Don’t Let Taxes Dim Your Retirement: How to Plan Ahead with Your ‘Tax Bucket List’

Taxes are on the minds of many this time of year with the filing deadline looming. But too often, people think about taxes only on a one-year-at-a-time basis, forgetting or putting off the need to adjust their strategy for future years – most importantly, their retirement.

As you prepare for your non-working years, it’s important to consider the burden taxes can pose in retirement. Being proactive and developing a tax-efficient strategy is especially important for those who will retire soon. If you have a tax-deferred retirement account (IRA, 401(k), 403(b), SEP, etc.), you unfortunately have an account that has one of the same features as a variable-rate mortgage. At any point, the IRS can change the rate (here, though, it is the tax rate rather than the interest rate).

Some financial professionals think that given our growing national debt, tax rates will likely go up at some point in the next few years – rising from the historically low rates we have now. And remember that when you withdraw money from one of your tax-deferred retirement accounts, whether because you need the money or you were forced to due to required minimum distributions, you must pay taxes on every dollar.

Do you know what your tax rate will be one, five or 10 years from now? Perhaps you want to withdraw as little as possible and leave it to your children. Do you know what taxes they will have to pay on those funds 10, 20 or 30 years from now? And the future tax burden your spouse could face after your passing is something you must also consider.

The good news is that you can take steps to preserve some of your money in tax-free environments, thereby reducing your debt to the IRS. First, consider the three “tax buckets”:

  • Tax deferred bucket. These are assets such as traditional IRAs, 401(k)s and deferred annuities within a qualified retirement plan, etc. These accounts generally grow tax-deferred, which means you only pay taxes when you withdraw the money.
  • Taxable bucket. This is the money you have probably already paid taxes on, and if you invest it, you pay taxes when you realize a return. These are non-IRA assets, such as brokerage accounts, savings accounts or certificates of deposits at your bank.
  • Tax free bucket. This money grows tax-free, and whether you withdraw your gains or leave the money to your beneficiaries after your death, it is tax-free, subject to certain limitations. These assets include Roth IRAs and life insurance.

It’s more common to have most of your money in the tax-deferred and taxable buckets. If you are interested in being proactive for the long term, here are two strategies worth considering to put more in your tax-free bucket:

Roth IRA conversions

Some conditions must be met to contribute to a Roth IRA, such as earned income, income limits and contribution limits, so not everyone can contribute to a Roth. However, converting your tax-deferred money to a Roth IRA is possible for everyone. A Roth conversion must keep the big picture in mind, but if we look at the long-term savings of a Roth conversion, it can be significant.

Here’s an example of a married couple, Greg and Tina, both aged 65 with an annual income of $75,000, whose goal is to convert $200,000 of a traditional IRA (tax-deferred) to a Roth IRA (tax-free). The tax impact on them from a traditional IRA vs. a Roth IRA is based on these assumptions: living through age 90, a 25% effective tax rate (combined federal and state) on RMDs and taxes paid on death, a 15% capital gains tax on reinvested RMDs, and a 5% average rate or return over the period. In a $200,000 conversion to a Roth IRA, they would pay $46,000 in taxes – in the year of their conversion – under the current tax code. If Greg and Tina do nothing (do not convert to a Roth IRA) and instead simply draw their required minimum distributions beginning at age 72 until they have both passed away (surviving spouse passes at age 95), they would pay $62,692 over that period of time.

The bigger tax savings are down the road. For a Roth IRA, their taxes on reinvested funds are $0, and the taxes on the value at death are $0. Total taxes paid for the Roth IRA: the $46,000 paid for the one-year conversion.

By contrast, capital gains taxes on reinvested RMDs for the traditional IRA are $26,796. Taxes on value at death for the traditional IRA: $41,665. Total taxes paid if they had stuck with the traditional IRA: $131,153.

Note: A Roth conversion is a taxable event and may have several tax-related consequences. Be sure to consult with a qualified tax advisor before making any decisions regarding your IRA. This is a hypothetical example provided for illustrative purposes only; it does not represent a real-life scenario and should not be constructed as advice designed to meet the particular needs of an individual’s situation.

Life insurance

High-income earners are not the only group of investors who turn to life insurance. Pre-retirees and retirees are interested in this option because, in addition to the death benefit and potential for tax-free income, if the contract includes the additional benefits of long-term care, they can kill two birds with one stone.

The death benefit is also tax-free. If you are looking for the following features, a permanent life insurance policy might be a consideration for you:

  • Tax-free death benefit for heirs
  • No income limitation on contributions
  • Tax-free growth
  • Tax-free withdrawals
  • Tax-free long-term care benefits (with the purchase of
  • an added LTC rider)

Keep in mind, however, that because this is life insurance, there are fees and charges, including surrender penalties for early withdrawals. You will need to qualify for the policy medically and perhaps financially and fund it appropriately for it to remain in force.

If you want the IRS to take the smallest bite possible out of your money, consider these strategies, which allow you to convert your tax-deferred money into tax-free money. Being proactive is the key to enjoying your retirement more on your terms.

Neither the firm nor its agents or representatives may give tax or legal advice. Individuals should consult with a qualified professional for guidance before making any purchasing decisions. Life insurance policies are contracts between your client and an insurance company. Life insurance guarantees rely on the financial strength and claims-paying ability of the issuing insurer. This article is intended for informational purposes only. It is not intended to be used as the sole basis for financial decisions, nor should it be constructed as advice designed to meet the particular needs of an individual’s situation. Insurance offered through J. Biance Financial, 545 S. Pine Street Sebring, FL 33870 863-304-8959. Investment advisory services offered only by duly registered individuals through AE Wealth Management, LLC (AEWM). AEWM and J. Biance Wealth Management are not affiliated companies. 01232363 03/22

Principal, J. Biance Financial

Justin M. Biance, a Certified Estate Planner and principal at J. Biance Financial (www.jbiance.com), is the author of “Designed to Last: Renovate Your Financial House and Retire With Confidence” and “The Great Inheritance: 7 Steps to Leaving Behind More Than Your Money.” He specializes in multigenerational legacy planning and creating tax-efficient strategies for transferring wealth to heirs.

The appearances in Kiplinger were obtained through a PR program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.

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