Taxes and Retirement Planning

The White House recently introduced what it billed the “biggest tax cut” in U.S. history. While a presidential tax proposal is not likely to get passed without significant changes, the fact that Republicans dominate both chambers of Congress suggests 2017 may well be a year in which significant tax reform is engineered.1

One thing should be perfectly clear: The U.S. tax code is highly complicated.2 There may not be anyone who understands it all off the top of their head. CPAs and tax professionals must conduct thorough due diligence to tailor strategies and complete returns for taxpayers with complex situations.

Because of this, we recommend our clients who require tax advice work directly with an experienced and qualified tax professional. However, we also believe financial and tax professionals should not work in a vacuum, and therefore are more than happy to work in concert with our clients’ tax advisors to help align their financial strategy with their tax situation.

This is particularly important when it comes to retirement planning, because you want to save as much as possible before you retire, which may include tax-deferred financial vehicles such as a 401(k) or IRA, but you don’t want to get hit with a big tax bill on untaxed earnings once you’re in retirement.3 This is a delicate balance that requires experience and collaboration from both a financial professional and a tax professional.

One tax issue each of us deals with is the federal income tax rate. Our annual earnings determine which federal tax bracket we land in, but that tax bracket isn’t the tax rate applied to our entire income. Instead, we pay every tax rate on income blocks up to our individual bracket. Like many things about filing taxes, this can be highly confusing for many people.

It may be easier to understand this through a hypothetical example. Let’s say Joe, who is single, had $92,000 of taxable income in 2016, which landed him in the 28 percent tax bracket. This is how his total tax is calculated:4

• He pays 10% on the first $9,275 (tax of $927.50)
• He pays 15% on the next $28,375 (tax of $4,256.25)
•  He pays 25% on the next $53,500 (tax of $13,375)
•  He pays 28% on the final $850 (tax of $238)
  • Total tax bill of $18,796.75

As you can see, Joe doesn’t pay 28 percent on the full amount of his taxable income; his taxable amount progresses through each income bracket and their respective tax rates until it reaches his total taxable income for the year. Therefore, a person who falls in the highest tax bracket is only paying that higher tax rate on a portion of his or her income.

This is an important distinction to remember as the U.S. works toward tax reform. On one hand, reducing the number of tax rates from seven to three (Trump’s proposal: 10 percent, 25 percent, 35 percent)5 looks to simplify tax filings, but for many people, this could mean paying a higher tax rate on larger blocks of income. Let’s take the hypothetical example of Joe again, using the same income brackets (to date, no tax rate income brackets have been proposed). Here’s how Joe’s scenario might break down:

• He pays 10% on the first $9,275 (tax of $927.50)
• He pays 25% on the next $81,875 (tax of $20,468.75)
• He pays 35% on the final $850 (tax of $297.50)
  • Total tax bill of $21,693.75

This example simply illustrates how a progressive income tax works. Obviously, it doesn’t take into consideration credits and deductions, which vary substantially among taxpayers. Nor does it include payroll taxes.6

Federal income brackets and their respective tax rates are the most fundamental issues Americans are subject to when filing taxes. But as you can see, there’s nothing straightforward about them. This is worth remembering as tax reforms continue to be proposed and debated moving forward: Nothing concerning taxes is simple, and there are usually layers that impact us that the average layperson isn’t likely to see.

Content prepared by Kara Stefan Communications

1 Fox News. April 26, 2017. “Mnuchin vows ‘biggest tax cut’ in US history, confirms plan to slash business rate.” http://www.foxnews.com/politics/2017/04/26/mnuchin-vows-biggest-tax-cut-in-us-history-confirms-plan-to-slash-corporate-rate.html. Accessed May 5, 2017.

2 Vanessa Williamson. The Atlantic. April 18, 2017. “How the Tax-Filing Process Confuses Americans about Tax Policy.” https://www.theatlantic.com/business/archive/2017/04/paying-taxes-confusion-policy-1040/523287/. Accessed May 5, 2017.

3 Fidelity. March 1, 2017. “How to invest tax efficiently.” https://www.fidelity.com/viewpoints/investing-ideas/tax-strategy. Accessed May 5, 2017.

4 Tina Orem. Nerd Wallet. Sept. 8, 2016. “2016 Federal Income Tax Brackets.” https://www.nerdwallet.com/blog/taxes/federal-income-tax-brackets/. Accessed May 5, 2017.

5 Martha C. White. NBC News. May 2, 2017. “Even Families Making $100K Won’t Be Better Off Under New Tax Plan.” http://www.nbcnews.com/business/taxes/even-families-making-100k-won-t-be-better-under-new-n753941. Accessed May 5, 2017.

6 NPR. 2017. “On Tax Day, an Economist Outlines How the Payroll Tax Works.” http://nhpr.org/post/tax-day-economist-outlines-how-payroll-tax-works#stream/0. Accessed May 5, 2017.

These hypothetical examples are for illustrative purposes only. This information is not intended to provide tax advice. Be sure to speak with qualified professionals about your unique situation.

We are an independent firm helping individuals create retirement strategies using a variety of insurance and investment products to custom suit their needs and objectives. This material is intended to provide general information to help you understand basic financial planning strategies and should not be construed as financial advice. All investments are subject to risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. 

The information contained in this material is believed to be reliable, but accuracy and completeness cannot be guaranteed; it is not intended to be used as the sole basis for financial decisions. If you are unable to access any of the news articles and sources through the links provided in this text, please contact us to request a copy of the desired reference.

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