Are you really providing tax-efficient retirement advice, or just lip service? Understand how taxes really work so you can help clients avoid common tax pitfalls.
The federal income tax system in the United States is progressive, meaning individuals or couples with lower levels of "taxable income" pay a lower rate than those with higher levels of "taxable income." The challenge with income tax lies in the definition of "taxable income." Taxable income represents a highly complex set of interactions between different rules related to different types of income.
This creates a difficult landscape for advisors and clients to navigate when constructing financial plans.
Some types of income, such as Social Security benefits, are based upon how much other income we have. For example, if a client had only Social Security benefits, they would be entirely tax-free, but once you begin to add other types of income, Social Security benefits begin to become taxable.
The tax code creates not only certain types of income that are only taxable based upon the other income on the return, but also deductions and exemptions that are dependent on other income on the return.
For example, let's look at the medical expense deduction, because it is quite common for retirees. In general, health care costs become deductible when they exceed 10% of adjusted gross income (AGI), which is found on line 37 of the Form 1040. In other words, if you have $50,000 of AGI, only amounts above $5,000 of medical expense would be deductible. So, if a client has a $15,000 medical expense, he is allowed to deduct $10,000. However, he has to get that money from somewhere, so he withdraws it from his IRA. And that move has two major consequences. First, the IRA withdrawal pushed his AGI up by $15,000 to $65,000 — meaning he is only able to deduct $8,500 of medical expenses rather than the $10,000 that he could have deducted prior to making the withdrawal.
Secondly, the $15,000 IRA withdrawal caused him to have to pay taxes not just on the $15,000, but also on an additional $1,500 of deduction that was lost because of another tax rule — a limitation to itemized deductions for people over certain income thresholds. In other words, he pays 1.1 times the tax rate on the extra withdrawal.
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