Ideally, you’d retire tax-free, too – disinheriting Uncle Sam! Nice thought; but when you retire, investing isn’t so easy. There’s more to think about.
First, that tax-deferred retirement account has been growing for decades. At retirement, it might be quite large and at some point Uncle Sam (your business partner in life – the one that can make up the rules beyond your control) will force you to begin taking distributions, whether you need them or not. These required minimum distributions (RMDs) each year will be based on your account value. Obviously, the higher the account value, the higher the RMD.
Do you know what tax brackets will look like when you turn 70? Of course not, but given our nation’s debt (see it in real time at https://www.usdebtclock.org/) , you might be able to assume a direction (pick up or down). But, unknown taxes on your RMDs are only one factor. The size of your RMD will impact how much of your Social Security is taxable and, oh yes, the size of your RMD will also impact your Medicare premiums.
Instead of Tax-Delayed, wouldn’t Tax-Free be better?
There are two options you can use to help minimize taxes: you can either withdraw funds to complete a Roth conversion or use an over-funded permanent life insurance policy. – both will allow you to grow and access money on a tax-free basis. Each has it’s benefits worth considering.
How much to withdraw?
Our tax code is progressive. Part of your income is taxed at one rate and other portions are taxed at another. For example, you may have one portion of income taxed at 12% with money above that bracket being taxed at 22%. The highest bracket you’re in is your marginal tax bracket. Since current tax law is due to sunset at the end of next year, taxes now are ‘on sale’. It may make sense to convert whatever you can that will keep you in your current bracket; however, you will pay taxes at current rates on that withdrawal you use for conversion. Another point: make sure you can pay those taxes from other funds – paying from converted funds defeats the purpose of the conversion – you want to convert the full amount.
Other options.
There are other avenues available to mitigate taxes, but nothing is perfect for everyone. Whether they make sense for you is something you should discuss with your tax and CFP® professional.
- Donor-advised funds (DAF): You contribute charitable donations to a fund you control when distributions are made and receive the tax benefit in the year you make the contribution to the fund. Making multiple donations in a single year can provide offsetting taxable distributions from your retirement account in that same year.
- Charitable remainder trust (CRT): You contribute future charitable donations into the trust that you control when distributions are ultimately made (usually at death); however you receive the tax benefit of the donation the year you make the contribution. You can also receive income from the trust while you’re alive (within IRS limits). Again, making multiple donations in a single year can offset taable RMDs from your retirement accounts. You should talk with your estate planning attorney.
- Qualified charitable donations ( QCD): Anyone over age 70-1/2 can make a direct donation from a qualified account to a charity – this bypasses the standard deduction limits which means the donation becomes a tax-free transfer. You should talk with your tax advisor and CFP® professional.
Food for thought….
Jim
