PODCAST: Defusing the Retirement “Tax Bomb” with David McClellan

If you’ve dutifully socked away money in a 401(k) or IRA for years, you could be in for an unpleasant shock when it comes time to take money out of those accounts. Also, the IRS is sending out a surprise round of checks.

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David Muhlbaum: You've been told by plenty of people, us included, that saving for retirement is important. You've probably also heard that step one is putting aside salary in a 401(k) plan, if one is available to you, or some other retirement vehicle. But there's a catch. Saving for your retirement is a good thing, but in short, if you keep deferring the taxes, they'll likely bite you in the end. We'll talk to an expert in defusing what's sometimes called the retirement tax bomb. Also, more checks from the government? Well, maybe. All coming up in this episode of Your Money's Worth. Stick around.

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David Muhlbaum: Welcome to Your Money's Worth. I'm Kiplinger.com senior editor David Muhlbaum, joined by my co-host, senior editor Sandy Block. How are you doing, Sandy?

Sandy Block: Oh, I'm doing great.

David Muhlbaum: Good for you. Well, you know as well as I do that one of the most popular things we've ever written about were the pandemic-era stimulus checks, because, you know, money from the government, whee!

Sandy Block: You got a check, I got a check, almost everybody got a check.

David Muhlbaum: Yeah. Good times. Good times, until the bill comes due for old Uncle Sam. But we're just going to slide right by that political hot potato. Anyway, you gave me a heads-up that some of us are going to get more checks from the government, and that is related in a way to the pandemic, but it's more limited, even if it's related. So that's my hype. What's the reality, Sandy?

Sandy Block: Well, filing your taxes is never fun, but it was particularly stressful during the pandemic. You were more likely to win the Powerball than get someone from the IRS on the phone, and I can speak to that personally. And on top of that, various changes in the tax code complicated the process, which is why people tried to get someone from the IRS on the phone. So the IRS gave taxpayers more time to file and pay in 2020 and 2021. But even with those extensions, some taxpayers and businesses failed to meet the deadlines and they were charged a penalty.

So here's where the checks come in. Some of those taxpayers will get that penalty money back. The IRS is sending out more than $1.2 billion in tax refunds to about 1.6 million taxpayers who paid penalties for late tax returns. So by now, you're probably wondering, "What do I need to do to get this money?" And the answer, according to the IRS and our colleague, Rocky Mengle, is nothing. The IRS says that most tax refunds will be sent out by the end of September and you don't have to do anything at all.

David Muhlbaum: Okay. What if you filed late but you didn't actually pay the penalty?

Sandy Block: Well, there's good news for you too, because if you were hit with a qualifying penalty but didn't actually pay it, you won't receive a refund from the IRS because you didn't pay the penalty, but the unpaid penalty will go away. Now, note that I said qualifying penalty. The refunds will only be sent to taxpayers who were penalized for filing their late tax returns for the 2019 and 2020 tax years that were due in 2020 and 2021 respectively. Second, only certain types of returns are eligible for a penalty refund. We'll publish the link with the entire list in the show notes, but for individual taxpayers, it pretty much covers Form 1040 and variations.

One more thing: The type of penalty matters too. There's actually several different types of penalties you get for not only filing late but paying late, and these refunds are only available for the late filing penalty, which is 5% of the tax due for each month or part of a month your return was late up to a maximum penalty of 25%. And as a side note, that's why we always tell people even if they can't pay their taxes, go ahead and file your taxes because these late filing penalties really pile up in a hurry.

David Muhlbaum: It's not for late payment, it's for filing late.

Sandy Block: Right. So paying late doesn't get you off the hook. And if you pay late, then you have interest on the amount that you should have paid. That's not covered by this. And just finally, that you won't get a refund if the IRS thinks your late return was fraudulent, which is kind of how they roll.

David Muhlbaum: Oh, come on. Oh, come on now. Really?

Sandy Block: No refunds for fraud.

David Muhlbaum: Yeah. Geez. Okay, Well, how about people who are late filing their 2021 tax return? It wasn't a whole lot easier getting the IRS on the phone this year. Asking for a friend.

Sandy Block: Okay. Sorry, your friend is out of luck. The penalty relief doesn't extend to 2021 tax returns. And that's an important thing to remember, that if you filed for an extension on your 2021 tax return back in April, you have until October 15th to file to avoid a late filing penalty. And like Halloween and pumpkin lattes, it will be here before you know it.

David Muhlbaum: Yeah. And late payment penalties could still be piling up too.

Sandy Block: Right. That's right. If you owed money back in April and you haven't paid it yet, then yeah.

David Muhlbaum: Just bringing that little distinction back into it. Okay. So all right. Thank you, Sandy. Checks for some, not for all, but if you get one, good for you. Coming up, we will talk to an expert about how to structure retirement savings so that you can sock away plenty of money without getting whacked by a giant tax bill. Stick around.

Defusing the Retirement “Tax Bomb” with David McClellan

Welcome back to Your Money's Worth. We are going to talk about a topic that we've broached before, how to minimize taxes on retirement savings, but with a new guest who's going to take us a bit deeper into some of these angles. And even though optimizing retirement savings is pretty dry stuff, we know it's popular based in part on the traffic we've been getting to the articles that our guest, David McClellan, has written for Kiplinger.

So at the core, David is a partner at Forum Financial Management, a financial advisory firm in Austin, Texas, but he's also VP and head of wealth management solutions at AiVante, a company using machine learning to forecast healthcare costs for the individual. Now, that second bit sounds fascinating, but not immediately germane to the retirement tax burden. But healthcare does get dragged into these calculations, and hopefully we'll get to that too. Welcome David. Thank you for joining us on relatively short notice.

David McClellan: Yeah. Well, thanks for having me. Excited to be here.

Sandy Block: So David, I understand that last night you were deep into your fantasy football draft, and I hope that went well for you.

David McClellan: I think so. I geek out on fantasy football, especially the auction format. I'm very analytical and I've developed custom spreadsheets to help me draft well, but I'm perpetually the bridesmaid and coming in second place. I've never actually won my fantasy league. So there's a lot of luck involved, more so than what I hope people have with the retirement planning.

David Muhlbaum: Well, you bring your analytics skills to the table there too. So Sandy handles sportsball around here, and she also knows more than I do about retirement tax bombs. But I have been educating myself in part by reading the articles you've been contributing to our Building Wealth channel. And these, well, they have a lot to say. You wrote over 5,000 words. But what I want to note for listeners, who really should check these out because we're only going to be able to scrape the surface in 25 minutes or so, is that David and his editor have divided those 5,000 words into a seven part series so you can both see the overarching principle and have it broken into digestible chunks.

Now, David, you clearly go deep here, and we do want to get into some of the finer, less obvious points so that people who are already deeply committed to retirement savings, maybe about to retire, maybe even drawing on their retirement savings, can come away with some useful guidance, possibly something that's new to them. But I think it would be helpful if we start with the test case, the sample couple you use in your articles, because that was very vivid in showing how people who are making good money, not yet really rich, can end up on a track that could cost them millions of dollars in taxes that they didn't have to pay down the road. So can you tell us a bit about this John and Jane Doe model?

David McClellan: So in the article, I used a case study of a working couple who was age 40 who have already saved $500,000 combined in pre-tax 401(k) accounts, and they're basically maxing out their contributions every year at $20,500 a year and then also receiving a $6,000 employer match. Now, that is a very common situation. This is a couple who are saving really well and following the conventional wisdom that the industry has, that they should be saving everything they can in tax-deferred accounts. Now if they keep doing that, by retirement at age 65, they will have saved $7.3 million tax-deferred, which sounds like they're in great shape. I mean, who wouldn't want to go into retirement with $7.3 million?

And the problem is that that tax-deferred savings also represents a growing tax liability, because tax-deferred savings is not tax-free savings, and sometimes investors forget that. When you start taking withdrawals from a tax-deferred account like a 401(k) or a traditional IRA, all of that income, the entire withdrawal, is taxed as ordinary income. And for this couple, when they first started taking required minimum distributions at age 72, when the government basically is forcing them to start making withdrawals so that they can be paid the tax bill, their first RMD is going to be $435,000, and that will continue to grow as they get older, reaching, for example, $739,000 in taxable income just from their required minimum distribution by age 80. So do you think they have a tax problem in retirement?

David Muhlbaum: Yes.

Sandy Block: They sure do. And I want to back up a little bit, because in reading your article, you go into a lot of strategies, but it seems like one of the easiest ways, and perhaps not used enough, for a couple to avoid this scenario is going back to when they're in their 40s and diverting some of those contributions to a Roth 401(k) instead of a regular 401(k). My understanding is a lot of people don't do that because they think, "Well, I'm missing out on a tax break," but maybe I'm not asking for another analysis. But how would that help them?

David McClellan: Yeah. It's a very common thing for people to do is to contribute on a pre-tax basis to their 401(k), and there's a lot of reasons for that. The conventional wisdom, the financial press, other financial advisors, CPAs, basically, they're all reinforcing the point save every dollar you can in tax-deferred accounts, and that's often the default setting in most 401(k) plans. So people, when they enroll in their 401(k), they basically start contributing on a pre-tax basis and never think twice about it.

Five or six years ago, I think there was something like maybe 30% of 401(k) plans even supported a Roth option, but I think now that number is maybe as high as 70 or 80%. So it's much more common now, but people don't know about it because they have to do a little bit of legwork on their 401(k) platform to research it and find out if that's an option. But it's the easiest way to get rid of this tax liability over a long period of time, and particularly impactful for younger savers. If you're 40, you got 25 years in which your contributions can either grow in a tax-deferred way if you're contributing on pre-tax basis, or it can grow in a tax-free way if you're contributing on an after-tax Roth basis.

So that makes a big difference as to the growing pool of retirement savings that you have. Do you want that pool to be pre-tax and you're going to have to pay taxes on it at some point, or do you want it to be tax-free Roth? The other thing about this is that investors often say, "Well I'm not eligible to contribute to Roth in a 401(k) because my income is too high," and that's a common misnomer. What they're referring to is income limits on wealth IRAs, which do exist, and many people make too much money to be eligible to contribute to a Roth IRA. But inside a 401(k), there is no income limit. So if your plan offers a Roth option, you can start contributing to it regardless of what your income is.

David Muhlbaum: So William Roth has entered the chat, so to speak. I'm referring here to the late senator who helped launch the very popular and often financially advantageous approach of prepaying the taxes on money you're putting aside for retirement. So we just talked about the Roth 401(k), which allows people to put money they make on the job aside in a retirement plan on a post-tax basis so that the growth they hope to enjoy in the years ahead will be tax-free.

Sandy Block: As long as their employer offers it.

David Muhlbaum: Yes, as long as their employer offers it. Yes. Good point, Sandy. But there's more to Roth than the 401(k). Senator Roth left quite a legacy. We sure do say his name a lot. So David, in your articles, you bring Roth up a lot because there are other solutions for people at other stages of the retirement path. I was hoping you could walk us through a couple of the other strategies for prepaying taxes, I'm thinking Roth IRAs and Roth conversions.

David McClellan: Yeah. Certainly. Well, each investor's situation is unique and so the strategies that are going to be most effective are going to vary for people. But oftentimes, you need to pursue all of the three strategies which I outlined in this series. So briefly, the first one, which we've already talked about, is basically shifting your tax-deferred savings to Roth accounts from pre-tax accounts. And because most things don't have a free lunch, the disadvantage of that is that you no longer get the tax deduction in the current year, so you're choosing to pay higher taxes in the current year with the reward that your taxes in retirement are likely to be much, much lower. So that's strategy one.

Strategy two is a concept called asset location, which we can talk about in more detail in a minute. But the third one that you referenced is Roth conversions. And Roth conversions are going to typically play a bigger role for people who are older and perhaps already retired. And it is if you are, say, 60 and you're retired and you have this really big tax-deferred account balance, then you have a window of time in which you can start to whittle away that tax liability by every year doing Roth conversions. So let me sidetrack for a second to explain how a Roth conversion works.

So in a Roth conversion, you're essentially moving money from a pre-tax account like a 401(k) or traditional IRA into a Roth IRA, and every dollar that you move is considered taxable income. So if you did $100,000 Roth conversion, that's $100,000 of income that you're essentially adding on for that tax year to all of your other sources of income. So Roth conversions typically don't make sense for people who are saving a lot who are currently earning a lot. If you wait until your income is low, such as in retirement, then you have an opportunity to do Roth conversions every single year. And with many of my clients, that's exactly what we're doing. We're doing significantly sized Roth conversions every year early in retirement trying to whittle away that tax bomb because you can't solve it in a single year.

David Muhlbaum: But there's a window, because you've got to get it done before the RMDs kick in.

David McClellan: Yeah. So the big closing of that window is at age 72 when your required minimum distributions come into play, because at that point, you don't want to be doing Roth conversions on top of your RMDs because both of those are considered taxable income. An earlier window is once you start to take Medicare at age 65, because if you have significant income from any other source, then you will face Medicare means testing surcharges, which is another major focus point of this article.

So the ideal time period, if you retire early, is up through age 63, because Medicare means testing actually has a two year look-back, meaning your premiums when you are 65 are based off of your income when you were 63, so that's the prime window to do big Roth conversions. And then as you start to hit Medicare, maybe you're doing smaller Roth conversions and you're probably stopping them altogether by the time your RMDs kick in at 72. So it's an ongoing strategy to try to bleed away this tax liability and smooth out the taxes that you're paying throughout retirement.

David Muhlbaum: Well, Sandy warned me against bringing up the Medicare means testing. "Too complicated," she said, but, well, David said it first.

Sandy Block: David did a really good job of explaining the two year look-back. That's what I was worried about. I think he makes a really good point there. But maybe, David, you could just briefly as possible explain what the debt Medicare surcharge means and how high your premiums could potentially go if you're hit by it.

David McClellan: Yeah. So I first stumbled on this topic in 2019 when I was doing some research around medical expenses in retirement for the technology firm AiVante that I work for, and I was shocked by what I discovered and ended up actually writing a white paper in 2019, which is referenced in my Kiplinger article for anybody that wants to go into the details, because I really explain the mechanics of how Medicare premiums work and what happens with Medicare means testing. And it is usually something that is completely shocking to people.

Most people, for starters, think that Medicare is free. You're paying into the Medicare system through payroll taxes throughout your whole life, and then you discover in retirement, once you start taking Medicare at 65 or so, that you actually have to pay premiums for Part B, which is basically the doctor services, and Part D, which is drug. Part B is by far the larger component of that. And what I came to learn is that in 2007, Medicare means testing was implemented for the first time. And what that means, it's also referred to as IRMAA surcharges, which is just a really complicated acronym, but basically, Medicare means testing.

David Muhlbaum: Yes. But it's memorable because it sounds like your great-aunt.

Sandy Block: Yeah, your mean great-aunt.

David Muhlbaum: Your mean grandma, definitely, because she's coming for your wallet. So the Medicare means testing surcharges, if you take a step back to the big picture of Medicare, you may be aware that Medicare has some significant solvency issues. In many cases it's in worse financial situation than even Social Security.

Sandy Block: And harder to solve.

David McClellan: And harder to solve. There are no easy solutions, and no politician really wants to touch this with a 100 foot pole because it's going to be very politically unpopular. But one of the things that they can do, and they first implemented in 2007, is means testing. And basically, what that means is if you have high income, then you are going to pay more for Part B and Part D Medicare premiums, potentially as much as four times as much. And that comes as quite a shock to people. So as an example, the premiums are $2,041 for Part B in 2022 if you are in the base income bracket, which has basically an adjusted gross income of under $182,000. So most people who are entering retirement think, "Well, this isn't relevant to me because I'm retired. I don't have a job. I don't have any income. So I'm just going to pay the base premium like anybody else."

Well, what about required minimum distributions? Recall back to that case study, the couple that was going to have hundreds of thousands of dollars of required minimum distributions. Well, at the highest means testing tier, that base Part B premium goes from $2,041 a year to $6,939 a year. Now, that's an increase of almost $5,000 a year. And if you think about that's just for a single individual, so if you're a married couple, that's $10,000 more every single year that you're going to be paying in Medicare means testing surcharges, or you certainly have the potential for that. Now, that's a very high income bracket, but if you're doing that every year over a 20, 30 year retirement, it starts to add up to real money, hundreds of thousands of dollars in surcharges. And basically, surcharges is just another word for tax. So these are taxes which I think can be largely avoided or minimized with proper planning.

David Muhlbaum: I mean, it's interesting because with time, we turned this four figure charge into an annual five figure charge, and then over lifespan, we're into six figures or more. And I guess this is in part where you're experiencing the actuarial and long-term Medicare costs comes into play in forecasting. Sorry, I didn't mean to say Medicare costs. Healthcare costs.

David McClellan: Yeah. Well, underlying the Medicare means testing is the basic problem that medical expenses keep rising at a much higher rate than inflation does. So if you look back at the period from 2007 to 2019, premiums for higher earners in Medicare increased from 5.0% to 8.6% annually depending on which Medicare means testing tier you are in. And inflation, which I think everybody has on the forefront of their minds now, any high inflation rate compounded over a long period of time can be absolutely devastating. So the masses, most people who are paying the base premium in Medicare, over that same period from 2007 to 2019, their premiums only increased by 3.1% annually. But higher income people, it was 5%-8.6% annually. Medical costs and expenses keep rising, and they have to make the numbers work somehow, and so the people who are earning more income are going to be paying a lot more.

Sandy Block: And one other thing I wanted to mention, David, because I hear this a lot from readers, is that those surcharge thresholds, there's a real cliff there. If you just go over the threshold by a dollar, you could end up paying a whole lot more for your premiums. Isn't that correct?

David McClellan: Yeah, but only for a single year.

Sandy Block: Oh, is that right?

David McClellan: Yeah. So it's not a permanent cliff that you've fallen off of. So your premiums will get adjustments every single year, and that's why the ongoing every year that the tax management decisions that you're making are going to be really important. And it may make sense, for example, one year to do a really big Roth conversion, even though it's going to trigger some Medicare means testing because you're going to have some tax benefits for the next 20 years after that. And in order to benefit from that, you're okay eating the Medicare means testing surcharges in that one year.

David Muhlbaum: I'd like to come back to a term you brought up in this podcast earlier, and it's one of the points in your pieces, but the words are a little hard to say on the air. I don't mean that I can't pronounce them, I just mean that this term sounds a lot like something that we commonly use in investing. You were talking about asset location, and that sounds a lot like asset allocation. So let's break this down.

Asset allocation is the longstanding idea of buying some of one thing and some of another and so forth. Some stocks, some bonds, some cash, some MLPs, different kinds of investments. Asset location, if I understand this correctly, is picking where you put different assets depending on the tax approach of the vehicle that holds them. Some types of investments go in your pre-tax accounts, some go in your post-tax Roth accounts. I just threw a bunch of terms out there and I'm hoping you can tell us a bit more about asset location.

David McClellan: Yeah, sure. So backing up, asset allocation is, highest level, a decision on what asset classes to invest in. So for example, a very common asset allocation for people in retirement at the highest level would be, say, a 60% stock, 40% bond allocation, conservative growth allocation, and the asset allocation is what defines the risk and expected return for the investor. And there's not necessarily a good or bad, every investor situation is different and their willingness to take risks to earn a higher return is different. So most people are familiar with asset allocation, at least in some level. Asset location is a term that even most financial advisors don't know about and don't implement. So asset location means what tax bucket are you placing different asset classes into?

So there's three basic tax buckets. There's taxable accounts, like a non-retirement brokerage account as an example, there's tax-deferred accounts, which we've talked a lot about, how to defer tax liability associated with them, and tax-free accounts like Roth. So there's three tax buckets that you have to work with. Now, a lot of investors and financial advisors will implement the exact same asset allocation, that 60% stock, 40% bond allocation, into each of those tax buckets, and that's a mistake. So go back to the big picture strategy of what we're trying to do, which is to limit the growth of tax-deferred accounts.

So if I have a 60% stock, 40% bond allocation, and remember that stocks are riskier and have a higher expected return than bonds, so if I'm going to pursue that particular strategy for a client with asset location, we would look to put all of the bond exposure into tax-deferred accounts and then load up especially the Roth accounts with the riskier assets that have higher expected returns and potentially doing the same in a taxable account. So for the same risk reward dynamic, that overall 60/40 investment strategy, you are essentially putting the bonds that are going to grow slower in the tax-deferred account and the riskier higher growth items, asset classes, into the Roth accounts.

And the net result of that over, say, 20 years can be enormous, because what you're doing is limiting the growth of the tax-deferred accounts and maximizing the growth of the Roth accounts. So this is a harder thing to implement. Oftentimes, you would benefit from working with a financial advisor to implement this, and the investments that you have, some lend themselves to asset location better than others. So one of the concepts here is you need asset class pure investments, meaning perhaps a international small-cap value fund would be a great candidate, very focused high expected growth investment.

David Muhlbaum: And the inverse being a target-date fund.

David McClellan: Right. The inverse, a target date fund, would be a great example, because it is essentially a blend, or growth and income fund would be another example, it's a blend of both stocks and bonds. So when you have a product like a mutual fund or ETF that is blending different asset classes, you don't have the ability to separate the asset classes and place them into the right tax bucket to optimize the taxes. So asset location can make a big difference in terms of reducing this tax liability over time.

David Muhlbaum: Well, I look forward to our listeners going back to their advisors and saying, "I want to talk about asset location," and those advisors going, "Yeah, asset allocation. No, we got that." No, no, no. Asset location. So if we have one solid takeaway, it's that distinction in terms. But I think we're going to have many more from what David has had to share with us. And again, as I warned, we're just scratching the surface. You really should check out his pieces at kiplinger.com about the tax bomb and how to defuse it. I will include a link. Thank you again for joining us, David.

David McClellan: Okay. You're welcome.

Sandy Block: Thank you, David.

David Muhlbaum: That will just about do it for this episode of Your Money's Worth. If you like what you heard, please sign up for more at Apple Podcasts or wherever you get your content. When you do, please give us a rating and a review. And if you've already subscribed, thanks. Please go back and add a rating or review if you haven't already. To see the links we've mentioned in our show, along with other great Kiplinger content on the topics we've discussed, go to kiplinger.com/podcast. The episodes, transcripts, and links are all in there by date. And if you're still here because you want to give us a piece of your mind, you can stay connected with us on Twitter, Facebook, Instagram, or by emailing us directly at podcast@kiplinger.com. Thanks for listening.

Sandra Block
Senior Editor, Kiplinger's Personal Finance

Block joined Kiplinger in June 2012 from USA Today, where she was a reporter and personal finance columnist for more than 15 years. Prior to that, she worked for the Akron Beacon-Journal and Dow Jones Newswires. In 1993, she was a Knight-Bagehot fellow in economics and business journalism at the Columbia University Graduate School of Journalism. She has a BA in communications from Bethany College in Bethany, W.Va.