The 3 Biggest Tax Mistakes to Avoid When Retiring Before 60

Full transcript includes subheadings:

The three biggest mistakes that I consistently see people make when they’re retiring before the age of 65 include failure to have a health insurance strategy, taking distributions out of the wrong types of retirement accounts at the wrong times, and failure to locate the proper investments in the proper retirement account.

As a company, we’ve been doing this for over 40 years. My name is Ty Bernicke. I’ve been doing this and helping people with this for over 29 years now, and I’m going to be going over each of these today.

Mistake #1: Health Insurance Strategy Before Medicare

So mistake number one, many people who are going to be retiring before the age of 65 will go either on Affordable Care Act insurance or a state sponsored version of Affordable Care Act insurance if they do not have health insurance provided to them from a previous employer between when they retire and the age of 65 when Medicare kicks in.

And one of the important things to know about this is when you’re on ACA insurance or Affordable Care Act insurance, or a state sponsored version of Affordable Care Act insurance, the cost of the insurance is based on the amount of modified adjusted gross income you have. So the more modified adjusted gross income you have generally speaking, the higher the cost of the insurance.

So to understand how this works, because many of you are going to be relying on retirement investments for income before the age of 65 to get you throughout your retirement, it’s important to know what I call the different tax buckets, because that’s going to affect your modified adjusted gross income.

The Three Tax Buckets

So if imagine for a second if you had to take all the different investments that you have and you have to place those investments into one of three buckets, there’s the tax deferred bucket, which would include things like IRAs, 401(k)s, 403(b) plans and 457 deferred compensation plans.

And when you put money into this bucket, the money goes in on a pretax or a tax deductible basis, which means you save money in the year you place money into this bucket and the money grows tax deferred. However, when you take money out of this bucket, it counts as income and it increases your modified adjusted gross income.

Now when you contrast that to what we call the tax free bucket, which could include things like Roth IRAs, Roth 401(k)s, Roth 403(b)s and Roth 457(b) plans. Many of you won’t have all of those different types of investments, but chances are you have one of them, or maybe a few different ones that fit into this tax free bucket.

And with this bucket, the money doesn’t go in on a tax deductible or pretax basis. And as the money grows, it grows tax free. And if it’s withdrawn for qualified reasons in retirement it comes out completely income tax free.

Now the final bucket is what we call the non-qualified bucket. Sometimes you’ll hear people call this the taxable bucket.

But if you were to invest into a non retirement account, so not an IRA, not a Roth IRA, not some sort of tax qualified retirement plan. So if you were to invest $100,000 into this bucket and you later want to take that $100,000 out, you can take it out and there aren’t any tax implications on what we call the basis, which is the total amount that you put in.

If you have stocks or mutual funds that invest in stocks that appreciate in value, again, whatever you put in, you can take out tax free. The gains will be subject to capital gains tax and also will count towards modified adjusted gross income.

Also, any interest that you earn on CDs or money market accounts or government bonds or corporate bonds, that all also counts as taxable income towards modified adjusted gross income.

Even municipal bonds that aren’t subject to federal income tax, that also counts towards modified adjusted gross income when we’re planning for Affordable Care Act insurance.

What Counts Toward Modified Adjusted Gross Income

So the reason that this is important is because when again, when you retire before the age of 65, but prior to Medicare kicking in, if you go on Affordable Care Act insurance or a state sponsored version of it, it’s important to know what counts towards modified adjusted gross income, because that will increase the cost of your health insurance to a certain point.

Things like wages, salary pay, Social Security income, pension income from a previous employer, distributions from that tax deferred bucket generally count. And if you’re under the age of 59.5, you also might be penalized on that money in addition to it being taxed, in addition to it counting towards modified adjusted gross income, which could increase the cost of your ACA insurance, net business income, municipal bond interest, any income, dividends, and capital gains on that non-qualified bucket that we talked about earlier.

All of that counts. More important than what counts is what does not count. Qualified distributions from Roth IRAs—that money comes out income tax free and does not count as modified adjusted gross income. And the other thing that doesn’t count towards modified adjusted gross income is distributions from the non-qualified bucket that are the basis that we referred to earlier.

So the reason I’m sharing this with you is many people go into retirement and they haven’t taken an inventory of how much money they have in those different buckets and how they’re going to be taking income out of those buckets in retirement to reduce their Affordable Care Act insurance premiums to get them to Medicare age at 65.

So make sure you have those buckets organized correctly before you retire. Each year that goes by where you’re not thinking of this prior to retirement is a lost opportunity.

Mistake #2: Distribution Strategy and Tax Planning

So we’re going to switch gears here and go into mistake number two: distribution strategy and failure to have a long term plan. Many of you, when you retire are eventually going to take Social Security income at some point. Some of you will have a pension from a current or previous employer. Some of you will work part time or have business income, and many of you will rely on distributions from investments.

And so in order to understand the importance of a long term plan, I think it’s important to understand how tax rates work.

Understanding Tax Brackets

So presently in 2025, a single individual has a $15,750 standard deduction, which means the first $15,750 of income you have coming in is not subject to tax because you get a deduction. Now, you might have itemized deductions that are even greater than this, but we’re just going to keep it simple for the purpose of this short video today.

And once you exceed that threshold, the next $11,925 is taxed at 10%. If you’re married, you get a $31,500 standard deduction, and the first $23,850 of income is subject to tax at 10%. And once you go above $23,850, the next amount to $96,950 is subject to 12% in taxes.

Now, one of the things I want you to pay attention to is look at the size of the jump from this tax bracket to the 22% tax bracket. That’s one of the biggest jumps in the tax code. And when we’re looking at people’s future income streams, we’re always trying to think about how can we avoid these big jumps from 12% to 22%? You can also see there’s a big jump when you go from 24% to 32%.

So looking at the collective total of all the different income streams that you have coming in between Social Security and pension income and those different buckets that you have, it’s important to make sure you organize those buckets in a way that you try to avoid these big jumps in the tax code, to avoid pushing yourself into a higher than necessary tax bracket.

Key Planning Considerations

So different considerations that you should have—I do think it’s important to have a long term game plan where you kind of plan out over the next ten years plus where you think your income streams are going to be coming in. But it’s not as easy as making a long term plan and just sticking with the long term plan, because inevitably there are going to be years where you need more money because you need a new roof or a new furnace, or a daughter’s getting married or whatever it might be.

You’re going to have these one-off expenses that pop up that are going to require you to zig and zag with how much money you’re taking out of your various buckets, or where you’re getting that income from.

So every year you should be looking at: how much income do I think I’m going to need this year? And where am I going to pull that income from to avoid those big jumps in the tax code that we just mentioned with the various tax brackets? Making sure that you have a plan for your ACA health insurance costs and how you’re going to pay for them if you need ACA insurance prior to age 65.

Planning for IRMAA

Another thing that’s very important to consider: once you get two years before Medicare kicking in at age 65, you have to start thinking about something called IRMAA. So IRMAA means essentially that if you exceed $106,000 as a single individual, or $212,000 as a married couple, and you’re filing as a married couple, once you hit those thresholds and beyond, the cost of your Medicare is going to go up.

So a lot of times we’ll try to avoid that from happening. It doesn’t always make sense to do it, and there’s a lot of people that can’t do it. But if you’re in that situation, you ought to be conscientious of it because you have to start considering it before Medicare even kicks in at 65. So the decisions you make at 63 will ultimately affect what you’re paying for Medicare two years down the road and beyond.

Other Important Factors

Again, like I mentioned before, upcoming one-off expenses—always making sure that you’re thinking in advance of the next year on what you think you’ll need to make sure that if you need to get a little extra money out this year, and you can do that and avoid pushing yourself into a higher tax bracket, that could be very advantageous.

And of course, making sure that you’re looking at ongoing tax law changes. Again, this is why we like to make a long term game plan, but have to look at each year independently because tax laws can change like that. And we have to account for that with where you’re getting your distributions to minimize the taxes associated with that.

Required Minimum Distributions

A big thing that you also have to think about is required minimum distributions. Depending on your age today, you’re going to have required minimum distributions that likely start either at 73 years old or 75 years old, and that new amount of income that is required to be taken out of that tax deferred bucket that we mentioned earlier, that new source of income could potentially push you into those much higher tax brackets.

So if you can get that money out at a younger age, at a lower tax bracket to avoid the higher tax bracket later, that can make sense in a lot of situations.

And of course, there’s many other variables to consider. But considering your long term game plan and adjusting that long term game plan each year by some of these things that I just mentioned are very important.

Mistake #3: Asset Location Optimization

Mistake number three is something that we call location optimization. So that basically requires placing the proper investments in the proper buckets for minimal taxes throughout retirement.

So to illustrate how this works, I thought it’d be easiest to just do a real simple example. Again, we have somebody that has a $2 million portfolio. And for simplicity, we’re going to assume that this person has $1 million in the tax deferred bucket. We’ll just consider it all invested in an IRA, a million in the tax free bucket or what we call the tax free bucket. And we’ll assume that’s invested in a Roth IRA.

For simplicity and for this example, I’m going to assume that stocks grow at an average rate of 9% per year, bonds grow at 4% per year. We’re going to assume a ten year time horizon just so we have something to go on, and we’re going to assume that this investor just wants to have 50% in stocks, 50% in bonds, because that’s what their risk tolerance dictates.

Example: Poor Asset Location

So in this example, a million in an IRA, million in a Roth IRA, 50% invested in stocks and 50% in bonds. And on the left side here, we’re going to assume that they go 50/50 on the IRA, 50% stocks and 50% bonds, and 50% stocks and 50% bonds in the Roth IRA. And you can see over a ten year time horizon, assuming a 9% growth in stocks, 4% in bonds, both buckets grow to a little over $1.9 million because they’re invested identically.

The total at the end of ten years would be $3.8 million between the two buckets. And again, I realize this is a very simplistic example, but it’ll illustrate the point I’m trying to get everybody to understand.

Example: Optimized Asset Location

So that’s one example. If we go over here, I only changed one thing. I still have them at a 50/50 overall allocation. But the IRA, we assumed as 100% invested in the bonds. The Roth IRA, I assumed, is 100% invested into stocks. So they still have half their money invested in stocks, half their money invested into bonds, just like this example on the left hand side.

The difference is that because the bonds grow at 4%, which most people would assume bonds over a long period of time on average tend to grow less than stocks, that would grow to $1.48 million—over $400,000 less than the example on the left here in the tax deferred bucket.

The tax free bucket grew to a little over $2.3 million, which is a little over $400,000 more in the tax free bucket. They still have the same amount of money because it’s the same allocation, 50% stocks, 50% bonds, but they have significantly more in the tax free bucket and significantly less in the bucket that’s going to—that they’re going to have to pay taxes on. All that money when it comes out is going to be subject to tax at whatever tax bracket they’re at.

So having $400,000 more in a tax free bucket and a little over $400,000 less in the bucket that’s going to be taxed is obviously a big boost for this particular example.

So making sure you locate the right investments in the right buckets can dramatically decrease your overall tax burden throughout your retirement. So locate the investments in the right buckets.

Conclusion

So with everything that we went over today between making sure you take care of Affordable Care Act insurance, if that’s going to be a thing for you, making sure that you have a long term distribution strategy that’s adjusted annually, and making sure that you locate the proper investments in the proper buckets—all of those things are where we see people make a lot of mistakes, and it’s relatively simple to work with a professional to get that organized.

And even if you do this on your own, I’m hoping that you got some good information in this short video today. But if you do have questions on this and you want to talk with a Certified Financial Planner, you can set up a 15 minute meeting by going to Bernicke.com or clicking the link that we provided to you in this video.

Again, I hope you got some good information. I’m Ty Bernicke from Bernicke Wealth Management. Thank you for your time.