How the “Conventional Wisdom” May Cost You in Taxes

Here’s a headline for you: The financial “conventional wisdom” may cost you BIG in taxes! 

I’m Rick Plum, and welcome to this week’s edition of Lucia Capital Group Weekly. 

One of the most common pieces of financial advice that’s out there (and it’s been around for years) says that a retired person should always spend their taxable money first, leaving their IRAs and other tax-deferred accounts to grow until many years later.  In other words, they say you should never tap into your pre-tax accounts (like your 401k and traditional IRAs) before you’re required to do so at Required Minimum Distribution age, which is either 73 or 75, depending on when you were born.  And of course, they also say “Do NOT touch the funds in your Roth IRA until you’ve exhausted all of your other accounts.” 

This is what’s known as “conventional wisdom,” which to my way of thinking is pretty far from being wise.  The truth is that for many retired people (or those nearing retirement), that advice is simply wrong and could be costly from a tax perspective.     

So how can deferring taxes until later be a bad thing? No one likes to pay taxes. Aren’t you better putting off the misery for as long as possible?  

Well first, let’s look at our progressive tax system.  As our income increases, the tax rates scale upward. That’s how it works. But by using the lower income tax brackets more effectively today, we may be able to keep our taxes lower later on.   

This means that by going against “conventional wisdom” and starting to take at least some money out of your tax-deferred accounts in the early years of retirement and beyond, you may be able to dramatically reduce your tax expenses over the long haul.   

How so? By reducing the amount of money that’s in your IRA, instead of letting it grow untethered for the first 8 or 10 years of retirement, you reduce the amount of money that you’ll eventually be required to take out at age 73 or 75. Remember, your RMDs for any particular year are calculated based on the account balances at the end of the prior year.  

So for people with large IRA balances, the RMD rules usually force them to take out much more money than they need to live on – money that’s taxed at ordinary income rates.  And, that extra income that you don’t need could wind up causing you to pay more taxes on other income you may have (like Social Security).  The old “ripple effect.” 

The idea here is to reduce the balances in your tax-deferred accounts before your RMD age by as much as is reasonably possible. What’s reasonable? Well, if you discover that you’ve got some room currently in, say, the 10 percent or 12 percent bracket, maybe you withdraw just enough to get you to the top of that bracket without going over it. That money will eventually have to be taxed someday anyway, so if you have the flexibility to do it now in a lower bracket, that’s obviously much better than being forced to take it out later on at what could be a much higher bracket. 

Of course, I need to add that this scenario isn’t always the case. Depending on how much other income you have, you may not have room in your bracket, or you may be in a higher bracket now than you will be in retirement. Those things do happen. But it’s always worth taking a look. 

It all comes down to tax management.  Should you pay a little bit of tax now, with the goal of preventing a much bigger tax bill later? These are the types of questions we answer for our clients every single day at Lucia Capital Group. If you want to find out if this strategy may work for you, let the advisers at Lucia Capital Group do a quick review of your situation. By saving you from “conventional wisdom,” we may also be able to save you a whole lot in taxes. 

How can we help you the most? Just give us a call.