It isn’t the job of the IRS to simplify the tax code, but here at Premier Planning Group, we take great pride in making the complex simple. To help understand the tax code, I use a three-color analogy that breaks down the way your income is taxed. This process is quite important to understand as not only will it make things simpler, but it can also help you plan your income distributions in retirement and potentially lower your tax bill.
The colors I use are green, red, and yellow. Let’s discuss what each color means and how you can use them.
Breaking it Down: Green, Yellow, and Red
Your green money is completely tax-free. That means as long as you follow all the rules, you can take this money out of these accounts without having to worry about any tax bills on the distributions. For instance, when you contribute to a Roth IRA, neither the growth of that money nor the distribution is taxed. If you have a solid amount of money in the green category at retirement, this is a great resource for you to generate the retirement income you need without having to add to your tax bill.
Red money represents tax-deferred money, which means you defer taxes on it when you contributed it, but you still owe taxes when you distribute it. A number of retirees have significant portions of their money in the red category, and it is held in their traditional IRA, 401(k), and 403(b). When you use this money to create your retirement income, you will owe taxes on the distribution at your ordinary income tax rate. If, for example, Congress raises tax rates in the future, you would be on the hook to pay those taxes at whatever rate Congress set.
Yellow money has already been taxed, but if you have any future growth as a result of capital gains or dividends, you will owe taxes on that amount. Depending on the type of investment and how long you held on to it, this could be taxed at your ordinary income rate or your capital gains rate. For example, if you use $100k of yellow money to buy Apple stock and grow it to $200k, you only get taxed on the $100k of growth—and at capital gains tax rates (15%) instead of ordinary income tax rates, which is quite a bit higher for most people. Yellow money is also 100% liquid at all times.
When you look at your overall financial picture, it’s important to know how much you have in each color, as that will often affect the timing of distributions when you go to create your retirement income. If you don’t have a plan for this, it could lead to you paying too much in taxes, which is one of a number of mistakes too many retirees make.
Putting a Plan in Place
Just like putting off your financial planning can have negative effects, putting off your tax-planning strategy can also have negative effects. Because of IRS rules (like contribution limits), it often takes years to put the right amount of money in each of these colors.
For instance, if you are 50 years old and have done a great job saving and investing but have most of your money in the red bucket, then you don’t have a lot of flexibility on what your tax situation will be in retirement. You will simply have to pay taxes on the distributions, at whatever tax rate is in effect in that year.
Yet if you take action now, there is still time to make changes and put a tax-planning strategy in place. It likely won’t be achieved in one year, though. A 5-to-10-year tax plan is more realistic and will help you lower your lifetime tax bill as well as give you more flexibility on your distributions in retirement.
Creating Your Tax Plan
Simply put, the longer you wait to create a tax plan, the more you risk paying higher taxes in retirement. To help create reliable income distributions in retirement and potentially lower your tax bill, you should strive to have all the colors of money in your portfolio: red, yellow, and green. Do you have a strategy that accounts for all three colors? If not (or if you’re not sure), we at Premier Planning Group are here to help. Call our office at (443) 837-2520 or email my executive assistant, Talia Grover, at taliagrover@premierplanninggroup.com to set up a complimentary consultation.
About Brion
Brion Harris is the CEO, founder, and managing partner of Premier Planning Group, an independent financial firm specializing in working with pre-retirees and retirees, helping them create customized wealth preservation and retirement distribution strategies. With over 20 years of experience, Brion has developed deep knowledge and skill in helping his clients simplify their finances and find confidence in their financial future. Brion and the Premier Planning team are known for their unparalleled client service and their dedication to building long-lasting relationships with their clients. As a result, Brion has been the recipient of the #1 Advisor Leadership Award* at Summit for seven years running and has a reputation as one of the top retirement advisors in the business.
Brion is a proud 20-year resident of the Annapolis community, where he resides with his wife, Elizabeth, their three children, Addison, Jay, and Scarlett, and their two dogs, Pepper and Coco. When he’s not working, you can find him boating, skiing, traveling, and enjoying good food and music with his family. If you want to learn more about Brion, connect with him on LinkedIn.
*The #1 Advisor and Leadership award is based on production data and is awarded by the Summit Financial Networks region of Cetera Advisor Networks LLC. Brion Harris received the award in 2019, 2020, and 2021. This award is not a guarantee of future investment success. This recognition should not be construed as an endorsement of the advisor by any client.
The #1 Advisor and Leadership award was based on production data while at Summit Brokerage Services, Inc. Brion Harris received the award in 2015, 2016, 2017, and 2018. This award is not a guarantee of future investment success. This recognition should not be construed as an endorsement of the advisor by any client.
For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give legal or tax advice.