 15:50

Two pillars of the campaign. I return to normalcy. Uh-huh, yeah, so this is an interesting question because there are no break-even ages on Roth conversions. It really is a matter of if you can pay taxes at a lower rate now than in the future, and that includes for your beneficiaries, you get an immediate tax benefit. Like, I may be planning to live to 95, but if I pass away in the next year, anything left in my IRA becomes an inherited IRA to my beneficiaries.

If they're in that 10 year drawdown window going to be paying at a higher tax rate, then I would have paid on my Roth conversion. There's an immediate tax benefit. The after tax legacy value increases immediately. So there really isn't a break even age on a Roth conversion. It's just any opportunity to pay taxes at a lower rate is going to increase the after tax value of the assets immediately. So I don't have an answer of what exactly this person was thinking about. It's not really a break even age type of question.

EMR vs. Effective Tax Rate

Alex Murguia 17:06

If it's there, take it. ⁓ How does the effective marginal rate differ from the effective tax rate as described in most retirement financial software? If different, how do I calculate it?

Wade Pfau 17:22

So there are two completely different concepts. The effective tax rate is really another name for the average tax rate, which is just your total tax bill divided by your income. And we talk about like your average taxes and the marginal tax rate is your tax on your next dollar of income. So the effective marginal tax rate is the effective tax rate on your next dollar of income. And what the word effective means in this context is it's not just the income tax brackets. It's all these other things, the way Social Security is taxed, the IRMA surcharges, the loss of Affordable Care Act subsidies, the phase out of below the line deductions, the preferential income stacking issue. The effective marginal tax rate is what's the overall tax I'll pay, all those other things considered on my next dollar of income. The effective tax rate is just simply what's my total tax bill divided by my total income. So it gives me a sense of like, well,

Alex Murguia 18:16

Yeah.

Wade Pfau 18:18

What percent of my income goes to taxes on average. So they're completely different calculations. And in terms of how do you calculate the effective marginal tax rate, well, that's what the tax maps are showing you. It is a demonstration of effective marginal tax rates. And you really do need a specialized tool to see that if we have that tax map calculator at the Retirement Researcher Academy. That's one example.

Qualified Longevity Annuity Contracts

Alex Murguia 18:45

Okay. Do I understand correctly that purchasing a qualified longevity annuity contract from pre-tax retirement accounts that once successfully defers taxation and reduces RMD requirements in the short run?

Wade Pfau 19:00

Uh-huh. Yeah. That's the, the idea behind a qualified longevity annuity contract. Those were created in 2014 to deal with a problem that if I got a deferred income annuity, so I pay the premium today, but the income doesn't start until some point in the future. And if that point was after required minimum distribution start, there was like a paradox where I would owe required minimum distributions on a illiquid asset that I cannot distribute from. It could be very problematic. And so that's why qualified longevity annuity contracts were created. I could buy a deferred income annuity in my IRA. It won't start income till I turn 80 or 85 and so an additional tax benefit overlay of that is I don't have to worry about RMDs on that premium after age 73 or 75 depending on my year of birth. It's just when the money starts coming out at whatever age I that income turns on, well, that comes out of the account as ordinary income and I pay taxes at that time. So it gives you the additional tax benefit of pushing back RMDs on the amount of the premium into the qualified longevity annuity contract.

Tax Diversification and Roth Accounts

Alex Murguia 20:15

Okay. ⁓

Wade Pfau 20:23

Yeah, I mean, now we can say just in an ideal world, yeah, it's great if pretty much everything's in Roth accounts because you never have to pay any taxes and probably you won't have your taxable social security would fall under the standard deduction for you. So yeah, I mean, in an ideal world, having everything in Roth's would be wonderful. Now, in real life, the point is, well, how do you get there? How do you get everything into Roth's? And that's where it can be harder.

To set that up just because there's limits on how much can go into Roths each year. So then it's just back to, well, using the effective marginal tax rate analysis, using tax maps, looking for opportunities to do Roth conversions, to voluntarily pay taxes at lower rates than otherwise, because I think building up that Roth account will help me in the long term. So yeah, in an ideal world, everything's in the Roth, but in real life, it's not that simple.

Alex Murguia 21:20

I would also say, I'm going off the phrase retirement money and the concept of tax diversification. Retirement money, I take this particular question to be that someone's already, let's just say, 77 years old and they're taking money. But when you're 50, do you want to just put every amount of savings dollar in a Roth?

Let's say you qualify for a contribution in Roth. Do you want to do that or not?

Wade Pfau 21:53

Right, so that's not necessarily, that's where you look at what tax rate am I paying today versus in the future. And when you're in your peak earnings years, if you're in the 35, 37% bracket, you got a very nice income there, you're probably better off taking that tax deduction now with the opportunity to in the future, look for Roth conversion opportunities at lower tax rates. But right, you don't automatic.

So that's where it's hard to answer this question. Like, is it an idea of most of your money is in Roth accounts? Well, in an ideal universe, yeah, that's great. But no, in real life, that doesn't mean you want to just contribute all of your funds to Roth accounts. You still want to do that same analysis of we have to pay taxes, but let's look for opportunities to pay taxes at the lowest possible rates. And that could very well mean in my peak earnings years, I contribute to a traditional tax-deferred account. To get that tax deduction today.

Reverse Mortgages and Roth Conversions

Alex Murguia 22:43

Must have been in liquidity.

Wade Pfau 22:49

To get that tax deduction today.

Alex Murguia 22:53

And what about the person that would say, but I need some liquid assets that I can access to and not worry about IRA rules or anything like that.

Wade Pfau 23:01

⁓ well, yeah, Roths have some flexibility in that regard too, because you can always get your contributions back. But right. ⁓ If you're under 59 and a half and you're looking to need more than your contributions, you get into the issue of there won't be a qualified distribution and there's a 10% penalty. So that could speak to other liquidity needs as well. I was interpreting this question more of like, I'm 77 years old. Am I better off just having all my money in a Roth?

Alex Murguia 23:29

I was too, but there's a listener out there that may not be there and it's kind of nuanced the way it was phrased. So I wanted to just make sure we cut that off at the pass.

Wade Pfau 23:31

And the answer is yeah. Okay. Yeah. Right, if I'm 45 years old, is it a good idea to have all my savings, all my retirement money in a Roth? Not necessarily, for the reasons we just talked about.

Alex Murguia 23:51

Alright, could you use a reverse mortgage to pay the taxes on a Roth conversion?

Wade Pfau 23:56

Mm-hmm. Yeah, that's a legitimate use of that growing line of credit on a home equity conversion mortgage. These are proceeds from a loan, so they don't get accounted in your ingested gross income. And it could be a resource to pay the tax bill on a Roth conversion so that you don't have to, like we were talking about earlier, ⁓ have to take more money out of the IRA to pay the tax bill. It can be an alternative way to pay the tax bill without triggering more taxable income. That's one of many legitimate uses of reverse mortgages.

MAGI, ACA Subsidies, and Reverse Mortgages

Alex Murguia 24:27

Mm-hmm. Incorporating reverse mortgage cash distribution strategies could impact MAGI strategies, therefore impacting ACA subsidies. Can you just go over the acronyms?

Wade Pfau 24:43

Yeah. Yes. well, the, MAGI (modified adjusted gross income), your modified adjusted gross income, the, this is getting into all the, these tax issues that we've been talking about in this case, specifically affordable care act subsidies. Your modified adjusted gross income is your adjusted gross income plus non-tax social security. So a hundred percent of your social security benefits plus any taxes, empty interest sources like municipal bonds and so forth, plus any foreign income, foreign income that was otherwise excluded, all these other little things too. And ⁓ the higher that MAGI, the less subsidies you get. And now with the threshold of 400% of your federal poverty line, your subsidies for the Affordable Care Act drop to zero. So the reverse mortgage could have a positive impact here, where I need money to spend, but if I take it from anywhere else, I'm gonna lose Affordable Care Act subsidies.

That could be a legit reason to consider taking it from the reverse mortgage because it does not go into my modified adjusted gross income. Now there's going to be a small window where this is relevant because you have to be at least 62 to, well at least one spouse has to be 62. I guess you could have an age difference and the younger spouse could be using the Affordable Care Act. But at least one spouse has to be 62 to consider a reverse mortgage. And then at 65, you've got Medicare coming your way. So there could be a window there where a reverse mortgage could be a very powerful tool to help avoid the loss of my tax credits or subsidies for the Affordable Care Act. And especially at that very important cliff where if I'm $1 over 400% of my federal poverty line, which for a two-person couple in the continental US would be $84,500, I don't have any subsidy anymore.

Roth Conversions vs. Gains Harvesting

Alex Murguia 26:36

I'm in my 60s, is it better to do Roth conversions or tax gain harvesting? Or do you alternate years of doing one and then the other?

Wade Pfau 26:47

Yeah, and this is another question where I address this in the book. There's no like super easy or straightforward answer, but I do tend to lean towards Roth conversions. Just we kind of address this with the gains harvesting. It's hard to know if you're ever going to get any benefit from it because you kind of got to fall in this window where you need to spend those funds in the future. So you'll be selling shares in the future. And so the gains on those shares you sell would be taxed at 15% in the future, but it just works out nicely where you could have them taxed at 0% now when they would be taxed at 15% in the future. If these funds end up going to your beneficiaries, you get to step up in basis anyway so that it doesn't matter. And if they're always gonna just be taxed at 0% no matter when you sell them, or they're gonna always be taxed at 15% no matter when you sell them, you're not gonna get any benefit from gains harvesting.

So to me, just seems more clear. The opportunity to benefit from Roth conversions is more clear to me than the opposite, than the opportunity to benefit from gains harvesting. Now I wouldn't necessarily alternate from year to year, but if you do see potential value in both, what I talk about in the book is potentially Roth convert up to the, like through a 12% income bracket and charting any non-linearity there. And then, then you could do some gains harvesting on top of that until you get to where the 15% bracket starts for gains. So blending the two, if you're going to do both, think blending the two might be an option rather than alternating from year to year. But again, I would lean more towards Roth conversions and just consider gains harvesting if I don't need the Roth conversions and I've got some gains where I might be able to pay at a 0% rate.

Tax Planning Tools and Resources

Alex Murguia 28:40

Yeah, I mean the way to say that to me, if I'm looking at, if I'm listening to your question at the higher level is Roth conversions, the benefit is apparent and immediate. Gains harvesting, there could be a benefit, but we won't know.

Wade Pfau 28:54

Right, fair way to put it.

Alex Murguia 28:57

All right. Do you have an automated tool for a person or couple to generate their personal tax map?

Wade Pfau 29:04

Yeah, yeah, and we've talked about that a couple of times, but it's worth just highlighting again at the Retirement Researcher Academy, our membership site, we do have the tax map calculator. I'll update it quite soon for the 2026 tax code. It's still running on the 2025 numbers, but by the end of February, we'll have it set up to deal with 2026. As we noted earlier, you don't generally do Roth conversions until late in the year anyway. so for now, you can start thinking about what you what might be reasonable for the year, but it's really an end of year type conversation. And we do have that packed out.

Alex Murguia 29:36

And that's on our membership site on retirementresearcher.com. And then the last question here is, do you or McLean provide tax map consulting beyond the calculator?

Wade Pfau 29:49

Yeah, so McLean Asset Management is a sister firm. I don't personally do that, but yeah, we have plenty of advisors who can incorporate tax planning into the financial plans and to the extent that using those tax maps can be helpful. Yeah, it's something that's available.

Alex Murguia 30:08

Well Wade, it looks like we did our own little mini webinar in the last few podcasts here going over the questions. Just reading them out, anything come to mind that you'd like to add or is that a wrap?

Wade Pfau 30:23

It's a lot of great questions. So thank you to the community for that. had, I did try to get, there were a couple other maybe questions we didn't quite touch upon, but will at a future point, including a lot of questions come in. I need to do a deep dive into how Larry Kotlikov has been talking about Roth conversions. But other than that, I think we really did address most of the questions that came up. And so thank you. A lot of great questions and great to hear how people are thinking. It's fun to do the webinar and having more than a thousand people on the call all at once. And if you weren't able to catch the webinar. So in the show notes, you can find a link to watch that webinar. You can also find the link to get a copy of the third edition of the Retirement Planning Guidebook. yeah, thanks everyone for being part of the journey that we're on here.

Alex Murguia 31:13

Yeah, and Wade, you had a thousand people, so I think what we're gonna do is doing the Super Bowl when they have that halftime show with Bad Bunny. I think we're gonna try to livestream another workshop where you can answer questions, where people can like, right, what do think, is a halftime show?

Wade Pfau 31:27

There you go. Yeah, the alternative, that's like the Puppy Bowl and stuff,

Alex Murguia 31:33

Alright everyone, thank you for listening and we'll catch you next time on Retire with Style.

Wade Pfau 31:41

Thanks, everyone.