Capital Growth,Cash Flow, Taxes And Timing: Planning for Your Retirement the Smart Way
Show of hands — How many relish the thought of shellin’ out big wads of cash to the taxman?
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Yeah, me too.
On the other hand, we all wanna retire with the largest, most reliable AFTER tax income possible, right? So, here’s a poser for ya…
You have X number of years to go before you retire, usually 10-30 or so. You have the ability to rollover one or more of your current retirement plans — Sep/traditional IRA, former employer 401k, etc. — to a Solo 401k. You’d then move that money over to the Solo’s Roth ‘side’. Since you have an impressively high balance, all of which was originally contributed pre-tax, movin’ it all over to the Roth side means you’ll owe a painfully large pile of cash to the taxman. Ouch. “Why the #^$&#@ would I ever even consider doin’ that?!”
What’s Your Ultimate End Game?
If it’s after tax income in retirement, AND payin’ ONE hefty tax bill now will increase that number, why all the anxiety?
To be fair, I’ve been there and done that a few times myself, so I empathize big time. Regardless of what my head knew to be empirically factual, the very thought of writing a check for up to, and a couple times even over $100,000, will cause some very authentic anxiety. Let’s understand what’s behind any decision to purposefully force ourselves into payin’ hurtful amounts of taxes.
Remember, your end game is after tax income in retirement, about 10-30 years from now. If you can turn that income into tax free by IRS definition, more the better, right?
One of the little details investors often don’t wanna think about when investing for retirement, is that if they are indeed highly successful in creating impressive cash flow for that time of life, they’re almost always doing so without the slightest consideration of their income tax stance at the time. Imagine all the various tax shelters available to you today. The interest and property tax deduction on your home, for instance. Just the tax deduction will remain at retirement for most, as who wants a house payment in retirement? Your kids will be long gone, so no help there with deductions. Though most of your real estate investments will still supply a 30-50% tax shelter for the cash flow generated, most if not all of it will go bye-bye in a few short years after you retire. In other words, in retirement, every April 15th you’ll be reliving the wrong end of a good news/bad news joke.
What’s the good news? Man, we’re printin’ money in retirement. What’s the bad news? The IRS is our new partner.
In my state, California, income tax for a high earning taxpayer BEGINS at 9.3%. It then goes up from there to over 12%! Add federal rates in the 30s, and you’ll begin to see how quickly not having a solid after tax strategy for retirement income can, and likely will come back to bite ya where ya sit. Let’s take a swipe at some numbers.
Retired in California in 2015 — Gross Before Tax Income of $500,000
Before we start with this, don’t begin with the thought that half a million is simply a pipe dream, cuz I’m hear to tell ya that if you have the time, the capital, and the right strategies, that could be you. Regular folk like you ‘n me often have humble beginnings for sure. But given enough time and wisdom, it’s likely you can retire with a five figure after tax monthly income. I see it all the time. Thing is, it’s boring as all get out, along the way. That is ’til the day you retire. 🙂 So, the tax bill for half a million a year income in this scenario would be around 37% overall, state and fed. That’s a net of roughly $315,000. Now, let’s go back to comparing ‘what ifs’ as it relates payin’ a huge tax bill today, in order to have much of your retirement income be viewed by the TaxMan as tax free.
NOTE: For the sake of this post we’ll assume all income is converted to tax free 15 years before retirement. That’s not the reality for most, but it will help illustrate the point. Also, and of paramount importance is this: The decision to pay a large tax bill today so that tomorrow’s retirement income is tax free, must, by definition be a Captain Obvious no-brainer. So, you paid the big tax bill, and it hurt like the dickens. But now it’s 10-30 years later, and time to retire. Your neighbor, whose income at retirement is completely taxable will need to receive about $185,000 a year more than you do, in order to end up with the same spendable income. They chose NOT to bite the bullet and pay taxes back in 2014. If taxes rise, their spendable income drops, but it’d have no impact on you whatsoever.
Furthermore, if your tax free income is derived 100% from discounted first position notes, secured by real estate, here’s what you’ll have to anticipate.
- Every time a note in your Solo 401k/Roth IRA or other tax free entity pays off, you will quickly and happily rinse ‘n repeat. That is, you’ll take the untaxed profits along with the original capital invested in the note and buy more notes carrying larger payments. This will lead to more AFTER Tax income. Happy days.
- Your neighbor will have to make a ton more than you just to end up the same. After awhile he’ll not wanna talk about what coulda, should, woulda been the case had he done what you did, back in the day.
- If, as mentioned earlier, your tax free income derives from discounted notes, the time spent managing is significantly reduced, especially when compared to real estate. Is that an argument against investing in real estate? Not on your life. But, as good as real estate is, in the end, when it’s all free ‘n clear, it really defaults to being your ‘family bank’. Yeah, there’s the income for sure. Given all your tax free income, though, it’ll be great ‘walkin’ around’ money. 🙂
For those who’re still massively skeptical, let me put it this way. The neighbor in the above example will get to experience the following, while simultaneously realizing the depth and breadth of his fundamental mistake. That is, not paying the huge tax bill when it made sense. If his original tax bill, 10-30 years ago woulda been $250,000 — ONE TIME — he wouldn’t hafta pay cumulative tax bills in just his first decade of retirement at the income level mentioned, of not a whole lot less than $2,000,000! That amount only gets more depressing as his income rises, if it does. If the analysis is solid, and it screams at you to pay the taxes now, just this one time, and the result will be tax free income in retirement? For the love of all that’s sacred, DO IT!
Photo Credit: OhKyleL