The Power of Zero paradigm changes a bit when you have a pension. The best case scenario in terms of tax rates that you are going to experience is likely to be while you’re working.
Let’s say we have two 60-year-olds that want to retire in 5 years. They have $500,000 in their IRA’s and 401(k)’s, and one of the spouses has a pension of $5,000/month. They are currently in the 22% tax bracket.
If you have a $5,000 pension, that is construed as provisional income by the IRS. This means that up to 85% of this couple’s social security becomes taxable. When they couple the pension and social security together they are looking at filling up the 10% tax bracket and most of the 12%.
Any dollar that the example couple takes out after retirement is going to flow into their taxable cylinder and they will pay taxes at the 22% tax rate or in the future the 25-28% tax bracket.
We have a situation where if the couple wants to take money out of their IRA, the best case scenario is that they will be able to keep 78% of their money, and that doesn’t count state taxes.
Where the opportunity lies when someone has a pension, is we can make the case that since they will be in the 22% tax bracket in retirement, they might as well be converting and maxing out that tax bracket until they are 65.
We want to drain those IRA’s and 401(k)’s before they reach retirement so the money will come out tax-free. We worry about the things we can control, not the things we can’t, and we can’t control the fact that their pension and social security will be taxable but they can control the rate at which they get taxed on all their other assets.
If they only convert $70,000 per year to maximize the 22% tax bracket, they won’t get all the shifting done in the next 5 years. That means they will have to pay higher taxes on the balance. They really need to get the money out before tax rates go up for good in 2026 and converting up to the top of the 22% tax bracket isn’t going to cut it.
For only 2% more, they can convert an extra $150,000 per year which is a great deal (comparatively). Even if they pay an additional 2%, that will still be lower than the 25% tax bracket that the 22% bracket will be after 2026.
If you are already in the 22% tax bracket, and that is most people, and you have a pension that will likely cause your social security to be taxed, you’re in a situation where there is no real reason not to max out the 22% tax bracket and probably the 24% as well.
Every year that goes by where you fail to take advantage of the current 22% tax bracket is a year where you will be paying at least 25%.
The real concern is when the US has a sovereign debt crisis, which is where countries will no longer loan us money and we can no longer print money to escape the issue. Social security and Medicare are pegged to inflation so printing money won’t be a solution, the only viable option will be to raise taxes.
If taxes raise dramatically over the next decade, we’ll look back at the current time as an opportunity of historic proportions. Any sort of residual income will be taxed the same way and could cause up to 85% of your social security to become taxed.
The bottom line is to take a look at what your tax bracket is today and what the best case scenario is going to be once your pension and social security fill up the first two tax brackets. You’ll see that not a year should go by where you are not taking advantage of these historically low tax rates.
Your tax rates are going to double no matter what. When a spouse dies the cost of unlocking dollars from your taxable accounts doubles.
If you’re thinking that you can just live off of your pension and social security and leave everything in your IRA, there is legislation being considered right now that may limit or greatly affect that plan. If you have an IRA, you should really shift those dollars to tax-free with a Roth Conversion or a LIRP.
When we cut taxes, we did just the opposite of what economists said to do. Instead of cutting costs and raising taxes, we cut taxes and raised costs. Mainstream media outlets are starting to acknowledge that we have a debt problem and we’ll need to address it eventually.
If you have a pension, make sure you assess what your tax bracket is today and recognize that taxes now are lower than they will be in the future.
The highest marginal tax rate in 1960 was 89% and the poorest among us were paying 23%. We haven’t seen these tax rates in a long time but they are being talked about, experts across the country are making the case that we are at a crisis point.
Weigh the evidence and decide if tax rates down the road will be higher.
Every year that goes by is a year beyond 2026 where you will be paying the highest tax rates you’re going to see in your lifetime.
