When Frugality Hurts: Navigating Retirement’s Hidden Traps
Main Idea: Today I want to share with you why being frugal in retirement can potentially lead to unexpected tax burdens and future problems for your spouse, like those from RMDs, that undermine the very wealth you worked so hard to build.
Have you ever heard this story before?
A couple builds wealth for 40 years. They save diligently and invest on a regular basis. The finally hit the finish line of retirement, and now have trouble spending it.
While I'll save the financial behavior topic for a later date, today I want to share how being overly frugal might actually end up costing you more in taxes and expenses through RMDs, Social Security, and Medicare, leaving you with less money in the pot at the end of life than if you would've just spent with a plan.
Bumping Up Against Uncle Sam
RMD Tax Time Bomb
Required minimum distributions (RMDs) exist as one of the largest hurdles in retirement for many folks with a large IRA, 401(k), or similar pre-tax account.
Especially those hesitant to spend their savings.
You're probably familiar, but for those who aren't, an RMD is the amount the gov't requires you to withdraw from your pre-tax account starting at a given age (73 for most of you currently).
When you hit your RMD age, you are required to take out a minimum portion of your pre-tax accounts, depending on how long your life expectancy is.
Everything you pull from these accounts is considered taxable income, similar to your current W2 salary for comparison.
While the money is still yours, I've never come across a client who felt great about being forced to take their own money that they may or may not need, and be taxed on it.
This is an issue many folks (including those of you who are still in your 30s and 40s) don't understand.
When you contribute to your 401(k), you are essentially agreeing to have shared access with Uncle Sam as well as leaving it "up in there" what their portion of that agreement becomes.
Think of them kind of like your friendly, neighborhood mob boss.
Kidding, they did allow you to take a deduction earlier in life, but you get what I mean.
Speaking of taxes, carrying too LARGE of an RMD can bump you up into higher tax brackets, make Medicare more expensive, and tax more of your Social Security.
I break this down below.
Main point is this: the person obsessed with preserving their wealth into old age might actually be sabotaging themselves, eliminating the "benefit" of saving altogether.
By refusing to draw down your pre-tax accounts or convert them into after-tax options like a Roth IRA, you are unknowingly setting off massive tax time bombs that could potentially end up costing you more in the long run...and that's due to these RMDs.
For those charitably inclined: Qualified Charitable Distributions (QCDs) allows folks 70? or older transfer up to $108,000/yr directly from an IRA to a charity, tax-free. For RMDers, this amount counts toward your RMD but doesn’t hike your taxable income. That can potentially help keep you out of higher tax brackets, lower Medicare premiums, and reduce the taxable chunk of Social Security—all while supporting a cause you like.
Widow's Tax
Being married is the greatest thing that's ever happened to me.
Many clients I meet with agree; even after 4 decades for those counting at home.
In fact, one of the most common goals of husbands I sit down with is that their wife is taken care of when they're gone.
This unquestionably comes after some joke about dying first.
But why I bring this up in a conversation about withdrawing money in retirement is because take what I told you above with the tax time bomb with RMDs, and now make that bomb even larger if you pre-decease your spouse early.
Why?
When you die, your spouse will have to file taxes as single.
These brackets are significantly less than married filing joint brackets (see below).
So the IRS cuts you a break after your spouse dies, right?
No. Remember that piece I mentioned about your friendly, neighborhood mob boss?
Assuming you left all accounts to your spouse, they will be required to keep the same RMDs, only this time they'll break through those higher tax brackets much quicker.
To add fuel to the fire, your standard deduction, which is the annual amount the government allows you to subtract from your taxable income, is also cut in half!
If you'd allow me to use my buddy, Business Brad, I'll share an example here below:
Brad’s $1 million IRA triggers a $37,735 RMD at 73 while he’s married, taxed at 22% (joint bracket). After he passes, his widow faces the same RMD but now pays 32% as a single filer—$12,075 vs. $8,302 in taxes.
I'll continue this example later as we include Medicare and Social Security, but this is a good reminder this does not only solely apply to those near retirement.
Like your health, it can be helpful to get ahead of these potential issues early on!
Government Benefits - Social Security, Medicare
Beyond tax brackets, RMDs can also sting your Social Security and Medicare.
Think of it like a butterfly affect.
Your RMD leaves you with a larger taxable income than you planned for (or maybe even need), you're retired so you have no way to take deductions anymore, and now you may possibly be looking at more of your Social Security being taxable.
Remember, for people below a certain threshold, you pay 0% of your SS payment.
While that may seem low (see below), roughly *50% of Americans do not pay tax on their SS.
Now with that said, see the table below, where you'll notice how quickly you can arrive at 85% of your payment being taxable if you're drawing from assets that are considered as taxable income.
I've seen some folks in retirement hit the top income range threshold from one RMD alone!
Now let's briefly talk about Medicare. I know it's boring, I'll be brief.
Medicare Part B and D premiums can spike under IRMAA (Income-Related Monthly Adjustment Amount) surcharges, potentially adding thousands to your annual costs.
Think of this similar to your income tax brackets. Those who make more...pay more.
For those not familiar with Medicare terms, here are a few important definitions:
So basically, Medicare Part A represents what most receive for free when they turn 65.
Parts B + D represent what those 65+ must pay into based on income.
If you have taken nothing else from these two pieces, just know that carrying too large of pre-tax accounts leads to larger RMDs which can lead to more expensive Medicare coverage, and less payment from Social Security all whilst leaving your spouse in a tough position if you pass on early with a significant portion in your pre-tax accounts.
Ouch.
Parting Thoughts
Now I realize if you're reading this and you're not close to retirement, you probably don't think this applies much to you currently.
...But your current stage of life might be exactly when you should start considering making some moves with your financial advisor to combat these issues folks face later in life.
Before I share the next few items, I want to give the full disclosure that these are not pieces of advice or recommendations, but actions I've seen be ideal for certain clients I know.
5 Actions For You to Consider with an Advisor
1) Find your expected RMD. Divide your 401(k) or IRA balance by 26.5 (current life expectancy for people at 73). While it probably will change by then, you'll understand how it works.
2) Consider Roth conversions when or if the time is right with your financial advisor. Although they require upfront taxation, the government doesn't apply RMDs to Roth accounts.
3) Consider checking your beneficiaries and make sure they're aligned with what you want, both from an inheritance AND tax standpoint.
4) If you want to see your kids benefit from your wealth, consider giving earlier in life to children where it can knock down your RMD while giving it to them when they need it most. This will also help with some inheritance issues that I mentioned a few weeks ago.
5) Talk to your spouse! I realize many of you are the managers of household finances, but communication is half the battle in making sure family finances have a smooth transition.
CONCLUSION
Follow Up to Read or Watch:
Action Item: See 5 above.
My name is Jordan McFarland and I'm a CERTIFIED FINANCIAL PLANNER? at SageSpring Wealth Partners in Dallas, TX.
My goal with these brief articles is not to make you an expert, but get you thinking about ways you can optimize your finances and get ahead for tomorrow.
If any questions or thoughts come up during your reading, you can email me at [email protected].
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