“Why I do it – pt. 2”

My last post was the first in a 4 part series of the most rewarding conversations I have had with clients while wearing my hat as financial advisor.  In it, I relayed the satisfaction that comes from connecting people to their assets and helping them get the most out of their savings.  Few things can replace the satisfaction obtained by instilling the confidence in people to spend their money in ways that truly bring them happiness (in this case – excusing them from annoying record keeping work).  This, part 2, will be all about optimizing the tax situation for the client, something that is an everyday part of just about any FEG team member.

A few years ago, I met a widowed lady who was nearing the point of drawing on the social security from her deceased husband at age 60.  While she came to FEG for investment advice and to truly have a fiduciary oversee her assets, one of the first orders of business for us was to look at her tax situation and the tax structure of her accounts.  In order to understand why this particular situation was so satisfying, you’ll need to be familiar with how social security is taxed. 

Social Security income can be taxed federally at anywhere from 0% to 85% of the total amount of benefits. For example, we’ll say your total social security benefits are $25,000.  Of that $25,000, somewhere between $0 and $21,250 will be added to the 1040 as income; it depends the amount of other income that shows up on your tax return.  The IRS refers to this as provisional income; which it calculates by adding up a recipient’s gross income, tax-free interest, and 50% of Social Security benefits. Once your provisional income exceeds $25,000 (as a single filer), social security becomes taxable. Once it exceeds $34,000, 85% of your social security benefits are taxed. In the case of this client, she was living off of savings she had stashed away and a modest pension so her provisional income for tax purposes was very low before age 60.  But introducing social security meant introducing another variable.

Any more provisional income, such as withdrawals from retirement accounts, would mean more of her social security benefits would be subject to tax.  Consider a scenario where she withdraws $10,000 from her IRA after social security benefits kick in.  This would mean not only adding $10,000 of income to the 1040, but also likely causing more of her social security to be taxable. In essence, this means that IRA withdrawals would be taxed twice!!  This notion bears worth repeating: the $10,000 IRA draw was likely going to be taxed federally at 10 or 15%.  Additionally, the $10,000 draw was going to push her provisional income up over the $25,000 and possibly another $10,000 more in social security benefits being taxed (also at 15% – or perhaps higher).  Minimally, the tax bill for a $10,000 withdrawal from her IRA during her social security era was going to cost $2,500 in federal taxes. This isn’t an issue for her if she does not need to withdraw any money from her IRA. It will, however, become an issue when she turns 70.5 and the IRS forces her to take money out of her IRA-called a Required Minimum Distribution.

Fortunately, we were able to apply some remedies.  It would have been great to have met her a year or two earlier and do even more, but it was still rewarding to work with her and save her what we could in future taxes.  The remedy was fairly straight forward and meant establishing a Roth IRA and taking some of her IRA dollars and putting it into that Roth. In the financial world, this is referred to as a Roth Conversion.  This conversion meant putting income on her tax return now, but would allow for tax free withdrawals later. But in her case of being in a very low tax situation at the time, a good portion of the dollars we converted from an IRA to Roth was done with zero federal tax implications! All told, rather than the $2,500 in future taxes we were forecasting in the example above – converting $10,000 from IRA into tax free Roth status carried a price tag below $500.

By simply shifting assets in the types of accounts she owned, we were able to shield her from future tax costs with very little impact today. Tax efficiency isn’t just for the ultra-wealthy, it is for everybody.  As this case will show it can be even more important to the financial wellbeing for those living a modest lifestyle. That, more than anything is what made this particular case help fuel my desire to keep coming back to do it again.