3 Retirement Mistakes You Didn't Realize You Were Making

Today, we’re going to cover 3 mistakes that we see both investors and their advisors making that could cost you hundreds, if not thousands, of your hard-earned retirement dollars.

1. Overlooking Taxes in Retirement vs. Taxes Today

2. Not Using a “Buckets” Retirement Strategy

3. Causing The Social Security Tax Torpedo.

#1 Overlooking taxes in retirement for taxes today

No one likes paying taxes. I don’t like paying taxes. We work our butts off, and we want to keep as much of our money as possible. Heck, one of my favorite sayings that I tell clients,

“We’re going to pay our fair share in taxes, but there’s no need to leave the IRS a tip!”

However, we find both investors and advisors are so overly focused on paying less taxes today, that they forget about the bigger picture.

The single most important question everyone should be asking before making any tax planning decisions is,

If you will have more taxable income during retirement than you have today, you might want to consider paying taxes today instead of saving taxes today.

If you believe that tax rates will be higher in the future than they are today (I do), you might want to consider paying taxes today instead of saving taxes today.

Here’s an example:

Steve and Mary are 60 years old. They were diligent savers. Mary is retired, and Steve quit his job to start his own consulting company. Steve brings in about $100,000 a year in consulting. When Steve plans to retire in 5 years, they will have approximately $100,000 per year in pre-tax retirement distributions, $20,000 per year in rental income from their beach house, and about $60,000 per year from social security income.

When retirement starts, Steve and Mary are expected to have $180,000 per year of income. Today, Steve pays taxes on $90,000 of self-employment income.

Using today’s tax brackets, that is a 12% marginal tax bracket today versus a 22% marginal tax bracket in retirement.

Steve’s advisor and accountant (both of whom always get credit for helping clients save money on taxes) say that Steve could save a few thousand dollars in taxes this year by contributing to a SEP IRA (a 401k for self-employed people).

But wait. 12% today vs. 22% in the future.

And Steve also agrees that given the state of the U.S. debt, it is unlikely that taxes will be lower in the future than they are today.

So, in this example, the best advice the advisor or the CPA could give Steve and Mary is to actually pay the taxes today!

You could put the money into a Roth IRA (after-tax), where it can grow tax-free and where they will not pay taxes on the income when he uses the money during retirement.

Saving on taxes today might feel good and provide instant gratification and a sense of accomplishment for his advisor, but deferring today is highly likely to cost Steve more money in the future.

Everyone’s situation is different. When planning for retirement, it’s time to start thinking about tax tomorrow vs. tax today.

It’s time to start peaking around the bend before making decisions.

#2 No Buckets - Heavily invested in one type of account or investment.

Planning for retirement is all about options. Flexibility. Freedom to choose.

Ideally, we want to be in a position where we work because we want to, not because we have to. We have the freedom to choose when to officially retire.

This is a primary goal for most of the people we work with. They don’t really want to sit around and do nothing all day. What they want is to know they can.

We help them prepare for retirement in a way that creates this freedom.

Part of this process involves filling up various buckets. We want freedom and flexibility to choose when we retire and to determine where we will source income during retirement.

If we are too heavily invested in a single type of account, like a 401k, this limits our retirement planning opportunities. When all of our money is in pre-tax 401k contributions, the distributions from this account can have a hefty impact on our social security income (more on this next).

If you plan to retire before age 59.5 and the majority of your money is in retirement accounts or annuities of any kind, you’re going to pay a 10% penalty on top of taxes at every single withdrawal up until age 59.5!

Retiring before age 60 is really tough without a variety of buckets to work with.

What are buckets?

Buckets can be different types of accounts and or different types of investments.

Buckets can be divided by tax type, as you see above.

Pre-tax accounts are like 401ks and Traditional IRAs. They are Pre-Tax because we put the money away before paying taxes on the income. Later, when we withdraw the money, the IRS will collect the taxes.

Tax-managed accounts are your joint investment accounts. You and your spouse have an investment account managed by your advisor. You pay taxes on this account each year and get a 1099 for it. Your advisor should help manage the account to limit the tax impact each year. Hence, “Tax Managed.” Your High-Yield Savings Accounts are Tax-Managed Accounts. We get a 1099 and pay taxes on the interest each year.

Tax-free or Tax-Deferred accounts are the third bucket. Roth IRAs, Roth 401ks, and Cash Value Life Insurance are a few examples. We pay taxes on our income. Then, we invest the money in an account that pays no taxes as the money grows, and when managed properly, we pay no taxes when the money is withdrawn to spend.

Alternatively, different asset classes can also be divided into different buckets. Investment real estate is one bucket. Private business investment is another. Stocks and bonds are another. Small business ownership is another.

Different Buckets have different strategies for both investment returns and taxation. Buckets are another form of diversification.

The more buckets you have to choose from when we create a retirement income plan. The more opportunity we have to:

1. Help you continue to grow your wealth during retirement.

2. Help you to manage the impact of taxes during retirement.

3. Help you mitigate risk from the fluctuation of markets and the economy during retirement.

When both investors and advisors fail to diversify their assets into several different buckets, they increase their risk of being pigeonholed into decisions they wouldn’t otherwise make if they had options.

These decisions can have a major impact on your current and long-term wealth.

It’s also an advisor's job to help push you to diversify, knowing the situation you’ll be in during retirement if you don’t. Unfortunately not all advisors are being proactive for their clients.

If you are heavily invested in a single bucket (over 75% of net worth), I encourage you to start diversifying your wealth into other investments to help create flexibility for your future.

#3 Understanding Social Security Taxation: Avoiding the Tax Torpedo

Many retirees (and advisors) are surprised to learn that Social Security benefits can be subject to taxes. The real question is: how much will you owe? Here’s what you need to know about Social Security taxation and how to avoid unexpected costs.

Tax Brackets for Social Security Income

Social Security benefits are taxed based on three income brackets:

• 0%: If your income is below a certain threshold, your Social Security benefits may not be taxed.

• 50%: Once your income crosses a certain level, up to 50% of your Social Security benefits may become taxable.

• 85%: For higher income levels, up to 85% of your benefits could be taxed.

The Social Security Tax Torpedo

The term “tax torpedo” describes the sudden increase in taxes on Social Security benefits when income crosses specific thresholds. This jump can cause the percentage of your social security income that is taxed to soar from 0% to 50% or even 85%.

Furthermore, starting Social Security benefits can impact your overall marginal tax rate. Depending on your income level, it could “torpedo” you from 12% to 22% or from 24% to 32%. This jump can significantly affect your retirement income, making it crucial to plan carefully.

For 2024, the Social Security tax brackets are as follows:

1. 0% Tax: Social Security benefits are not taxed if your combined income is below $27,000 for individuals or $32,000 for couples filing jointly.

2. 50% Tax: Up to 50% of your Social Security benefits may be taxable if your combined income is between $27,000 and $44,000 for individuals or between $32,000 and $44,000 for couples filing jointly.

3. 85% Tax: Up to 85% of your Social Security benefits may be taxable if your combined income exceeds $34,000 for individuals or $44,000 for couples filing jointly.

Let’s look at a quick example of the impact overlooking this information can have:

Say you started your retirement living off your cash in the bank and social security income. Eventually, the extra cash runs low, and it’s time to start drawing from retirement accounts.

You were getting almost $60,000 a year from Social Security and $30,000 per year from your cash savings, so your taxable income was below $30k. You are married, so 0% of your social security income was subject to income tax.

Now, fast-forward. We used our extra cash, as planned, for the first few years of retirement, and now it’s time to replace that $30,000 per year. And it’s all pre-tax from your IRA, so really, we need to withdraw more than $30,000 to account for taxes, say 15%. So, we withdraw $34,500, with $4500 being withheld for taxes.

With $34,500 of IRA distributions and $60,000 of Social Security income, you just went from 0% of your Social Security income being taxed and having $0 of total taxable income to paying tax on 50% of our Social Security income and having about $27,000 of taxable income. You went from a 0% marginal tax bracket to a 12% marginal tax bracket, and the effective tax rate on your next $1,000 of income would be 22%!

This move cost you around $2700 in additional taxes.

Unfortunately, for many, this could have been avoided with some fairly basic proactive planning and attention to detail.

Let’s quickly play it out…

Instead of fully exhausting our cash and then starting distributions, from the start we split income from cash and from pre-tax distributions. We took $20,000 from pre-tax retirement accounts (instead of $34,500) and the rest from cash. We would end up getting a few more years out of our cash bucket, creating more flexibility, and instead of paying a few thousand dollars in taxes, we paid more like $35!

And this is one example of why I believe to my core that when it comes to financial planning and your money, the devil is always in the details.

Summary: The Importance of Strategic Planning

#1 Work with a professional to help you look at the big picture. As investors, we don’t know what we don’t know, and that can make it very challenging to look ahead. Think twice before blindly “saving on taxes today.” – Make sure to consider how saving today will impact your tax bill later. Will my tax bracket be higher or lower?

#2 Spread out Your Money. If you are heavily invested in one bucket today, start to build up a different bucket(s). If you aren’t sure which bucket to work on next, speak to a professional who can help guide this decision with your best interest in mind.

#3 Finally, Social Security planning is nowhere near as simple as many people and advisors make it out to be. There are a lot of different ways to skin this cat. No one way is best for everyone. Everyone has their own unique situation to deal with when it comes to social security. Creating a plan, following the plan, and making adjustments as necessary are the best ways to help yourself avoid things like the Social Security Tax Torpedo.

Securities offered through LPL Financial, Member FINRA/ SIPC. Investment advice offered through IHT Wealth Management, a registered investment advisor. IHT Wealth Management and AutomotiveWealth are separate entities from LPL Financial. 

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