Ep 37: Taxes In Retirement: Are You Really Planning On Being Poorer?
Nicole Wipp: [00:00:00] Is your whole retirement planning strategy based on the assumption that you're going to be in a lower tax bracket upon retirement?
If yes, then you're probably like most Americans, at least most of the people that I talked to. And, that assumption, that idea, this notion that you're going to be in a lower tax bracket also implies that you plan on being poorer in retirement than you are now. Yet, the problem with that is, most people don't want to be poor in retirement. They want to have the same or better lifestyle and retirement. Right?
So that's why I brought back John Rohrhoff from JR financial services, because not only is John a financial planner, but he's also a CPA. And so he really knows a lot about taxes. So let's talk about the income and retirement tax myths that so many people fall prey to today.
This is the smart planning 1 0 1 podcast from Honolulu Hawaii Aloha everyone, I'm Nicole Wipp and I'm your host.
So today I love to welcome back John Rohrhoff from JR financial services. If you don't know who John is, please refer back to episode 36, where I interviewed John about socially responsible investing, but also check out his bio in the show notes page. John is amazing. He's really smart. And I love the way he thinks, because he's a very practical thinker.
So if you haven't yet thought about taxes and retirement, whether you are already retired, you're about to retire or you're 20 years away from retirement, taxes is something that you really do need to think about. And, that's why I asked John to come back and talk to us about that today.
So John Rohrhoff welcome back to the smart planning 101 podcast. We are talking today about something that I think for both of us is a geeky yet exciting topic because it really affects so many of our clients. It's a passionate topic for both of us, do you agree?
John Rohroff: A hundred percent Nicole, thanks for having me back I'm super excited to talk about taxes today as exciting as that sounds but this topic resonates with me personally and with all my clients It's one of the biggest issues as an advisor that we have to tackle.
Nicole Wipp: Yeah, so one of the things that I brought up to you prior to this podcast today was this idea that people make decisions based on a model of being quote unquote poor in retirement or that they're going to be in a lower tax bracket in retirement.
And so they have this model that they're following but you said but that's not possible for most of my clients or that's not possible for a lot of my clients. They already have so much money that the idea of being in a lower tax bracket for them is no longer feasible. And I see that with my clients as well and yet they're continuing to make decisions on that basis. It can really impact their taxes. So let's talk about that. Why is this happening? What are people thinking about here?
John Rohroff: Great point Nicole. People are just I don't know if they hear it in society so much or it's just it's almost like a known fact that isn't true. They just believe they're going to be spending less money and living a lower lifestyle when they get to retirement than they are when they're working.
And one of the first questions I ask every client I work with is when do you want to retire and what is your lifestyle look like? And generally they don't have an answer for specific details of that but I come back to them and say "Hey if we could retire and live the exact same lifestyle that you're living today would you be happy with that?" And they say yes! So if we're going to plan to live the same lifestyle in retirement than we're living today how are we going to do it on less money?
Nicole Wipp: It's a nonsensical way of thinking about it, and yet I think it's just more that people just don't think about it. Would you agree? It's not that they have thought about it in that respect It's just that they haven't really thought about it at all.
John Rohroff: Exactly, they haven't thought about it and they don't understand all the rules of our tax code. Frequently I have people telling me social security isn't taxable. And well, it's not all taxable but it depends on other factors in your life if it's taxable or not. And generally the people I work with it becomes mostly [00:05:00] taxable and they don't realize that their pensions are probably taxable and all the money they've been saving in their tax deferred retirement accounts is now taxable and they take the money out. So when they switch from saver to spender and have to turn on these income sources or take the money out all that money is now taxable money.
Nicole Wipp: Why are you putting all that money into tax deferred investment, if you could be using it in a more productive way today as well? There's trade-offs on that as part of this big tax question that people aren't frequently thinking about.
John Rohroff: Correct. And it seems that our society in general has decided to default Savings is to just put money into my tax deferred 401k or 4 0 3 B plan through work. Which is great It gets people saving I have no issue with it. The problem is when that's where all of our money is and all of our money becomes taxable later, It could actually put us into higher tax brackets when we retire, than we are today.
So one of the questions I ask every client I work with I say "do you believe income tax rates in the future will be higher or lower than they are today?" And you think about that question, and 95% of the time people tell me they think tax rates are going to be higher in the future than they are today. And I tend to agree with them honestly. And I can actually prove that they potentially could be, and that we recently in 2017 had the tax cuts and jobs act reduce income tax rates. That is set to sunset or expire here at the end of 2025. So here we're only four or five years away from scheduled tax rates to increase. And if you look at the data in general, everyone's tax rate is going to go up slightly when this happens. So we can say today I'm going to defer money that I'm going to need in the future at a scheduled higher tax rate It just doesn't make any sense.
Nicole Wipp: It really doesn't. We don't know none of us have a crystal ball and everything's moving at a really fast pace right now to all the time. And so the idea about what your situation is going to be is not clear but we you say historically we can see that there's always been a rise.
John Rohroff: It's funny you say that So I have in front of me right now the historical top marginal income tax rate for the United States going back to 1920. And if we look at income tax rates if you could Google historical top marginal tax rates and look at the chart currently right now we are at some of the lowest tax rates of all time And what that tells me as an advisor I'm constantly preaching "buy low, sell high". So if we are low tax rates that tells me we should probably sell that because in the future they're probably going to go up to more historical levels.
Nicole Wipp: Okay Yes, And that does make a lot of sense. Just because we're an historically low tax situation does not mean we're going to remain there. What goes down might go right back up.
John Rohroff: Correct, and we look at you mentioned what's going on currently and there's a lot of money being spent by the government with an increasing national debt. We hear about funding systems for social security and Medicare that are going on a run out of money, At some point in the future. The only way that we pay for these things is to get more money from taxes.
Nicole Wipp: Exactly. But I want to go back for a second to the social security thing because I think you're right, like to me that it seems to be one of the most persistent and pervasive thought processes is people think that their social security is non-taxable. And then on top of it can you also address the fact that really though your social security for hopefully most of the people listening to this podcast is going to be a minor point of your retirement income and definitely should not be a major point of your retirement income.
John Rohroff: Nicole, So the social security is huge and honestly being a tax professional and a financial advisor, I have a unique benefit in that I understand the tax system and how social security is taxable or not literally is about a 30 line worksheet on a tax return. So I'm going to I'm going to give you a brief overview of what that 30 line worksheets says, and essentially, if you make over $15,000 of income [00:10:00] then your social security is beginning to become taxable and it doesn't take long for it to be fully taxable up to the maximum limit of 85% So most of my clients end up having 85% of their social security income as taxable income.
Nicole Wipp: Yeah, $15,000 is definitely not a income level that most of our clients can live at. It's not going to be a realistic scenario for them to pay zero income tax on their social security.
John Rohroff: A hundred percent. And when we look at what makes it taxable it's your pension, just a pension can make all your social security become taxable up to the maximum amount. Or your withdrawals from your retirement account also increases that social security tax. And the one thing that people don't think about is I can keep my tax bracket low but every dollar you pull out of a tax deferred account then makes a social security dollar taxable. So if you pull $1 out you now have $2 taxable in certain circumstances.
Nicole Wipp: Wow I actually have never even thought about it that way. That is really interesting. And then the other thing is do you really think that your children are going to pay less in taxes? Because, the purpose is to have all this tax deferred money is to avoid taxes, What makes you think you're going to have less taxes taken out in the future?
John Rohroff: And nobody can come up with a good answer because it's really hard logically to think that you will, Cause like you mentioned if you leave it to your kids, if it's in a tax deferred account they're most likely going to have to pull it out over 10 years. And unless they're not working or not making very much money and in a low tax bracket it's just going to put them up in a much higher tax bracket.
Nicole Wipp: Yeah, So the whole thing about these tax deferred accounts is very fraught when it comes to taxes. And I think the bottom line of this is that you really need good advice.
John Rohroff: Yes, And we're talking about these tax rules that can vary by situations. So the biggest point I want people to take away from this is they should examine their tax situation and apply it to their unique financial situation because it can be different for everybody. And there's no rhyme or reason or rules to say if you make this amount of money do this or make this do that you really have to apply it to your situation specifically.
Nicole Wipp: All right, So to that end can we please talk about compounding growth, Because this is something that people always use to justify this as an action right? " Oh I'm getting the compounding." That's what I hear all the time I'm sure you hear it all the time. Can you please talk to us about these issues?
John Rohroff: Oh yes. This is one of my favorites " I'm going to defer my taxes because I'm going to get compound growth in my investment." Great But nobody thinks about compounding taxes owed either.
So let's go through an example simple example we can do. And we're going to say that Nicole you have $100 and you can either Defer your pay your tax today or pay your tax later in your retirement. Pay very simple a hundred dollars, And we're going to double that money in 10 years we're going to fast forward 10 years and you knew you now have $200. So if you did not pay taxes and you pull this money out 10 years from now that's doubled your, $200 is now taxable.
Let's assume a 25% tax bracket for easy math. So if we have $100 doubled to 200 how much tax do we owe at 25%? $50 we now have $150 left. So we at a hundred dollars grow to 200 and paid our tax at the end because we deferred it and we have $150.
Let's now pretend that we're going to pay our taxes today. So we take your a hundred dollars, We're going to pay our $25 in taxes 25% We have $75 That money is going to double in 10 years, Tax-free we now have $150.
So in both situations we started with the same amount of money and ended with the same amount of money. We just paid our taxes at different times but ended with the same amount of money. So we had compound growth but paid on the end in taxes. We compounded our tax bill due.
Nicole Wipp: Yeah And We can grow our money in ways that don't have to result in compound taxes or it doesn't matter It's six of one half dozen of the other. [00:15:00]
John Rohroff: Exactly, so what my advice would be to take your situation as it is today, project it out into the future and get an idea of what tax bracket are you in today, versus what tax bracket might you actually be in the future. And most people I run into, if your lifestyle is going to remain the same when you retire as it is today, I would say Hey let's just call it the same. So then it all comes back down to that question, "Do you think tax rates will go up or down in the future?" And if you think they're going to go up you might as well just pay your taxes today because then you would have won.
Nicole Wipp: And now can I put a little elder loss spin on this John?
John Rohroff: Absolutely.
Nicole Wipp: Because this issue that we are talking about right now tax deferred assets, qualified assets, is one of the biggest elder law challenges that my clients face. And what I mean by that is tax deferred assets cannot be protected in the same way that non tax deferred assets can be. You cannot put qualified funds almost ever into a trust, for example. And so, when that's the case what happens is it ties people's hands for asset protection later in life when they need it the most.
So this whole thought process that we as a country have come to around shoving all of our money into 401ks and IRAs as a habitual thing, I think we should be habitually saving, there's no doubt about that. But the idea that's the right thing to do and it's the only right thing to do because of compounding growth And because of all these other things that people think about has really caused a situation that on the backend when people are faced with long-term care health issues and things like that that now their hands are tied they cannot protect their money Very easily or without a major tax expense. And all of that goes right back to what you're saying because if you want to protect your money then you're going to have to blow the tax on these major investments, Most people are just not willing to do that There is no answer then at that point.
John Rohroff: Yeah you're a hundred percent correct And if that is the case that it leans more towards keep your money in places that have the benefits Now that aren't going to hurt you. If the qualified plan is going to hurt you later on and it's got no benefit to you, should you be using it? Should be a question that you should at least investigate.
Nicole Wipp: Yeah And I think really right That's the bottom line of this whole conversation is if you have been in the paradigm of thinking about shoving your money all into tax deferred investments, if you've been thinking in the paradigm of that like how most people in this country are. Maybe you should think again. Right? Isn't that what we're just saying think again about what you're really trying to accomplish here.
John Rohroff: Exactly, Think again, tie it back to your situation is what I want everyone to do and look at the pros and cons. It probably comes from that It looks like you have more money when you haven't paid your taxes yet. Because if you look at your net worth statement my deferred retirement account is going to be higher in net worth than ever retirement account that has already paid taxes on it or a savings account or any other accounts. People don't take the fact that their deferred account is not really the true value when they get to retirement.
Nicole Wipp: Yes, People think that's quote unquote their money but it really isn't a large portion of that money is the government's money.
John Rohroff: Correct, And you are you're growing that portion with your portion but they don't understand the fact that taxes are going to take a chunk out of that,
Nicole Wipp: And I think one of the best ways for people to understand that this is the truth is to think about that IRA stretch situation. Because we had it where the stretch was unlimited but then that recently, changed the law has changed to a ten-year stretch but regardless the reason That this is aloud over time is simply because in the end the government's going to get its money.
John Rohroff: They are going to get it's money. Exactly It's a hundred percent true. And when I look at it as an advisor this is probably why we hear and are taught to do the things we're taught is, I'm generally going to make more money If you have more money and if you haven't paid your taxes yet I'm making more money, The government's going to make more money because you're growing their taxes due, so it all just comes back to think about, [00:20:00] it tie it to your situation and lay the pros and cons out.
Nicole Wipp: Okay So you just said something that provoked me So now I have to address it which is this. You just rightfully pointed out John, your investment advisor makes money on the assets under management And so I want the client to be thinking about what's best for you Not what's best for that advisor And what's best for the advisor Monetarily is more assets under management but that may not be what's best for you. What's best for uncle Sam is more taxes, we all can agree That's not what's best for you .And so that's why it's really important Like you said for you to look at your individual situation and say what's best for myself my money and my family.
John Rohroff: Hundred percent true Nicole. Another reason to have an advisor that's a fiduciary, That's looking out for your best interest, because in general advisors get paid on assets under management like you mentioned and if you haven't paid your taxes yet that means your advisors making more. And that investment company is making more that's holding the investments and it just goes up and up. You can start at the bottom Everybody is making more money, The more money that you have that's helping you.
Nicole Wipp: And you're not necessarily going to be keeping all that money because it's going to go and taxes and fees and all of these other things. So it's just something to really think about and look at your long-term strategy. I very much, and I hope you agree John, advise that clients look into having a fiduciary advisor making sure that they have a CPA or tax advisor that understands their investments and how they will affect both their current and future tax.
And then I also would say which is probably something that most people aren't thinking about is having an elder law attorney that understands the financial implications of future money and protection, as well. Because, the legal aspects is a very different lens that we view these things through And a lot of people aren't looking at that.
John Rohroff: Yeah you're a hundred percent true. Those are the main lenses that the taxes the finance and the legal, they all play a part in a role in your life And you should have an advisor who at least has knowledge in all those areas or is working with someone hand in hand with you to give advice in those areas.
Nicole Wipp: I cannot thank you enough John for coming on to talk about this today because like I said at the beginning this is a geeky topic but it's one that affects literally every one of us. And it's so important that we really do encourage people to really start thinking about these things. And so, I appreciate your bringing all of this to our attention today. Thank you so much.
John Rohroff: Thanks for having me Nicole It was great to be on and great to catch up with you.
Nicole Wipp: If you want to connect with John, make sure to check him out at his website jrfinancialservices.com.
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