For many people, reducing taxes is the easiest, fastest way to increase investment returns, put a retirement plan back on track, beat inflation, and enhance retirement security, explains Bob Carlson, editor of Retirement Watch.
Retirees and pre-retirees often leave a lot of money on the table for the IRS to scoop up because they don’t execute the key tax reduction strategies that can save thousands of dollars or more. The prime beneficiaries of such strategies are those with significant balances in traditional IRAs or 401(k)s. Congress provides a lot of tax breaks to encourage people to accumulate as much money as they can in tax-deferred accounts. Those tax breaks are only a mortgage. You pay the mortgage when taking distributions from the accounts. The key is to pay those taxes at the lowest rate possible.
That’s where these strategies come in.
1. Break the Number One Tax Rule.
The first tax strategy most people are taught is: don’t pay a tax until you have to. In other words, maximize tax deferral. That was a good strategy when it was developed, but things have changed. The 2017 tax law brought income tax rates for most people to their lowest levels in decades. Those tax rates will expire after 2025 unless a majority in Congress and the President agree to extend them.
Today, that looks unlikely, and there’s no telling what the situation will be after the 2024 election. There are many reasons taxes are more likely to increase in the coming years than stay the same or decline. The federal debt and annual deficits increased dramatically in the last few years. And, as you well know, Social Security and Medicare have solvency problems.
After the 2020 election, a significant contingent in Congress wanted to increase taxes across the board, including on retirees. We were spared that by a couple of votes. In addition, many people don’t realize that even without tax increases their tax bills are likely to increase during their 70s and beyond because of the Stealth Taxes. Consider paying some taxes before you must, because today’s rates are likely to be lower than future rates. That’s especially true if your goal is to leave at least part of your tax-deferred accounts to your children or other loved ones. They’ll owe income taxes.
The best time to consider this strategy is during the “bridge years,” the years after most people stop working and before required minimum distributions (RMDs) from IRAs and 401(k)s begin after 72. In the bridge years, many people haven’t claimed their Social Security benefits. The bridge years aren’t the only time to consider paying some of those deferred taxes. But that’s when the greatest tax benefits are likely. Look for opportunities to draw down tax-deferred accounts at fairly low rates today instead of leaving your accounts as targets for Congress and the Stealth Taxes.
2. Reduce Future Required Minimum Distributions.
When you have a substantial IRA or 401(k) plus other assets and sources of income, RMDs are a trap, a kind of tax time bomb. Most people in this situation distribute only the minimum required. But once RMDs kick in, the percentage of the account you must distribute each year increases. Leaving money in the account when you’re younger and letting it grow sets you up for higher tax bills in your 70s and beyond.
You are likely to owe more taxes on Social Security benefits and have to pay higher premiums for Medicare Parts B and D. Multi-year tax planning instead of year-to-year planning often shows the benefits of drawing money from tax-deferred accounts before you must. A simple strategy is to distribute enough from tax-deferred accounts to bring you to the top of your current tax bracket.
3. Invest the After-Tax Amount in a Taxable Account.
There’s a little risk you’ll pay higher lifetime taxes this way and a good likelihood they’ll be reduced. Convert traditional retirement accounts. An alternative or additional strategy is to convert part of a traditional IRA to a Roth IRA. Future distributions to you and your heirs will be tax-free. Beneficiaries don’t have to take distributions for up to ten years after inheriting them, so the balance can continue to compound tax-free for that long.
There are no RMDs for the original owner of a Roth IRA. You pay the taxes when the conversion is made, which is at a time that’s good for you, instead of after age 72 on a schedule determined by the IRS. A conversion also is a good estate planning strategy. You pay the taxes for your heirs. Otherwise, they’d have to pay taxes on distributions after inheriting a traditional IRA or 401(k).
4. Reposition the IRA.
Sometimes the way to maximize the after-tax value of a traditional retirement account for you and your heirs is to take distributions, pay the taxes and reposition the after-tax amount in a new vehicle. Permanent life insurance has a cash value account that you can tap tax-free if money is needed. But the main advantages of permanent life insurance are that the policy benefits are tax-free to your beneficiaries and the minimum amount of benefits is guaranteed by the insurer. The value doesn’t fluctuate with the stock market and might increase over time, depending on the policy you choose.
5. Give Through Qualified Charitable Distributions -- QCDs.
When you’re charitably inclined and age 70½ or older, make at least some of your charitable contributions through qualified charitable distributions (QCDs). A QCD is when money is transferred directly from a traditional IRA to a public charity (not a donor-advised fund, private foundation, charitable trust, or charitable annuity). The distribution is not included in your gross income for the year and counts toward your RMD if you need to take one. QCDs are limited to $100,000 per taxpayer per year and can be made only from traditional IRAs.
6. Make Charitable Bequests From Traditional Retirement Accounts.
When your estate plan includes charitable bequests, make them by naming charities as beneficiaries of your traditional IRA or 401(k). Don’t leave traditional retirement accounts to loved ones and give other assets to charities. Individuals who inherit traditional retirement accounts owe income taxes on distributions just as the original owner would have.
Beneficiaries inherit only the after-tax amount. But a charity is a tax-exempt entity. It owes no taxes on distributions it takes as a beneficiary of a traditional retirement account. Individuals receive bequests of other assets in your estate tax-free. In addition, when they inherit appreciated investment assets, they increase the tax basis to the fair market value on the date you passed away.
There are no capital gains taxes on the appreciation that occurred during your lifetime. Making charitable bequests by naming charities as beneficiaries of your traditional retirement accounts maximizes your family’s after-tax wealth.
7. Name a CRT as beneficiary.
Suppose you want the charity to benefit from part of your estate and want to benefit your children or other loved ones. You’re also concerned about the spending or money management practices of one or more of your children. You want some limits on their discretion over the money. With non-retirement assets, a good strategy would be to leave the assets in a trust for the children’s benefit. But trust as an IRA beneficiary creates some tax problems.
A good alternative is to name a charitable remainder trust (CRT) as a beneficiary of the IRA. The IRA is distributed to the trust, which owes no income taxes on the distribution. The trust reinvests the distribution. The CRT distributes income to its income beneficiaries (your children) for either a term of years or life, whichever you designate. They’ll owe taxes on the bulk of the income.
After the income period ends, the amount remaining in the trust goes to the charities you named. If your estate is taxable, the estate receives a charitable deduction for the present value of the amount the charity is estimated to receive.