A few months ago, I opened my inbox to a startling email: “Hey Drew just wanted to let you know that I reached out to my 403b provider and am starting to take money out for the rest of the year.” 

Despite meeting my client towards the end of her career, I was surprised to see she had suddenly decided to retire earlier than expected. Lucky for me, this decision gave me the opportunity to witness my favorite thing in this profession: guiding someone’s transition from work to retirement – without that necessarily being a part of our original plan.

My client probably thought of the catchy JG Wentworth commercial, “It’s my money, and I want it now!” when reaching out to her tax-sheltered annuity plan provider. Unbeknownst to her, the danger of this urgency is that many don’t generally consider what they owe the IRS. Fortunately, my client’s email was sent right before she completed the paperwork, and I was able to save her over $2,200 in taxes just that year. 

Are You Making an Avoidable Mistake?

Knowing where to take retirement income is a common issue. There are various retirement income sources, all with different rules and implications. Whether you are taking your money from Roths, 401ks, annuities, rental properties, or social security, the proper planning of each of these can have incredible impacts on the financial component of your dreamed years. 

Returning to my client’s example, she was about to make a widespread and avoidable mistake, and we prevented that by simply changing where she took her money.

Tax Loss Harvesting

403b, and most retirement plans through your employer require a mandatory 20% federal withholding for standard withdrawals. This client is in the 12% federal tax bracket, meaning she would be giving the IRS an interest-free loan until she files her 2023 return and recoups the overpayment. 

In addition, she has several other types of accounts to pull from – one being a taxable brokerage account that she just recently started. One of the silver linings of this lovely bear market is the tax benefits of losses, and she’s got them. 

What is tax loss harvesting? The IRS allows taxpayers to write off realized losses on up to $3,000 in capital assets annually. Any amount over $3,000 is carried forward to subsequent tax years. The result for my client is that we have eliminated that tax bill while she looks for a part-time job to keep her busy during the first few years of stepping away from teaching. Potentially this will bridge her the entire way so that she doesn’t have to trigger any taxable events for some years.

Have You Been a Part of This Story?

All advisors have handfuls of these anecdotes – their guidance and advice helped stave off some immediate consequences of impulsive decision-making. Other times the result isn’t so immediate and apparent. 

The Escape Door – The Backdoor Roth

Here is another example. With a slight change to my most recent Zoe referral’s retirement savings plan, we projected a tax savings of about $1.2 MILLION in retirement. In this case, the client makes too much money to contribute to a Roth IRA (phased out for single filers from $129,000-$144,000, $204,000-$214,000 for joint returns). Additionally, in her mid-40s, she’s been contributing her entire working life to pre-tax or tax-deductible plans. Decades of compounding returns with tax-free distributions make finance hearts start beating. With the client making too much money, we have to do a “Backdoor Roth.”

We did this with a financial planning software called a Roth IRA calculator. The tool lays out the tangible financial differences between the two types of retirement planning vehicles. This calculator easily shows us that the long-term benefits of the backdoor Roth far outweighed the status quo of pre-tax/tax-deductible savings. 

Common Tax Mistakes

• Claiming Social Security benefits before your full retirement age and having earned income. Even though many people are aware of this fact, I still encounter people all the time who don’t know that if you earn more than a certain amount (up to $21,240 for 2023), your benefits will reduce by $1 for every $2 over that amount.
• Taking large distributions from tax-deferred accounts for large purchases. Our goal is to avoid jumping to higher tax brackets and compounding the tax liability for clients. Many retire in the middle of the year and have earned income for that portion of the year. Consider financing the initial purchase and then paying off the following tax year(s) when you’ll only have income from your retirement assets.
  Tip: Another tactic I employ, if the calendar permits, is taking a portion of the distribution in December and the remainder in January to break up the reporting years.
• Poorly structuring the sale of a major asset – usually a business or real estate. Improper planning can lead to massive tax bills that otherwise would not have been incurred. Consider changing the payout from the sale of a business from a single year to a series of years to break up the tax liability and/or reduce it. For your primary residence, be aware of the rules to avoid capital gains taxes on the sale of the house where you must live for any two of the last five years to avoid the bill. A 1031 exchange is a powerful tax planning tool for investment properties to defer capital gains on real estate investments.

The Key to Avoiding Unnecessary Tax Expenses

The key to avoiding unnecessary tax expenses is to resist the urge to surprise your financial advisor and/or CPA and say, “Guess what I did last year?” Instead, discuss major events with these professionals beforehand. If your financial advisor cannot show their value, it might be time to consider hiring an advisor that can help you navigate the complexity of the U.S. tax code.

Remember to consider rules of thumb like

1. Talking to a financial advisor about your costs and goals. 
2. Being careful where you take your money from. 
3. Do not claim benefits before reaching your full retirement age. 
4. Do not act impulsively. 
5. If you need to, proceed with a backdoor Roth.