Plenty of retirements these days are built in large part by stashing away money week by week into tax-deferred accounts, such as traditional IRAs or 401(k)s, among other options.
And certainly, such accounts can provide a wonderful feeling of confidence, as well as a sense of anticipation, as you watch your money grow and count down the years until retirement.
But be warned: There could be an unwelcome surprise at the end of your retirement-planning rainbow. Don't forget that "deferred" is the key word in the phrase "tax-deferred account." You didn't pay any income tax on the money you deposited in those accounts over the years, so rest assured that when you start drawing the money out to live on in retirement, you will be required to pay taxes on money withdrawn.
In fact, the government is so determined to get those taxes you delayed paying that when you reach 70½ you're required to withdraw a minimum amount -- called required minimum distributions, or RMDs -- whether you need to or not, and whether you want to or not.
For so many people, the federal income tax in that scenario is a sleeping bear; it wakes up when we get into our 70s, and it growls loudly. At many of the workshops I conduct, people ask about the best ways to deal with this lurking tax menace. Here are some tips:
Stop making the problem worse.
Many people contribute to retirement accounts through a 401(k) with their employers. Those are tax-deferred accounts, but these days, some companies offer a Roth 401(k) option. With a Roth account, you aren't deferring your taxes, which means you can withdraw the money tax free in retirement. For most people, the Roth option is the way to go.
If you don't have a Roth option at work, you might want to consider opening a Roth IRA "at home," or a non-retirement account that would still let you save money but would give you a more favorable tax treatment.
Convert from tax-deferred to tax-free.
Instead of waiting until retirement, now may be a good time to move your money out of those tax-deferred accounts and into something that won't be taxed when you do retire. Sure, you'll pay taxes as you make that conversion, but there's a good reason to pay the taxes now rather than later. The federal income tax changes that took effect in 2018 are set to expire after 2025, so you have a short window of opportunity to make these conversions at a lower tax rate.
You might say: "But what if they extend the tax cuts?" Not likely. It took Congress 31 years to pass the Tax Cuts & Jobs Act of 2017. Also, with the changeover in U.S. House leadership, Washington is no longer a friendly environment for tax cuts past 2025.
Some things to keep in mind when considering a Roth conversion:
- First, you may not want to convert everything to a Roth all in one tax year, because this could potentially put you in a higher income tax bracket.
- Something a lot of high earners may not know is that there is no income limitation keeping you from converting from traditional to Roth.
- Another is that you can convert at any age, without penalty.
- Roths don't generate any taxes in retirement; they don't generate any RMDs; they don't cause your Social Security to be taxed; and they're great to leave to your heirs.
- But converting from traditional to Roth doesn't eliminate stock market risk.
Convert from tax-deferred to tax-free municipal bonds.
Tax-free municipal bonds are issued by your state, or a unit of government within your state. You're lending money to your state government, or your county, your town, etc. When purchased from your state, or within your state, the income you receive is "triple tax-free" (free of federal, state and local taxes).
Three concerns: As interest rates rise, the market value of your bonds falls, so this may be a risky option, should the Fed raise rates. And, if you live in a state where the government's finances may not be on solid footing, you could lose the value of your bonds in the case of a bankruptcy (e.g., Detroit's 2013 bankruptcy). Also, tax-free interest is one consideration the IRS uses to calculate how much federal income tax you pay on your Social Security benefits.
Considering these three concerns, I would steer clear of this option.
Convert from tax-deferred to tax-free life insurance, such as Indexed Universal Life (IUL).
An indexed universal life policy is a type of permanent life insurance. With IUL, you don't lose money in a market downturn, but you can lock in annual gains tied to a market index. This can work even better than a Roth conversion for a number of reasons.
First, you get protection from a market downturn. Second, there's an income tax-free death benefit in excess of the balance of your cash value account. Third, you can participate in the good years of the stock market through indexing, locking in your gains annually, so that you never give those gains back in a market correction. Fourth, you may be able to accelerate the death benefit to help pay for the costs of long-term care if you need it. Some policies offer a long-term care rider. However, in many cases these riders aren't truly necessary, as you could just use tax-free policy loans to access the money needed to help pay-for your long-term care. Fifth, life insurance doesn't generate RMDs, or any taxes on income through the use of policy loans, which keeps the IRS from further taxing your Social Security benefits.
It's important to remember that most life insurance policies are subject to medical underwriting, and in some cases, financial underwriting, and the costs of a life insurance policy, including premiums and cost of insurance charges, are dependent on your age and health at the time of application. We walk through these details with each client, and help them to make the decision as to whether or not this approach makes sense in their overall tax-planning.
Final thoughts about your legacy.
There's also another factor in all this that you shouldn't overlook: your family and your legacy. When we die, most of us hope to leave something behind for our loved ones, but the worst thing to leave your heirs is a tax-deferred account, like a 401(k) or IRA. They would actually have to pay income taxes on it. We can leave behind tax-differed money, or tax-free money. Which would you rather leave your heirs?
For example, if you leave a traditional IRA to your kids, they are forced to take the RMDs -- the required minimum distributions -- and the additional taxable income can move them up in tax bracket.
If your retirement plan has been built largely with deferred-tax accounts, now is the time to start contemplating a tax-efficient conversion to tax-free, keep more money for you, and less for Uncle Sam, in your golden years.
See Also: If You Hate RMDs, You Might Love QLACs
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Dan Dunkin contributed to this article.
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