Tax planning can be
As simple as choosing the
Right tax withholding

At SeaCure Advisors, we make a big deal about tax planning. The CPAs on our tax team do an expert job of helping us review tax returns and spot opportunities for our clients to reduce their tax bill over a long period of time.

As a planner, it can be fun, and, honestly, a little distracting, to go down the rabbit hole of advanced strategies involving Opportunity Zone Funds, Delaware Statutory Trusts, Captive Insurance Companies, or Property Assessed Clean Energy.

For the vast majority of people over age 59 ½, tax planning can be much simpler. It can start with something as mundane as the tax withholding on IRA distributions.

Once a person reaches the year in which they will turn 59 ½, he or she can take penalty-free distributions from a tax-deferred account. These accounts include IRAs, 401(k)s, 403(b)s, 457s, non-qualified annuities, and Modified Endowment Contracts. The common quality each of these accounts share is that a withdrawal from them will likely be taxed as ordinary income on the Federal level.

This is where you have to do some work.

You have to choose the amount of tax you want withheld from the withdrawal. Similar to the tax withholding on a paycheck, the withholding amount represents an estimated payment of your year-end tax bill. If you don’t withhold enough taxes, you may be hit with an underpayment penalty in addition to an amount due when you file that year’s taxes. Most people don’t enjoy that.

What most people do enjoy is a tax refund. But what exactly is a tax refund?

A tax refund is the return of estimated tax payments in excess of what you owed the government based on a given year’s income. If someone over-estimates their tax withholding, he or she will essentially be loaning the government money at 0% interest until the government issues a refund.

How can a person calculate a tax withholding amount that won’t result an interest-free loan to everyone’s favorite Uncle?

If the income you earned last year looks like it will be about the same as the income you’ll have this year, you can use last year’s tax return to help calculate a good withholding percent for your Federal taxes this year.

Please note, this does not apply to state taxes. States have their own rules about how they tax withdrawals from qualified accounts like IRAs. You will need to be familiar with those rules to calculate state withholding.

Looking at last year’s Federal Form 1040, look at the line item for Total Income. Then, towards the end of your Federal Form 1040, look for the line item for Total Tax. Divide your Total Tax into your Total Income and you have your Effective Tax Rate. Withholding at this amount, or slightly higher, is a good target for how much you should withhold from your qualified account withdrawals.

For example, in 2022, a married couple with $200,000 of total income is in the 24% tax bracket. If this couple needed a withdrawal from an IRA, they could withhold 24% and know they will absolutely not owe additional tax on that withdrawal. They also will have likely left Uncle Sam a tip.

Let’s say this same tax paying couple has a Total Tax of around $25,000. That is an effective rate of $25,000 ÷ $200,000 = 12.5%. This can happen for a number of reasons. Mainly, it happens because our income tax system is progressive. Also, some income might be taxed at a 15% capital gains rate. They might have Social Security income, 15% of which would be tax-free for them. The bottom line is that this couple is not giving 24 cents of every dollar to the government.

They may be able to withhold taxes at a 12.5% - 15% rate and be confident they won’t owe additional money at the end of the year. They can also be confident that they are not making an unnecessary and irreversible distribution out of a tax-advantaged account.

What does this mean in terms of real dollars?

Suppose this married couple wants $20,000 from an IRA. To net $20,000 (meaning the amount left over after taxes are withheld), they need to first calculate their withholding.

At a 24% withholding rate, in order to net $20,000, the couple needs to withhold $6,316 in taxes. This means their gross distribution out of their IRA is $26,316. ($26,316 x 24% = $6,316, meaning the couple takes home $20,000 after withholding).

At a 12.5% withholding rate, the amount withheld is instead $2,857. That means the couple needs to take a distribution of only $22,857 in order to have a net withdrawal of $20,000.

The $3,459 difference between the 12.5% withholding and the 24% can stay in their account and keep growing.

Assuming their IRA is invested in a portfolio earning an average 6% return, in 10 years that $3,459 compounds up to $6,195. Repeating this process every single year is how a person wins the tax game.

Tax planning doesn’t always look like complicated strategies involving accredited investors and alternative investments. It can be as simple as calculating your effective tax rate to know a good withholding percentage on qualified account withdrawals.

For a lot of people, this can be new and spooky territory. If you are interested in learning how you can use simple techniques to save money on your annual tax bill, we’d love to hear from you.