Episode 77: Retiring Soon? Essential Tax Tips for Your Last Working Year

In this episode of Accessible Finance, we delve into crucial tax-saving strategies for those nearing retirement. Hosts Eric and Rachael explore key moves, such as maximizing deferrals to 401(k) plans, utilizing donor-advised funds for charitable contributions, and planning for Roth conversions. They emphasize the importance of understanding marginal and effective tax rates, managing income to avoid tax cliffs, and the timing of retirement planning. Whether you're a year away from retirement or just starting to consider it, this episode is packed with valuable insights to help you navigate your financial future. 🎙️ Have a financial scenario you’d like us to discuss (without giving personalized advice)? Send your questions to podcast@equilibriumfp.com—we’ll keep your information completely anonymous! 📢 Don’t forget to like, subscribe, and share with friends who could benefit from smarter retirement planning tips!

Read the Transcript

Podcast Episode: Retiring Soon? Essential Tax Tips for Your Last Working Year

Eric: [00:00:00] Welcome to episode 77 of Accessible Finance. Let's dive in. 

Rachael: Alright, Eric, so today we are gonna discuss a question that we hear a decent amount from our clients who are very close to retirement, which is, I'm planning to retire next year, or in the very near future, how do I reduce my tax bill before I stop working?

What can I do now to lower my taxes? 

Eric: Yeah, 

Rachael: so what's the first thing someone in this situation should be looking at? 

Eric: Deferral, right? So if you're in your high, your last earning year, you're typically going to be earning, like this is usually one of your higher earning years, right? Mm-hmm. So you're gonna want to try to defer as much of your [00:01:00] salary right now as possible and start to plan for how to situate your money within your taxable accounts and your tax deferred accounts likely to execute some series of Roth conversions.

Rachael: We can't get through an episode without talking about it. 

Eric: I hope not. 

Rachael: Um, 

Eric: we were, we, there was, there were a few where we didn't talk about Roth conversions and honestly it was terrible. 

Rachael: I know you, you went through withdrawals yourself. Um, okay, so then let's talk through some of the key moves and what they should be prioritizing before that.

Paycheck ops. 

Eric: Okay. Um, this is one that's kind of interesting, right? So, well, you wanna max out your pre, pre-tax accounts, which pre-tax accounts that are deductible, right? We're not telling you to go make non-deductible contributions. Like, like crazy. You actually would probably rather that money be in a taxable account so that you can pay taxes on conversions later.

And what I mean by that is, um, I think it's 23.5. I should know. I'm, I'm 98%. It's 23.5. Uh, contribution to actually, if you're about to be [00:02:00] retired, then it's gonna be more than that. 'cause there's a catch up contribution. Um, it's over 30, uh, anyway, sorry. 

Rachael: It's gonna drive him crazy. It 

Eric: really is. Yep. Look it up.

Go quick, quick, quick. Oh my gosh. It's important. 

Rachael: You need to keep speaking. 

Eric: All right. All right. All right. Um. The Catchup contribution is the most that you can defer into your employer's plan, right? But you are still going to like, after that, there's typically a non-deductible. Um, after tax contribution that you can do, um, for strategies that are like the mega backdoor Roth.

But essentially I'm saying that you don't want to make non-deductible contributions. You're looking for deductible contributions, right? So typical contributions, um, to your, or deferrals to your 401k plan. Sorry, lots of words. 

Rachael: Indeed. 

Eric: Yeah. Um, okay. 

Rachael: Um, you 

Eric: also, this is the kind of interesting part. If you know that you're charitably inclined, right?

Mm-hmm. You can accelerate your charitable contributions by using like a donor [00:03:00] advised fund. If you know you're gonna do that anyway, then you can do it Now when we think that your taxable income is the highest, and what that means is a donor-advised fund is a strategy. Where if I know that I'm gonna give $10,000 a year to charity, because that's, I'm charitably inclined anyway.

Yeah. And I like it. You know, I, I enjoy it and I feel like it, you know, I feel good about it. I'm gonna do it anyway. If I give $10,000 a year that's below the standard deduction, I. So I might not get any taxable benefit. Right. I still feel good about it. Sure. It's still a charitable act. It's still a good thing to do, 

Rachael: but you're hanging out with the standard deduction.

Eric: Right. But I'm gonna, so I'm doing that every year. I, I'm doing $10,000 a year to no tax benefit. Right. Okay. Because the standard deduction exceeds, you know, it's 14 k plus, it's going to exceed the $10,000 that I'm giving to charity. Yeah. And if I don't, you know, I no longer have a mortgage, I don't have health expenses over 7.5% A GI, I might not be able to itemize.

Okay. Which means I might not be able to use any of the things that I would ordinarily deduct if I did itemize since I'm taking the standard deduction. Sure. [00:04:00] Long-winded way to say, if there's no benefit to giving your $10,000 a year, you might want to front load it and say, Hey, you know what? I have a hundred thousand dollars maybe lying around.

Why don't I just give a hundred thousand dollars to a donor advised fund and then over the next 10 years, even assuming no interest or earnings on that month, on that a hundred thousand, which doesn't have to be the case. Right Point is. E then over the next 10 years, I can give the $10,000 and I can take that whole a hundred thousand dollars deduction.

Right now when my tax bracket in the year is the highest putting in 

Rachael: the the donor advice fund. 

Eric: Exactly. 

Rachael: And to be clear, I think, you know, we've talked to clients about this as well. Um, I. At some point there was some misunderstanding that went viral on social media that donating money ends up actually saving you money, and so we would never advocate.

Yeah. You know, setting up a donor advised fund for the purposes of saving you money. However. Like Eric said, if it's something that you are inclined to do anyway right. Then there is a way to also benefit [00:05:00] from that decision that would be made regardless, 

Eric: right? Yes. Just to be clear, the point that Rachel's making, I just, and she made it well, I just wanna reiterate, you will not net positive by handing dollars to charity.

Yeah. Does that make sense? Even if my tax rate okay, on my a hundred dollars is 99%. Yep. Okay. And I hand a hundred dollars to a qualified 5 0 1 C3 I Now, if I hand the money to charity. I lose $100. Mm-hmm. Okay. If I pay the money to the government at my 99% tax rate, I still have my $1 left. Yeah. I will always come out worse by giving the money away from a, how much do I have at the end of the day perspective?

Sure. Not from a, did I do the right thing? You know? That's correct. Completely agnostic to that right now, and 

Rachael: I think that, you know, if you're working with a, a advisor or, or planner, hopefully they're not. Um, imposing their own views or opinions correct on you. Right. So you should never, right now, these are your values.

You should be made to feel badly for not choosing a donor-advised fund or for choosing a [00:06:00] donor-advised fund, but you should definitely know the pros and cons, the benefits, and how to maximize. Mm-hmm. Um, the benefit to you, right. If you're doing it anyway. 

Eric: Right. And, okay. Sorry, side, so latter point, so we, we said.

Maximize your deferrals. Yep. To the 401k. Okay. Again, it's over $30,000 for the catch up. Um, accelerate your deductions, if you're gonna have any. It's mostly gonna be charitable. Mm-hmm. There are others, but probably not. Um, and then you want to, if you're gonna have bonuses or, you know, vesting schedules or anything like that, if you can push them out, if you have RSUs bonuses, any kind of compensation packages, if you can defer them, it is to your advantage.

Because we just said you're retired next year and unless you have. You know, taxable accounts that are producing dividends and, and interest. Mm-hmm. You're probably going to be ca just much lower. Yeah. Just dramatically lower. Right. Especially if we're talking about somebody that's in a 37% bracket, you know, making four or $500,000 or more.

Yeah. Um, you're gonna be thrown way down into the potentially even the 12 or the 22% [00:07:00] bracket. 

Rachael: So if we're thinking back to last episode mm-hmm. Um, and you're getting potentially thrown down. Into a lower tax bracket the next year, what might we be thinking? 

Eric: Roth conversions. This is So you want to, you wanna have a strategy, right?

We want I like ideally we can math out Exactly. Yeah. What we should do, because we know when we're gonna receive our social security. Yeah. We can know what that number is. What we're going to receive in Social Security. Yes. You should know all of this. We know how much is taxable of the social security.

Correct. We know that it's almost always gonna be 85%, but the point is we know we can know all of these things. Mm-hmm. We can know when your pension's gonna kick in, if there is one. Um, when your R RMDs are gonna kick in, we can actually use discount rates to have a pretty educated guess as to what those numbers even are gonna be.

We can quantify that. So the point is we can have like what we would call a ladder. We can do laddered Roth conversions. Right. And 

Rachael: to be clear that Laddered Roth conversion would start. Once you have retired, not in Absolutely. The year that you are much to Eric's dismay, he'd have to wait. No, 

Eric: no. I would absolutely be happy [00:08:00] to wait in this case, 

Rachael: but if you are in your.

Like Eric had said, right? If you are rounding out your career, you're at your highest earning potential at this point, right? You are making the most that you're gonna make. This is the worst year to sit there and say, let's do a Roth conversion. However, you know that your bracket right, your income that you're realizing is gonna dip down pretty dramatically, um, in most cases.

At the point in time that you have now retired. Right. So that is a huge, huge planning opportunity for Roth conversions. 

Eric: Correct. You search something up. Absolute yes. I just wanted to be clear that it was 23,500 for younger individuals under 50. Right. But if you're 50 or older, you can defer $31,000. Okay.

To your four one case. I love that. Thank you. So if we're talking about nearing retirement, we're going to assume that they're 50 or older. So we're gonna assume $31,000 is the number you can, um, defer from your salary to the 401k account. 

Rachael: Perfect. Now, okay. So [00:09:00] even though this, you know, these, these people, these clients have come in and said, Hey, I'm looking to retire.

How do I lower my tax bracket now? Right? How do I lower my taxes now? Um. We end up having to do, you know, a decent amount of education and discussion around the fact that it's not about saving on taxes this year. It's about saving on taxes over your lifetime. Mm-hmm. And setting your entire future up, um, for success when your income drops.

So how would you try to talk to them about kind of bracket planning? 

Eric: Um, the way I like the word, the phrase that I use, that I'm sure listeners have already heard mm-hmm. Is, um, effective, marginal, or marginal effective tax rate. Yep. Okay. And what I mean by that, I'm not trying to be cute, um, it's just your marginal tax bracket.

Right. So if I'm in the 20, if the last dollar that I earned is taxed at the 22% bracket today, my marginal tax bracket is 22%. Yep. Right. If in the future it's gonna be 32, right? Or 24. [00:10:00] Okay. Well now there's a little bit of difference there. So we're not 

Rachael: talking like, so we're 

Eric: just talking about 22 versus 24, talking about the last dollar of tax.

Rachael: Yeah. I think that's an important thing. Um, and we've talked about it before, but, um. Typically when people will see their marginal tax bracket, they'll assume that's the average, that's the tax to pay on everything, correct? 

Eric: Not the same, no. Um, 

Rachael: there are, that's why, you know, I'd referred to it as as bracket planning, but it's exactly that.

It's the fact that you're paying X amount of dollars in the 10% bracket, X amount of dollars in 12%, and it moves on and on and on. Mm-hmm. Um, the idea is to prevent you from having to pay. A single dollar in one of the brackets that we would kind of refer to as like the red zone or like Right. The really high bracket.

Correct. If we can avoid it, 

Eric: we're trying to reduce your effective tax rate, which is just your total taxes paid over your taxable income. Mm-hmm. Okay. And we're gonna do, when we say we're talking about marginal, effective rates, like what are you actually talking about? We're including. Two primary things, but we're basically including everything that's gonna have a tax impact.

Mm-hmm. So if [00:11:00] you earn too much to qualify for the child tax credit and you have, you know, two two kids, that's $4,000, you're not able to take. Yeah. Okay. So we want to count that $4,000 as an additional tax that you're paying because it's an opportunity cost of earning so much money. Yeah. If we could make you somehow earn less money or have less taxable income, it's not like we want to make less money.

We never wanna do that. No. We wanna try to defer. Or contribute to tax deferred costs. We 

Rachael: wanna realize lesson 

Eric: exactly. We want to have, we wanna reduce our taxable income so that we can qualify for all these credits, right? And deductions. And then we want to try to, um, use a little bit of tax rate arbitrage around things like Irma.

So I said, I mentioned child tax credit, but the two primary in retirement or as individuals approach retirement are going to be Irma, which is, um. The Medicare premiums that you would pay? Yeah, so there's a baseline premium, and then there are flat cliffs. What I mean by that is if you, if the cliff is, you know, $190,000, [00:12:00] okay, you're completely fine.

If you make 189,999, yeah, absolutely fine. Don't pay that. And then if you make one more dollar, okay, now you're paying an extra a thousand dollars in premiums a year. Right. That's just how it works. Okay. So they're cliffs, so they're, we want to, so what we wanna do with things like income manipulation is to move right up to the cliff, but never hit it.

Mm-hmm. So we wanna give ourselves a little bit of, um, of leeway there and not hit that. But Irma brackets and then net investment income tax are the two things that are going to increase your mar your effective tax rate. Over your marginal rate primarily, right? Those are the two chief offenders. 

Rachael: And now if listening to this is making your eyes glaze over, you're not alone.

I will say that I have met nobody who is Exci is as excited about talking about this as Eric is. But this is some very engaging it. Is 

Eric: it a compelling conversation? It's very dynamic. 

Rachael: Everyone wants, but I will say that it is incredibly, um, specific. [00:13:00] When we are using our planning software, it is in the amount of data that is needed and that you have access to, to be able to avoid hitting these like hidden landmines, right?

Specifically net investment income. And then, um, Irma is available. It's there, um, but it does require very specific. Knowledge and understanding of what contributes towards those numbers as you're making your way towards that cliff. 

Eric: Mm-hmm. 

Rachael: Um, like Eric said, once you've crossed it, there's no going back, right?

There's no undo button. You're just, you're there. 

Eric: And what's kind of interesting too, is Irma has. What's called a two year lookback. So what you did two years ago matters, and we, so we have to actually kind of try to play around with what we think the inflation rate's gonna be over those two years. It gets, it gets a little bit granular.

Yeah. It's, it's a little bit hard to math out Exactly. But the idea is that's, I guess that's why our profession exists largely. Right. So, um, [00:14:00] point is though your takeaways at home. You want to think about having enough in your taxable account to A, support your cash flows and B, potentially pay taxes on your Roth conversions.

Really just pay your taxes in general, but the Roth conversions are going to make you incur higher taxes than you would otherwise. The idea is we're trying to pay more taxes because we think that our rates are lower now. Yeah. Than they will be later when we're potentially taking RMDs from these huge tax deferred accounts.

Right. So when we execute these Roth conversions, we're actually reducing our tax deferred balances and therefore lowering our RMDs when they do kick in in the future. Does that make sense? 

Rachael: Yes. And for those, I think it's worth lots of acronyms, 

Eric: and 

Rachael: I think it's worth touching on RMDs and kind of how they are, that it's not a.

Flat number, right? No, it's 

Eric: not just like 4% of your account a year, right? Mm-hmm. So the divisors, right? See, the, the first year is what, like 25? You divide it by 25, you divide your, like total, you know, [00:15:00] IRA balance by like 25. And then that's gonna be ballpark, which you pay, um, as an RMD. And then that divisors goes down to where like, if you're like 110 or something, it's just one.

They make you take the rest of the account as your RMD, or it doesn't, I don't know if it actually hits one, but it's real close. Um. It goes 1.2 or something. Yeah, 

Rachael: it goes up pretty quickly. Um, because again, the government's not gonna not collect on their, the taxes. On that money. Right, right, 

Eric: right. Um, so they're making you take the, the idea is you have to take more, as a percentage of your account, you take an increasing percentage of your tax deferred total account balances, the older that you get.

Mm-hmm. Right? 

Rachael: Yes, it is, uh. It's something that I think, um, we'll see. You know, again, this is the scenario with clients coming in saying like, Hey, I'm really worried I'm gonna be retiring next year. What do I need to do now to set myself up for [00:16:00] success? And the reality is that there's so much to do in that year before retirement, but there's also so much to do in the years before, the year before retirement, and there's so much to do in the years after.

Retirement as well. So 

Eric: I was wrong. By the way, you're not Ed by at one 10. At age one 10, you're not required to take the entire account. You're retired required to take a half of the account. The divide two, 

Rachael: it just keeps cutting at half. But like 

Eric: the, the first year, if we're thinking that the first year is 73, you have the advisor's 16.4, the idea is you, the number starts, the divisors starts larger and becomes smaller so that you take a higher percentage of your account over time.

Rachael: Yeah. Perfect. So Exactly. I think that the, you know, biggest takeaway here is that, um, preparation is key. Um, if you're waiting until the year right before retirement, I. It's less than ideal, but you're at least preparing Correct? [00:17:00] Somewhat. 

Eric: Yeah. We can at least try to start moving some funds around, make sure our taxable accounts are funded.

Um, yeah, try to consider what we're gonna defer, what we can afford to defer because we might not have sufficient taxable balances anyway. You know, there, there's, there're there's a ton of planning to be done at this point in time. Maybe, maybe it involves working another year because our taxable balances are so low and we've deferred too much and we we're looking at tax planning and just.

You know, feel a little bit more comfortable with it if we have a little bit higher balances. So 

Rachael: how far Eric, um, in advance would you think would be an ideal time to start considering working with a financial planner? If you know, okay, I'm gonna retire. How many years out from retirement should I be looking to start?

This planning process? That's a 

Eric: good question. Um, especially because a lot of people tend to not fully retire, right? Because Yeah. And we would encourage, you know, staying active and staying involved in things that you care about and that you enjoy for 

Rachael: sure, whether it's part-time work or not. 

Eric: And yeah, so, um, it, it, it depends is the, the answer that nobody wants to [00:18:00] hear, gimme a real, maybe five.

I'd say five. I was 

Rachael: thinking five too. Um, and again, this doesn't even mean necessarily that you have to work in. Earnest necessarily with a financial planner. But if you're five years out from retirement, it's certainly worth, um, taking some meetings 

Eric: because 

Rachael: talking about what things to do. 

Eric: Mm-hmm. 

Rachael: Seeing what information is out there and trying to find the right fit too.

Because if you're trying to find somebody that you. Trust and is the right fit in a pressure cooker time, um, you might end up in a situation that 

Eric: Correct. 

Rachael: Is less comfortable for you to otherwise Yeah. You wanna work, work with somebody 

Eric: that you're comfortable with. I would also say that it's important when you think you're five years out to work with a planner.

Yeah. Because you might not be five years out. Yeah. Or you might be five years out, but instead of spending a hundred KA year, you gotta spend 80. 

Rachael: Yes. 

Eric: Does that make sense? That's a great point. You know, maybe I'm, maybe I'm actually fine now. That's a great point. And I thought I could spend, I thought I was five years out and I could spend a hundred, but I'm actually.

If I'm five years out and I earn what I'm earning, yeah. I might be able to spend one 20 or one 30. So I'm happy [00:19:00] to just, I, I might be ready to cut now. 

Rachael: That's a great point. I think that for so long, traditionally people retired at a certain age just because that was the factor that we used. Mm-hmm. And that's no longer the case.

We're seeing people retire at all ages. We're seeing people who enjoy their jobs and who wanna stay on for longer. We're seeing there should be a 

Eric: function of account balances. Yes. And things rather than, you know, just a number. It certainly should not just be a number 

Rachael: arbitrary Yes. No, um. Correct. So Exactly.

I think that, you know, if you're working with someone a year out from retirement, that's great. If you're a few years out from retirement, it's probably worth at least looking, reaching out. 

Eric: Yeah. Explore, see what it's like. Yes, 

Rachael: yes. Take your time. Perfect. Alright, well, if you're feeling overwhelmed by any moving parts that we talked about here, or if you have your own question, please don't hesitate to reach out to us at podcast@equilibriumfp.com.

Eric: All righty. Thanks guys. 

Rachael: Till next time.