The Formynder Field Manual

From the field

Welcome to the September edition of the Formynder Field Manual newsletter! This month, I focus on tax planning (the "windshield") which is different from tax filing (the "rearview mirror"). Many people, when they think about taxes, consider how much is being withheld from their paycheck, how much they paid in taxes last year, or how much of a refund they'll get next year. For the most part, this all has to do with your current year tax filing. Tax planning on the other hand looks at future year taxes.

How do I look at future taxes? Well, in the absence of my crystal ball which is pretty much deadlined permanently, I look at historical trends to anticipate what you might pay in taxes in 5, 10, 25, or even over your lifetime. I do this in an educated attempt to have you pay income tax when you are in the lowest tax bracket possible. As financial advisors, do we always get it right? Of course not, but these strategies go a long way to help clients only pay the taxes they owe.

While I've dedicated this newsletter to a few tax ideas, just know that this is not tax advice - it's education. I always recommend that you seek financial and tax professionals to determine how these strategies might affect you before you attempt to implement these ideas.

Feel Good Moment

Before we get into the fun topic of taxes, I always like to pause and reflect on moments of contentment and provision. This reflection is slightly sad, but still turned out well. In August, we had to say goodbye to an old friend, Aubie. Aubie was my 2011 Subaru Outback who treated our family very well, functioned as a truck as much as he could, and toted our family on a few long-distance road trips. He's been getting a little long in the tooth and as of recently, I might even classify him as maybe even a bit crotchety. In the past few years, I've had to carry oil and coolant to keep up with his appetite. But his most recent antics, and ultimately what led to his demise, was that he chose to start, or not start, when he wanted to. No rhyme or reason; it just depended on his mood in that moment. When I say that I drive cars into the ground, I think I finally reached it with Aubie. So we all said goodbyes and welcomed to our family Steve Jr, a 2019 Tacoma! Why Jr? Well, Steve Sr was a 2011 Tacoma named after the hedge in the film Over the Hedge and clearly if you get a younger, but similar looking Tacoma, they've got to be related. Anyway, we're excited to welcome Steve Jr into the family!

Monthly Focus

Before we start down the road of tax planning, I find that many people have a difficult time understanding how our tax system works. Without some knowledge, it makes implementing tax strategies a bit difficult. So let's start with the fundamentals.

Your Marginal Tax Bracket

The U.S. tax system is progressive. This means that although we indeed have income tax brackets of 10%, 12%, 22%, 24%, 32%, 35%, and 37%, that doesn't mean that you pay that percent of tax when you reach each bracket on your entire income. Instead, you pay 10% on the first income bracket, then you pay 12% on the amount of income above the 10% bracket. If your income continues into the 22% bracket, you then pay 22% on every dollar that encroaches into that bracket. And so it continues.

You can find out which tax bracket you are in by looking at your Total Income on line 9 of your Form 1040 and seeing where it lands in the same year tax brackets (they change each year).

Your Effective Tax Rate

This is where most people misunderstand the percentage of their income they pay to taxes. Since the tax system is progressive, your effective tax rate will ALWAYS be lower than the marginal tax rate. Check out the image below for a better explanation of how the marginal and effective tax rates work.

To find out your effective tax rate, take your Total Tax on line 24 of your Form 1040, and divide that by your Total Income on line 9.

Why Does Any Of This Matter?

Well first, why wouldn't you want to know how the tax system works? 🤓 Second, and probably more importantly, if you knew that you had some control as to how much income you are taxed on to control your marginal bracket, wouldn't you want to do that?

Enter the age-old question; do I contribute to Roth or tax-deferred retirement accounts? If you elect or contribute to Roth accounts, you are betting that you are in a lower tax bracket now and therefore willing to pay taxes now, but never again. Contributions to Roth accounts provide a lot of flexibility in your life now, in retirement, and even in your estate planning. Again, not advice, but I would highly encourage you to see if Roth is right for you by having a look at your taxes now and where you think they might go in the future.

On the other hand, if you elect or contribute to tax-deferred accounts, you are betting that you are paying the highest taxes now and will pay lower taxes later. In the example featured in the image, if this single filer thought they were in the highest tax bracket they would ever be in, they could contribute to tax-deferred accounts now and lower their taxable income by at least $30,500 in 2025, if this was someone under age 50 who maximized their 401(k) and IRA. This means that instead of $81,648 being taxed at 24%, only $51,148 would be taxed at 24%; an immediate tax savings of $7,320! But remember, in this scenario you are kicking the tax can down the road.

If you decide to elect or contribute to tax deferred accounts, you will have to pay taxes eventually. Again, the goal is to pay taxes when your income is low. A great time to look at is when you stop working and your taxable income drops. At that time, you could choose to pay taxes by doing what is referred to as a Roth conversion. A Roth conversion is where you take a portion of your money in a tax-deferred account and roll it into a Roth account. In the year you do this, whatever money was rolled into your Roth account is counted as income for the purposes of paying taxes - even if you don't technically receive it as income.

NOTE: before you attempt a Roth conversion, I would strongly encourage you to seek the help of a finance and tax professional. A Roth conversion must be reported on Form 8606 when you file your taxes or you run the risk of paying taxes twice!

There are usually windows of low tax brackets in your life. When you start working is a common window. Also, when you retire and before you begin to collect social security or even begin to withdraw Required Minimum Distributions (RMD). To see this visually, check out the green income line on the graph below. Also, if you ever want to see your historical earnings while taking a nostalgic trip down memory lane, check out your earnings history on your Social Security estimate.

Outside of filing your taxes correctly in the year of conversion, there are a few other important considerations to Roth conversions. First, if you convert too much, you could inadvertently push yourself right back up into a high marginal tax bracket, defeating the purpose. Second, when you turn 65, you sign up for Medicare Parts A & B (at least). Medicare can charge you Income Related Monthly Adjustment Amount (IRMAA) surcharges based on your income from two years ago. So if you do a Roth conversion that tips your income into an IRMAA surcharge tier at 65, you might be in for an unpleasant Medicare IRMAA surcharge surprise for the entire year of your age 67.

Back to Pictures

I realize I just completely nerded out on you. Let's back up to a 30,000 foot view to show you what this looks like in practice. Check out this example of someone's lifetime taxable income, which goes up throughout their working years, drastically reduces immediately after retirement, and then heads back up when they begin collecting social security and withdrawing RMDs. While I've not attached any numbers to this chart, the goal is to keep your effective tax rate as steady as possible.

One Last Thing - The Backdoor Roth Conversion

Sounds illegal, but it's not. In the original marginal tax scenario, the single filer with $185,000 of taxable income actually makes too much money to contribute directly to a Roth IRA. This rule does not apply to your Roth 401(k), just the Roth IRA. In those cases, contributions of after-tax dollars can go to into a tax-deferred IRA where then it can be immediately converted into your Roth IRA. Since taxes on the contributions where already paid, when it is rolled into a Roth IRA, the only taxes owed are on whatever investment growth may or may not have occurred during the time it was in the tax-deferred IRA.

Again, like most of this information, there are nuances and cautionary tales. So as noted with Roth conversions, please seek the help of a financial professional if you would like to explore anything you've read.