Spousal Tax Trap

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Zach – Hey everyone, Zach Holcomb here, back with this week’s blog on retirement today alongside me we have Mike Reese Certified Financial Planner. Now on our program, our goal is always to help you enjoy a prosperous retirement free from financial worries. We want you to enjoy the three Cs. Now those three Cs are confidence that your money will last control over your taxes and comfort that you and your family will be protected in both good markets and bad. With that in mind today we’re focusing in on a topic that many people often miss out on and that is something we like to call the spousal tax trap. Now Mike, what is the spousal tax trap?

Michael – Zach great being here as always and the spousal tax trap, I think is one of those topics that we don’t really talk about enough and it applies to you if you are married. So if you are single, then guess what? Today’s topic may not really apply to you and if you’re listening in after this point, it’s just because you want to increase your knowledge base, or maybe you’re going to get married someday and you wanna know what this is all about. But for the majority of you who listen in or watch who are married, this will apply to you or very likely will apply to you. And our goal today is to teach you exactly what this spousal tax trap is, so that you can learn, how you can avoid it. I want you to have the tools at your disposal to know, okay, what strategies need to be employed to avoid it? If it’s a problem and we want you to feel more confident and comfortable that you’re making all those right decisions. And so to answer your questions Zach what is the spousal’s tax trap? I think maybe an example would be a good approach. So let’s pick a name. Do you wanna pick the name of our fictitious couple here Zach you’re so good with naming people.

Zach – I think this week we’ll roll with Bob and Mary.

Michael – Aw, that is incredibly creative. You couldn’t go with like Gretchen and Jonas or something were going with Bob and Mary, fantastic. So imagine Bob and Mary are retired and they’re enjoying retirement they have, oh, approximately a hundred thousand dollars of income rolling in each and every year. I almost said each and every month and boy, wouldn’t that be nice a hundred thousand a month, but a hundred grand a year. So that’s about, eight, 9,000 a month. And if you look at what their tax liability would be at that rate, it’s somewhere around probably around $8,000 give or take depending on how their income is structured. But let’s use 8,000 as our example. And from their perspective, if you think about it Zach $8,000 a year of tax on a hundred thousand of income, does that sound like a lot or a little to you?

Zach – That sounds pretty reasonable in their case I think they’d be feeling pretty good about that.

Michael – I mean yeah, if you do the math, that’s 8%, 8% tax, it’s less than 10% effective rate. I mean, if you said to me, hey Mike, have I got a deal for you. We will tax your income at 8% for the rest of your life and we’ll lock that rate in today. I don’t know about you Zach, but I’m jumping on that. That would be fantastic. So there they are 8% or $8,000 a year. Now Bob dies, right. We use Bob and Mary, right. Bob dies, and the question now is what would the taxes be on Mary if Bob died tomorrow? And the answer is instead of 8,000 a year, she would end up paying somewhat closer to 12,000 a year. In other words, a 50% increase on taxes. That is the IRS’s gift to her, to support her as the grieving widow. So how do you like those apples?

Zach – Wow, so 50% I mean, why that number and what can Mary do to fix this?

Michael – Yeah, so by the way that’s a great question. And even before we dive into fixing it, this is just the, how you have the tip of the iceberg and then you’ve got the huge iceberg below it. You only see something like one ninth of the iceberg. See it gets worse for them because they’re not yet at a point where they have required distributions. Now, what I didn’t tell you in this example is that Bob and Mary are sitting on roughly a million dollars in their IRAs and 401ks. And when they hit age 72 Zach, they’re gonna have to start taking what are known as required distributions. And I like to call that a forced income. So this is income that they are forced to take even if they don’t want to. And every year that forced income gets a little bigger and bigger and bigger. And so if we look at Bob and Mary, let’s assume that the both of them live into their eighties, which is highly probable given longevity these days, if they both live Zach into their eighties, they may find that due to these forced income distributions. I mean, gosh they’re forced income might be a hundred thousand dollars or more that they’re taking out of their IRAs. And at that stage you could see their taxes go from the 8,000 today, easily around 20,000 or more. So how about that? How do you like the fact that, I mean, imagine Bob and Mary, they think they’re doing great today but at 8,000, how do you think they’re gonna feel when they’re giving the IRS 20 grand or more because they’re being forced to take distributions.

Zach – They’re not gonna be very happy about it. And is there anything that they can do to plan to prevent that?

Michael – Yeah because it’s an issue, right. Because we said they’re married, they’re paying 20 grand. Zach, what if Bob dies then? Yeah, what’s Mary gonna be paying now?

Zach – Shoot probably anywhere from almost 25 to 30,000 a year.

Michael – Exactly, is that the legacy you wanna leave your surviving spouse? Do you wanna leave your surviving spouse in that place?

Zach – No, not at all.

Michael – Right, here you are, you think you’re doing everything right. You’re following conventional wisdom doing what you’re supposed to do, just differing as long as possible. And then just taking out the required distribution. And as a result of that, here you are, after doing everything you’re supposed to, you’re leaving your surviving spouse, holding the bag, paying 25, 30 grand a year in taxes going up every year. Now, why is that? It’s because when you are married, you are, and you’re both alive. You are using the rates in the tax code called married filing jointly, married filing jointly tax rates. Those are the best tax rates in the tax code. They’re the best rates there are. But Zach, when one spouse dies and it didn’t have to be Bob, it could have been, Mary could have died first, but of course we know women almost about 80% of the time women live longer. So assuming Bob dies first that’s who we pick on, but either one for the surviving spouse, they go from married filing jointly to what, what is their new tax status.

Zach – Single rates, the single status.

Michael – Single, and single rates, which all you ladies watching this just as you know, Zach there, handsome young Zach is a single guy. So if you know any ladies, I’m just kidding here Zach I don’t need to set you up on our blog here. But the reality is that single rates are some of the worst tax rates in the tax code. So when one spouse dies, you’re going from the best tax rates to the worst tax rates, bang almost overnight. That’s why these rates go up so much for the surviving spouse.

Zach – This really is the spousal tax trap, it really is.

Michael – That’s exactly it. And so I know you’ve asked a couple of times, gosh, Mike how do we fix that, right? And that’s great, I know we’re always wanting to know, Oh my goodness, I don’t want to leave my surviving spouse in this position. What do I need to do? How do I fix it, right? Well, here’s the thing. We just said that when you’re married, filing jointly, you’re in the best tax brackets that the tax code provides. Why not take advantage of that, right. Why not take advantage of that? Why not go ahead and say, you know what? I’m going to start taking some additional distributions out of those IRAs today, even if I don’t have to, because what you could do is you can pull money out of your IRA when you’re married at lower rates than what they’re gonna be later on for your surviving spouse. So what if you, and I’m gonna give you two options here. What if you were to take advantage of that? What if you said, you know what I’m gonna do? I’m gonna take that additional money out now while I’m married, filing jointly, I’m gonna pay the lower rates now and I’m going to re-invest that money or redeploy that money in something that is tax-free, that would be an outstanding solution because the whole problem here with the surviving spousal tax trap, but the whole reason this tax trap occurs is because you’re leaving your surviving spouse, a bunch of money in an IRA that’s never been taxed. And so every time they take a dollar out of there, they’re paying tax at single rates, which are horrible. So the more money you can leave your surviving spouse tax free, right. And the less money taxable, the better off they are. So let’s talk about if you were to take advantage of this and by the way if you’re married, you can have up to $350,000 of AGI and be taxed at 24% or less. If you’re concerned about the spousal tax trap, you should be taking full advantage of that. Now heads up if you do that, you have to watch out there some Medicare issues too additional taxes on your Medicare well, they don’t call them taxes. They increase your Medicare premiums, but it’s really an additional tax. And you have to factor those in however, you should take advantage of this as best you can. So let’s say your income’s a hundred grand, that’s $250,000 you could be pulling out of your IRA and paying a lower tax rate on. So now should you pull that much out maybe not, but you should start taking money out and redeploying. So here are two options. Option number one, do a Roth conversion, right. Say you took a hundred thousand out of your IRA this year and you moved it to a Roth IRA. Instead of having an income on a hundred grand of income that year you’ll have income on 200,000, ’cause you took out a hundred grand, but you move it to a Roth IRA. That’s a $100,000 that your surviving spouse would get tax-free versus taxable. Then you do that every year for the next 10 years. That’s a million dollars you’re moving from IRA to Roth IRA at a pretty good tax rate. Now what’s a disadvantage on that do you think Zach? What’s the bad news, when you go from IRA to Roth IRA, what’s the bad news?

Zach – Well, you’re gonna have to pay a little tax.

Michael – You got to pay tax today, but I’d rather pay tax today at the lower married filing jointly rates than I would later on at the single rates. And here’s the good news for you if you’re over the age of 60, a lot of people don’t know this. You could just withhold the tax, just withhold the tax. You don’t have to write a check for it. Just withhold the tax, it makes it super easy. So that’s option number one. Now option number two is actually better, but you’ve got to be able to qualify. Option number two and this is gonna sound a little backwards thinking this is really gonna fly in the face of conventional wisdom, but option number two is take that same amount of money out of your IRA and instead of converting to Roth, use it to buy life insurance. Now Zach, why do we always hear about life insurance. When you retire are you supposed to be buying more or getting rid of it? What is conventional wisdom say?

Zach – Getting rid of it.

Michael – You don’t need it anymore. Maybe your house is paid for you have kids that are gone. What do you need life insurance for? Well, the answer for a lot of people is taxes and surviving spouse tax trap. What if you took that a hundred thousand out each year, money that you didn’t need. You withheld the tax say it’s 22% so you’ve got 80,000 leftover say, you could use that to buy for the next five years, do it for five years and use it to buy life insurance. Now you can buy specially designed life insurance for that 80,000, it’s actually growing inside that account. So you have access to it while you’re both alive tax free, but it buys a big old death benefit, right. Maybe it buys two, three, four million of death benefit, whatever the amount is who cares. The point is when you die, that’s an enormous tax free amount of cash that flows to your surviving spouse. And I’ve yet to meet the surviving widow or widower Zach who when their spouse left them a death benefit from life insurance especially a large amount, I’m still waiting to meet the first widow or widower that said, oh yeah that was a terrible idea, right. I mean, it’s talk about financial security for your surviving spouse. That is the way you leverage it in a tremendous way. I mean, that’s fantastic but you have to qualify. You have to be healthy enough to be able to get life insurance not everyone is, and you have to run the numbers and make sure that it makes sense for you. As an interesting side note, some of these life insurance policies actually provide long-term care benefits as well. So it kinda covers, it leverages your dollars so you’re leaving more money to your surviving spouse. It covers some long-term care issues if you need that before you die, 70% of us do. And then three, it helps with all the tax planning. So a lot of birds being killed with that one stone, if you will.

Zach – Right, so if all of this planning is done right for Mary What is the impact that she can expect from all of this?

Michael – Oh yeah you bet great question. And by the way, I guess I said there were two ideas here’s the third idea. Some Roth, some life insurance, you don’t have to do all the winner, or the other. You could do a little, a combination of the two and we have a lot of clients doing that but why, why do you do this tax planning? Well, it comes back to your question Zach which is, what’s the benefit? How does this help? Well, here’s the thing, first, number one, if you do it right, it actually helps both Bob and Mary, because what you’re doing by moving money from taxable IRAs to tax-free accounts in advance. Guess what when Bob and Mary are in their eighties, they don’t have these huge required distributions anymore. They don’t have that forced income. So instead of they’re not paying 20 grand a year anymore to the IRS, there may be pay back to their 8,000 where they started. In other words they’re really doing a great job of reducing future taxation while they’re both around. And that’s fantastic for both of them. So this isn’t just a benefit for their surviving spouse. This also helps both of you while you’re alive later in life. But number two, how does it help Mary cause we’re, we’re assuming Bob dies first, right. It could be, how does this help Bob, if Mary dies first, right, it’s all about planning appropriately. Instead of her paying 25, 30 grand a year and growing right every year for the rest of her life you do this the right way. You can usually get her tax liability down to a few thousand bucks. We could usually get Bob and Mary while they’re both alive, down to a few thousand dollars of tax, sometimes no tax, but usually it’s a few thousand dollars. And when the first spouse dies, instead of jumping up dramatically, we’re able to keep that tax liability at a very low level, few thousand dollars. Why, because if we do this the right ways Zach, over their lifetime, while they’re both around, we’re moving a large percentage of that IRA or 401k into these more tax favored approaches. So that way if more money’s in the tax-free stuff and that’s less taxable money coming out, that means less taxes on their social security means less tax on all their sources of income. And that could be a really beautiful thing. So that’s a great benefit.

Zach – Mike, this is unbelievable stuff. And it really sounds like tax planning can be very powerful for the families that plans in advance.

Michael – Yeah, it’s a huge deal. And this is, what’s so sad. I mean, everybody, when I ask people who does your tax preparation who prepares your tax returns? What do they say? Half of them that say, well, Turbo Tax, right. Or whatever, the H and R block version. I think they call it tax cut, but some type of computer program. If it’s not that then it’s maybe an accountant or somebody, but then I ask a different question, Zach and I ask, okay great, who does your tax planning? That’s where most people say, gosh, I don’t know. I don’t know. I don’t really have anybody that does that because you know, if you think about tax preparation what is that about? That’s about last year when you prepare your tax return, all you’re doing is you’re recording what happened in one year last year. Today, we’re talking about tax planning, tax planning is what’s gonna happen to your tax return each year for the rest of your life. Do you like what that looks like? Do you like that? And if you don’t, what can we do today to make positive outsize positive impacts later on in life. So tax planning, tax preparation, very different things. And this is an area where a lot of people miss and it’s unfortunate. So hopefully a lot of people are getting the message today about what is a spousal tax strapping and what can be done to plan for it accordingly.

Zach – Right, and if you’ve been watching or listening to us today like Mike said, you should have learned what the spousal tax trap is, how to avoid it or planning to avoid it. And you should feel more confident that you can plan accordingly for this. Now, Mike, if our listeners and viewers want some help in planning for this what’s the best approach for them?

Michael – Well, if you’re already a client you know we do this for you all the time, which is the tax planning side. If you’re not a client, one of the things I’ll lay out for you I’ll offer you absolutely for free we’re entering into the new year here. I will for free sit down with you and do a tax audit. And I know you’re thinking that sounds so exciting right no a tax audit doesn’t sound exciting and I know that. So what is a tax audit? A tax audit is you bring me a copy of your tax return and then we talk about your different assets. And what we do is we map out for you what your future looks like from a tax perspective, we help you take a look at where are you today? Could you save taxes today? Are you overpaying the IRS now? Which may be the case, Turbo Tax and tax gov, they don’t know what questions to ask a lot of times as to how to reduce your taxes today. But even more importantly than that, we look out to the future and we help you understand here’s where you’re going. Here’s what your taxes are gonna look like down the road. If you’re married, here’s what your spousal, your surviving spouse. Are you facing a tax trap for your surviving spouse? What we talked about today, what does that look like? So a tax audit helps you understand the road you’re on. Where are you today? And where are you going from a tax perspective, understanding where you are today is the first step, the first step of saving what is hopefully a boatload of taxes is over your lifetime. Once we understand that the second part of a tax audit is we start giving you an understanding of here are some different strategies and here are the types of savings that you could enjoy over your lifetime. Zach that number is often a very large number, tens of thousands of dollars, if not hundreds of thousands of dollars taxes that are saved money that you’re not sending to the IRS, that you’re able to keep in-house for yourself. So this is free, no obligations. I don’t know why you wouldn’t wanna take advantage of that and what Zach, what would be the best way to connect because the steps are in order to get that free tax audit. Step one is you need to connect with Zach for a 15 minute phone call and he just gets a little bit of your information he gathers documents, and then that way when you and I talk and do go over that audit, we can make sure you making the best use of our time together. So Zach, what’s the best way for them to get on your calendar for that 15 minutes to get the whole process started.

Zach – So there’s two ways that you can get on my calendar to start this process. The first one is you can just give us a call directly at our office, that number is 265-5000. Again, that number is 265-5000. Or you can go to talktomike.com that’s talk to and Mike is M-i-k-e and it links directly to our calendar where you can book that 15 minute call and that’s all you have to do. It takes like 15 seconds.

Michael – Wait so the website talk to mike that’s t-o, right, talk, T-a-l-k to, t-o and then Mike. Like just talktomike.com and it sends you straight to your online calendar.

Zach – You got it right there.

Michael – That’s really simple, that is easy. All right I think that wraps us up today, right Zach because we’ve covered our topic and our goal, like how you said at the beginning, what’s our goal, the three Cs. We want you to have confidence that your money’s gonna last control over your taxes talked a lot about that today. And of course the comfort that you and your family are gonna be in great shape both good markets and bad. We are big believers that your best is yet to come. We believe that you deserve to enjoy the retirement of your dreams. If you want to enjoy the retirement of your dreams, you gotta make sure that your financial houses in order, you’ve got to make these smart financial decisions. And it’s not just how you invest money. It’s a lot of other stuff, taxes being one of those areas. So Zach, any final thoughts before we wrap up today.

Zach – Give us a call, we’d love to help you out on this, moving into the New Year and you need to take action. Plan accordingly and planning ahead.

Michael – There you go I mean, if you don’t do anything different, you get the same results, right? So you wanna control your taxes? Let’s start with that tax audit. Talktomike.com. 512-265-5000. I’m looking forward to visiting with you. I hope you all enjoy the terrific week in front of you. Bye everyone.

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