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How to Fight Taxes in Retirement? Tax Diversification

Doug Garrison, CFP, MBA - Senior Wealth Advisor



We have little military history in our family. Neither grandfather served in World War I. My father tried to enlist in the Navy after Pearl Harbor. He was told he should continue in his job, helping to produce fuel and chemicals for the war effort. And my only government service was three years in the U.S. Peace Corps.

In spite of this, the U.S. Armed Forces have reminded me of the value of diverse ways of battling enemies. Our troops are prepared for warfare on land, in the air, or on the seas, and these days, even in cyberspace. Our country has a diverse array of defenders, ready for whatever threat comes our way.

Intellectually, we know we shouldn't regard taxes as "the enemy." But when it comes time to write that check at tax time, most of us feel that we're engaged in a battle with the government. "It's either us or them that keeps what we've earned, and we'll fight for what's ours!"

Complicating the battle even more, Congress periodically changes the rules of engagement. Before 1984, Social Security benefits were not taxable. Now, you can pay taxes on up to 85% of your benefits. Before 2007, Medicare Part B premiums for virtually all participants used to be the same amount. That changed. High-income Medicare participants now pay up to 80% of the cost of Part B. Congress's latest change is the death of the "stretch IRA" for most beneficiaries who inherit a non-spousal IRA in 2020 or later.

This battle becomes more critical as you face retirement. You're living off your wealth and may not have prospects of returning to paid employment. Remember dropping off your first born at college? It's not exactly the same, but each dollar of yours that ends up at the IRS leaves behind a sense of emptiness and regret.

So what's an investor to do? How can you prepare for the inevitable battle?

To prepare well, you need the portfolio equal to a defense force that can fight on land, sea or in the air. A major goal in retirement is to control as best you can your taxable income. You need "tax diversification."

Tax-Deferred Assets

Contributing before-tax dollars to a 401(k) or 403(b) plan or to an IRA provides immediate tax savings. You also get tax-deferred earnings until you take distribution. There's a place for that in building a retirement nest egg.

But temper your enthusiasm for generating a massive IRA by recognizing that:

(1) Federal income tax rates are currently near all-time lows for many. Current tax savings may not be as advantageous as you think. Phrased another way, paying taxes today and using after-tax dollars for savings may ultimately make sense.

(2) Every tax-deferred dollar that comes out of an IRA will be taxed as ordinary income. And you may be forced to take out larger Required Minimum Distributions (RMDs) than you need.

(3) With the passage of the SECURE Act, leaving an IRA to your children or grandchildren isn't as attractive as it was before 2020. With few exceptions, they will have to take their full distribution of the assets within 10 years of your death.

Tax-Free Assets

Assuming the account meets certain requirements, owning a Roth IRA provides a lot of flexibility in retirement. Roth IRAs can be funded by making annual contributions while working (if your income is below certain levels). You can contribute to a Roth 401(k) account if your employer's plan offers that option. Or by paying taxes on the converted amount, you can convert all or a part of a traditional IRA to a Roth IRA, perhaps over a series of years.

A Roth IRA provides access to money that won't increase your taxable income if you need to draw upon it routinely, or for an emergency or an unplanned expense. That can keep your taxes down and help avoid those nasty Medicare income-related surcharges. And while the SECURE Act mandates that most non-spousal beneficiaries take distribution of Roth IRAs within 10 years, just like traditional IRAs, those inherited Roth IRAs are tax-free to the beneficiaries. A "Roth conversion," paying taxes as you move money from a traditional IRA to a Roth IRA, also reduces RMDs from that traditional IRA, potentially lowering taxes in retirement.

Tax-Paid Assets

Basic savings and investments that you build with after-tax dollars are money that doesn't attract additional taxes when you access it. Yes, you pay taxes on interest, dividends and investment gains, but once those taxes are paid, that money is effectively tax-free, similar in many regards to a Roth IRA. If you support yourself in retirement through an investment account grown over the years with after-tax dollars, your taxable income primarily will be realized investment earnings and Social Security benefits.

At Investec, we work with clients to develop tax-effective investment and spend-down strategies. This has been a brief introduction to some of the advantages of having tax diversification. For a more in-depth review of your situation, and to develop your own battle plan against taxes, give us a call or schedule an appointment.

Let's Talk

Disclaimer: The information provided here is general and intended as educational in nature. It is not intended nor should it be considered as tax, accounting, or legal advice. Investec Wealth Strategies and its advisors do not provide tax, accounting, or legal advice. We recommend you seek the counsel of your attorney, accountant or other qualified tax advisor concerning your situation.