For many people, reducing taxes is the easiest and fastest way to increase investment returns, keep a retirement plan back on track, beat inflation and enhance overall retirement security.
Retirees and pre-retirees often leave a lot of money on the table for the IRS to collect 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. The mortgage comes due 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.
“The prime beneficiaries of such strategies are those with significant
balances in traditional IRAs or 401(k)s.”
1. Challenge the Maximize Tax Deferral 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 TCJA tax law reduced 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 primary one being the dramatic increase in the federal debt and annual deficits in the last few years.
Social Security and Medicare are facing solvency concerns. 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 the 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 at age 73 or 75.
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 today’s relatively low rates instead of leaving your accounts as targets for Congress and the Stealth Taxes.
2. Reduce Future Required Minimum Distributions (RMDs)
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 (IRMAA). 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 or convert 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 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 10 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 performed, which is at a time that’s good for you, instead of after attaining RMD age 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. 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.
5. 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 really inherit only the after-tax amount. But a charity is a tax-exempt entity. It owes no taxes on distributions it takes as 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.
6. Name a Charitable Remainder Trust (CRT) as Beneficiary
Suppose you want 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 a trust as IRA beneficiary creates some tax problems.
An alternative to consider is to name a charitable remainder trust (CRT) as 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 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.
Paul Staib | Certified Financial Planner (CFP®), MBA, RICP®
Paul Staib, Certified Financial Planner (CFP®), RICP®, is an independent Flat Fee-Only financial planner. Staib Financial Planning, LLC provides comprehensive financial planning, retirement planning, and investment management services to help clients in all financial situations achieve their personal financial goals. Staib Financial Planning, LLC serves clients as a fiduciary and never earns a commission of any kind. Our offices are located in the south Denver metro area, enabling us to conveniently serve clients in Highlands Ranch, Littleton, Lone Tree, Aurora, Parker, Denver Tech Center, Centennial, Castle Pines and surrounding communities. We also offer our services virtually.
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