Curt's Chalk Talk - Live! Tax Tripwires

Hi, welcome to Curt's Chalk Talk Live. I'm Curt Sheldon of C.L. Sheldon & Company. And today I'd like to talk to you a little bit about some tax trip wires, especially those that affect retiring senior military officers and NCOs. So the way we'd like to do this today is I'll talk for about 15 minutes or so, and then we'll open it up for questions. If there are no questions, then we'll call it a day. But we're going to cover some topics. As far as questions go, feel free to put them in the questions tab, written, or you can try raising your hand and I'll do my best to do an answer to those. Although I will say today is the first day with GoToWebinar, so I've been playing with the tech, but I haven't had the opportunity to respond to someone who has raised their hand. So with that, we'll go ahead and get started.

So there's several things that can go wrong or, if you will, trip wires when you retire from the military and start your second career. And the first one has to do with your withholding. Now, imagine this with me, if you will, that you find a new job, you've convinced the hiring manager that you're an operator that can make things happen. And you go in to work the first day and your boss sets you down with HR and they hand you a stack of paperwork. And like I said, you're an operator that can make things happen, so you don't particularly like doing paperwork. And you get to the W-4 in there and you go, "You know what? Married with four has worked just fine for me for the last 27 years on active duty. Married with four it is."

And you go to fill out the W-4 and you click on married or you check on married, and there isn't a four for you to take, or a one or a two, it's just married. And you say, "Well, that should be fine." Anyways, you hand it in and you go off to work. And the year passes and you go and file your tax return. And in April, you end up with, let's say, a tax bill of 8,000, 9,000, $10,000 due. And you go, "What the heck? [inaudible 00:02:12] with four married has worked for the last 27 years? Why the heck isn't it working now?" And it has to do with the way withholding works. So let's start here. And you're working for your boss and you're making X amount of money. And your boss looks at that and he says, "Well," or she says, "Well, some of it's going to actually get withheld at zero because it's less than the standard deduction, and some gets withheld at 10%, and some at 12%, and a little bit at 22%.

Seems to make sense, it should work. But it doesn't if there's a second source of income, because in reality you've got your military retirements here and your pay from your job goes on top of it. So he should start withholding at 22% and maybe some of it at 24%. So it's almost guaranteed that you're going to under withhold if you just do a W-4 and hand it in. And you're going to get hit, like I said, with an eight, nine, 10%, $10,000 tax bill that first year you file your tax returns as a civilian. So that's not something we really want to do. So what do we do about it? Well, I think the best thing to do is fill out what's called a form 1040-ES. And the 1040-ES is just basically completing your estimated, or your tax return using estimated numbers. So you're going to take your pay stub from work, your RAS. What the heck's a RAS? Your retiree account statement.

It's what tells you... Basically it's your LES for retirement pay. And you're going to complete your tax return. You're going to use your pay stub to figure out how much you're going to get paid and how much withholding there is. Same thing with your RAS. Add in your interest, take your deductions, and you'll get a pretty good idea on your taxes. And let's say that shows you that you're going to owe $6,000 at the end of the year. Well then you go into myPay and you look for the thing that says Additional Federal Withholding, and you click on, that and you put in, let's say we're six months into the year, you're going to owe $6,000. You say take an extra thousand dollars a month. Now don't forget to reset that next year. Now you might be able to go to $500 a month. I think that's the best solution of figuring out your taxes.

If you're not going to do that, then you might want to use the IRS's W-4 calculator. It's a pretty good estimator of what your withholding should look like, and it will tell you again how much additional withholding you should do. I like the 1040 better. We don't use the W-4 estimator in my company, we have spreadsheets that we do. But the W-4 estimator is a good thing as well. And then if you're unwilling to do either one of those, I'd make sure you've got at least 30 to 40 K in withholding in that first year. If you're hitting around $200,000, you're going to want at least that much. 30,000 is 15% of 20,000, and that's a pretty typical... Rather 30,000 is 15% of 200,000, and that's a pretty typical tax bill, 15%, that we see for most retired senior officers and NCOs.

Now, one of you out there is going to eventually end up, it's not going to happen to you, and you're going to say, "What the heck, Curt Sheldon lied to me." No, there is a case where you might not get hit that bad, and it tends to happen if you retire in maybe the first half of the year. It has to do with your social security. So you only pay social security on a certain amount of your income here in 2024, and it's $168,200 worth of wages. Well, if you had more than one employer during the year, they're not going to know how much you made the other company. And if those combined incomes exceed that $168,200, you're looking at probably getting some refunds on social security, and that social security withholding will go against your income tax due, and it may actually reduce that seven, eight, $9,000 bill down to something more manageable.

So that only happens, though, in a year when you have more than one job. Now, somebody may be thinking, "Well, I don't really want to pay the money early anyways. I'd rather have it sitting in my bank account earning interest and then I'll pay when I file my tax return." Realize that your taxes are due when you earn the income, not when you file your taxes. So the first year you might be okay because there's some ways that you can avoid under withholding penalties, but those are unlikely to continue past your first, that the year you retire. So you want to get this taken care of. It's bad enough to have to pay taxes, it's even worse to have to pay penalties. And oh, by the way, while I'm talking about taxes, DFAS will not do any state income tax withholding unless you tell them to do so.

So make sure you talk to DFAS or you fill out the paperwork, or go to myPay and have an appropriate amount of state income tax withheld. Now in that case, you'll need to put in a dollar amount. The good news is most states have varied flat tax brackets, so we don't get that same stacking problem that we had with the federal taxes. So you can generally just look at the state's highest tax bracket, here in Virginia it's 5.75%, multiply your retirement pay times that amount, and put in that dollar amount. So again, this is the biggest one we see. We probably have 10, 15 retiring senior officers and NCOs every year that get a big surprise and have to stroke a big check to the IRS. Now, the next thing I want to talk about that catches a lot of people, the second thing that catches a lot of people off guard is Roth IRAs.

Now, Roth IRAs are a great thing for saving for retirements, and we're a big fan of them here at C.L. Sheldon and Company. But there's a pretty good chance you're not going to be eligible to contribute to a Roth IRA after you retire from the military if you start a second career. And that's because there's income limits on the Roth IRA. So if you make too much money, you are not allowed to contribute directly to a Roth IRA. And if you're married, filing jointly, that phase out starts at $230,000 of adjusted gross income, so that's before your itemized deductions, to $240,000 of adjusted gross income. If your AGI is over 240, you can't contribute anything to the Roth. And at 230 it starts phasing out. If you're single, it starts at 146,000 and goes to 161,000. Same concept. If you're less than 146, you can do the full contribution.

You go over 161, and you can't contribute anything. Notice here a little bit of a marriage penalty. Married folks only have $10,000 worth of phase out, single have $15,000 worth of phase out, so they can actually get, again, a little bit more space, and there is more than half of the married phase out numbers. So some advantages there for single folks when it comes to that. Now, if this does happen to you, you need to get the money out of the Roth IRA before you file your tax return for that year, because if you don't, you're going to be subject to a 6% excise pen tax for every year that that money stays in the account. So to avoid the tax, you need to get it out before you file your tax return, with extensions. So you have till October 15th. And more importantly, you need to get out, not just the contributions but the earnings on the contributions as well.

And get those out, you can either recharacterize them into a traditional IRA or just take the money out and put it into a taxable account, but you want to get that out of there because who wants to pay 6% to the government every year for as long as that money's in there? It is interesting to note that if you don't do it the year you make the contributions in the future, you only have to take the contributions out. You don't have to take the earnings out, but you will have already paid a 6% penalty at that point. So again, something we probably don't want to have happened to us, it is a correctable problem, but probably better when you retire, or the year you're going to retire in January, stop your Roth IRA contributions, just put that money over to the side. At the end of the year, figure out whether you're eligible to contribute directly to the Roth IRA. And if you can, go ahead. If you can't, then you might want to look at doing what's called a backdoor Roth conversion.

We're not going to go into that today, but you can Google it and find out more about it. Now the next thing I want to talk about is a rumor that's been out there for quite a few years actually, and it has to do with your VA disability compensation and your taxes. Probably a better way to say just the VA disability. So there's a rumor running around out there that says, for example, and we're talking about people who retired for longevity, that if you are a hundred percent disabled, a hundred percent of your military pension is tax-free. That's absolutely not true. And in a court case in 2022 Valentine versus the Commissioner, the courts clearly stated that this was not true, and that the taxpayer who construed the IRS publication to indicate that this could happen, was, I think, the term they used, "Grossly misconstruing the IRS publications." So if you hear that, help me out, squash the rumor, and more importantly, don't do it yourself because you're going to set yourself up for problems.

Now what you can do, under internal revenue ruling 78161, is if you are less than 50% disabled, there is a potential that you can adjust the amount of taxable income on your 1099-R, which is what you get instead of a W-2 when you're retired, to reflect VA offset that should have been taken. And here's how that works. When you retire, you file a VA claim, and you start getting paid by the government for your military retirement. At some point in the future, the VA's going to settle your claim and give you a disability percentage. Now, back when I retired, slightly after the earth cooled, there was a long time between retirement and the time that people got their claims. For me it was 14 months. But if you're less than 50% disabled, for every dollar of VA disability that you receive, your pension is reduced by a dollar. So you basically turn taxable income into tax-free income, because VA benefits are tax-free.

So let's say six months passes before you get the adjudication, and find out that you're less than 50% disabled, well then you can, when you file your tax return, you can say, "For those six months, I should have received," let's say a hundred dollars a month, it's going to be more than that, but "a hundred dollars a month in VA disability. So my military pay should have been a hundred dollars a month less for those six months only." And then you can reduce the amount reported on your 1099-R by $600 to reflect that VA offset that should have been taken. Now the other thing I'll mention, I won't talk about it today, but if you're receiving CRSC combat related special compensation, then the whole scenario changes. You may have... Some of your military pension may become tax-free. It just depends on the situation. And you're going to need to actively apply for that with your service versus a VA claim.

The last thing I'll hit real quick, and then we'll go to questions is, Obamacare surtaxes. Now, generally speaking, we don't have to worry about those on active duty. And there's two of them that apply. So the first one has to do with your wages. This one's pretty straightforward. If you have wages, and they exceed $250,000, if you're married, or $200,000 if you're single, you're going to pay an additional 0.9% Medicare tax on those wages that exceed those thresholds. Nothing you can do about it, nothing that you need to do. Either your employer will take it out via withholding or you'll pay it when you file your tax return. So that's something to keep an eye on, nothing you can do about it. And then as a reminder, it's wages, so it doesn't include your military pension. The other Obamacare surtax is the net investment income tax, and that has to do with your investment income.

Now, in this case, the thresholds are $250,000 of adjusted gross income for married, and $200,000 of adjusted gross income for single. So that means it does include your military retirement. So what's this net investment income tax all about? So it's on investment income when you exceed those two thresholds. So I'll draw it out for you because I think it's a little easier to understand that way. So we've got the line here, that's our $250,000 line. If you're single, just imagine that it's $200,000. And let's say you have $230,000 of other income. So wages, military, retirement, and $50,000 of net investment income. And by the way, net investment income includes everything like dividends, interest, capital gains, rent received, income from a partnership that you're not an active participant in. So in this case, against 230 of normal, 50,000 of investment income, so we've got 30,000 that is subject to the net investment income tax.

Now, let's say we've got $250,000 worth of net investment or other income, we've got that same $50,000 of net investment income, and the entire $50,000 is going to be subject to the net investment income tax. And then in our third scenario, we've got $270,000 worth of other income, again, wages and pension being the primary one, and $50,000 worth of net investment income. And you're only going to pay taxes on that $50,000. This amount in here, no, you won't pay that because it's not investment income. Although going back to the additional Medicare tax, if that's all wages, then you'll pay some additional tax on that. So with that, we've covered about 15 minutes worth of things that can really trip you up when you do retire. So we'd want to watch out for these tax trip wires. Now I'm going to see if we have any questions. Right now, I don't see any in there. Let me check one other thing.

All right, so with that, since there's no questions, we'll call it a day. Thanks for coming in, for those of you who did. We will also make the video available for those who were unable to attend. And don't forget our Chalk Talk coming up in about a month in July. Keep your eyes open for that. And it'll be covering rental real estate, and things you might need to know if you're thinking about becoming a landlord. So let me check one more time on questions. And if we don't have any, we will call it a day. Have a great Thursday, I think it is, and we'll talk to you again soon. Last thing I'll say, if you have any questions that come up after we've left, feel free to reach out to me at Curt, that's C-U-R-T@clsheldon.com.