You should avoid taxes in retirement. This will not be easy. You have an investment partner and he will steal from you and take advantage of you. I won’t tell you who he is, but his nickname is Uncle Sam.
Your Uncle (IRS) is your investment partner. Unfortunately, he can rewrite the rules. Your partner has the power to increase his partnership percentage whenever he wants.
Do you want the government to tell you when to withdrawal money, how much to invest, and how much to spend each year? If you enjoy that arrangement, congratulations. That describes our current tax laws.
It’s All About Putting Money In
When starting out we are optimistic and naive. We pile our money into tax-friendly accounts. We tend to not consider how and when we will remove the money. That will all take care of itself in the future.
IRAs are common. Your employer likely encouraged you to take part in a 401k, 403b, and/or 457b. Contribute automatically. Payroll can send it to them before you even see your paycheck. Your employer may even contribute some also as a pension plan or matching fund.
Avoid Taxes Now
You also get a tax deduction. Every dollar you contribute to your retirement fund reduces your taxable income. Since you “make less” as reflected in a lower gross income, you will pay less tax. Your state and federal taxes are based on your income after this deduction.
Avoid Taxes & Hassles
There is even better news. The money in those tax-advantaged funds will grow and grow over years or decades. You can buy and sell anything in them whenever you want without it being a “taxable event.” No paperwork. No taxes due.
Isn’t this all a dream come true? What could ever be a downside?
Back to Reality
What is pleasant on the front end isn’t as pleasant on the back end. Uncle Sam will allow your tax-free growth, but he then gets impatient and wants his slice of the action. Tax-deferred does not equal tax-free, even though they sound similar.
Uncle Sam Wants Your Money
When does he get impatient? When you are “old enough” – per the government – to start withdrawing a large amount of your savings every year. That amount is your RMD. Required Minimum Distribution. It kicks in at age 70 ½.
This applies to your 401(k), 403(b), as well as your traditional IRA. If you aren’t expecting this, it can be quite a wakeup call.
Avoid Taxes on Unneeded Money
When I mention “RMD” to my peers or younger investors I see blank stares and confused looks. Almost no one even knows about it.
When I say that to my in-laws or other people in their seventies, I get groans and eye-rolls. They are very well aware of it. For them, it means a complex and everchanging annual calculation. It means fears of penalties for not doing it right. It means paying tax on money they don’t want or need at the time.
Not Too Much or Too Little
You must remove just the right amount of money from your tax-deferred accounts each year. If you take out too much your social security will be taxed at a higher rate. If you don’t take out enough, you will pay a stiff penalty to the IRS.
Run the Math with Care
If you are doing your own investments, you will need to figure out how much to withdrawal. If you work with a broker or mutual fund, they will do it for you. Either way, the income will be taxable and may bump you up to a higher marginal tax rate.
For example, a 90-year-old with $1.7M would have an RMD in 2019 of $149K putting him into the 24% tax bracket. If you fail to withdrawal the money, they will take half. Yes, the fine is 50%!
Pay if you do, pay if you don’t. Your choice.
Prepare While You Are Young
This is good to know about even if you are nowhere near 70 years old. If retiring early you may want to start some early withdrawals while you are in a lower tax bracket. It is worth modeling tax scenarios with different withdrawal schedules.
The Roth IRA Advantage
Roth IRAs are a great investment option. Although you won’t get a tax deduction when contributing, you avoid taxes when removing the money later. The latter factor becomes more important as we reach our “retirement” years. To some extent, this is a bet on our own future. Will tax rates be higher in the future? Will our incomes be higher?
The United States is Broke
There are a lot of unknowns about our nation’s future. But we do know that Uncle Sam is destitute. We shifted from a creditor to a debtor nation in 1985. It didn’t take us long to become the world’s largest debtor nation.
Our financial situation hasn’t improved since then. Both democratic and republican administrations have since worsened the situation. I see no end in sight. There is not an easy, quick fix to this fiscal disaster.
I’m A Fortuneteller
My crystal ball tells me tax rates will be higher in the future. The U.S. owes 122 trillion dollars of unfunded liabilities. Not to mention the growing national debt and annual federal budget deficits. Our day of reckoning is coming. The rich will be the only ones able to pay more of their “fair share.”
We all feel we pay too much income tax. In reality, the marginal tax rates are currently at historic lows.
The top tax bracket in 2019 is 37% and that kicks in (for married couples) only for income above $612K. The top federal tax rate was 70% when I was little. When my father was in high school the top bracket was 90%.
Pay Less on Less Now
Based on my prediction of higher taxes I love the Roth IRA option. I expect to invest and grow the funds over time. It is better to pay now on this smaller amount rather than later on a bigger portfolio.
Does that make sense? 30% tax now on 100K is better than a 30% tax later on 500K, right? But again, I don’t think tax rates will be the same or less. They will be higher. If tax rates increase even a percent or two in the future, the Roth bet will win big.
Leave My Backdoor Out of This
For higher income professionals we cannot contribute to a Roth IRA. It used to be that only resident physicians made so little money that they could take part in Roth IRAs at all. After 2010 we can now “convert” money into a Roth IRA. We can convert all our traditional or rollover IRA money into a Roth IRA. I did that in 2011.
We can also make ongoing contributions to a non-deductible IRA up to the maximum allowed by the IRS. In 2019 that amount is $6k per year for those under age 50, $7K for their elders.
We can then “convert” those funds into a Roth IRA no matter how high our income is. You may have heard of a “backdoor Roth IRA.” That is when you add to an IRA and then convert it to a Roth.
Avoid the RMD
There is another benefit to a Roth IRA. Roth accounts are not subject to RMD. Contributing or converting to a Roth may cost you some tax money now. But it makes sense to avoid RMD requirements and tax later. I’m thankful to JL Collins for explaining RMD in his excellent book, The Simple Path to Wealth.
Employer-Sponsored Roth Option
Some companies offer a Roth 401k. That won’t provide you with a tax deduction today but will help your future tax situation. They work a lot like a regular 401K. You won’t have to worry about making too much money to contribute to it. Route money from each paycheck to the fund. The maximum is the same as a traditional 401K.
In 2019 that amount is $19k per year for those under age 50, $25K for their elders. These after-tax dollars will grow tax-free. Later you can remove the funds tax-free.
Consider whether it makes sense for you. It is a similar decision-making process to the Roth IRA decision.
Avoid the Roth 401K RMD
The Roth 401K is subject to RMD. That is odd because the alleged reason for RMDs is the IRS wants its share of taxes due. You can’t avoid withdrawals on tax-deferred accounts forever. RMD for Roth funds makes no sense. But then again it is a government program. I guess a little nonsense should be expected.
The good news is rolling it into a Roth IRA is not a taxable event. So, I plan to roll all my Roth 401k money into my Roth IRA in the future to avoid the required distributions.
Investing outside of retirement accounts isn’t a bad option for most of us. You won’t get a tax deduction for the contribution. But there are fewer restrictions about what you do with the money. There won’t be any penalties for “early withdrawal.” There are no RMDs for taxable accounts.
Get your financial house in order. Invest in retirement accounts. You can put only so much into a retirement fund each year. You may find money left over. Those funds can go to taxable accounts.
Cut Your Tax Bill
Be aware that interest, dividends, and capital gains may increase your annual tax bill. There are ways to avoid taxes. Long-term capital gains are taxed at a rate much lower than ordinary income. So waiting until the gain from the sale is considered “long-term” will help. Investing in broad-based index funds will reduce the fund turnover or “phantom income.”
Choose Investments Wisely
Investing in municipal bonds, I-bonds, or tax-advantaged funds reduce your taxes. You may still need to pay state income tax and capital gains tax on any municipal bond fund appreciation. Avoid buying high-yield corporate bonds, TIPS, or REITs in these taxable accounts.
Become a Landlord
The IRS offers many favorable laws that help real estate investors. Rental income and appreciation taxes are lower than other investment or work income. If you sell a property at a significant gain you can still avoid paying taxes. Use a “1031 exchange” to buy another similar property.
Asset Allocation in Taxable Accounts
It is best to reallocate by adding new funds to the lower component rather than sell. For example, if you want to be 50% stocks and 50% bonds and stocks have risen.
You may end up being 60% stocks, 40% bonds. Reallocate buy adding new contributions to the bond funds. There will be no taxable gain.
Also, take advantage of “tax loss harvesting.” If you have a loss of capital (e.g. after a market correction) you can “realize” that loss. Selling after the loss helps you avoid taxes on portfolio gains.
Start an HSA
An increasing number of American workers have a high deductible health plan. There are some downsides to that, for sure. One of the upsides though is eligibility to contribute to an HSA (Health Savings Account).
The idea is to encourage workers to save for their own medical costs. The unused money will grow tax-free and can be spent on medical bills later. You can avoid taxes and get your medical bills paid. This should make health “consumers” more price-conscious. A price-sensitive population will slow the growth of medical expenses.
HSA is a Retirement Fund
Medical costs aside, you should still consider this account. There is a loophole that makes HSAs enticing. You are not required to pay your medical bills with your HSA. You can use the money as a retirement account.
Every year you can contribute thousands of dollars ($7K for a family in 2019). The contribution is pre-tax (tax deductible), unlike Roth IRA contributions. When you withdraw the money for medical expenses you avoid taxes. Thus, it has tax free growth and withdrawal like a Roth but a tax deduction on the way in like a traditional IRA.
It has the best of both worlds, which is why this is worth taking advantage of if you are eligible.
Record Medical Now and Pay Later
There are lots of other great features. You can pay your medical bills with other funds and save your medical receipts. Your HSA money then grows tax-free. Later you can submit the receipts for reimbursement. You will avoid taxes and penalties.
Wait and Don’t Use for Medical
What if you are healthy and plan to stay that way? Well then wait until age 65 and then use it for any non-medical purpose you like. Penalty-free!
If you die, your spouse will inherit it with the same rules in place. Dependents would inherit the money with no penalty. You can invest in any funds you like – even index funds like VTSAX. Sweet, eh?
Many of the tools I outlined here can be combined. Municipal bonds, stock index funds, Roth IRAs, Roth 401k, real estate, and an HSA can all help you avoid taxes. How do you plan to avoid taxes on your retirement income? What did I miss? Other tips to share?
I am grateful to Mr. Collins for explaining much of this in his excellent book, The Simple Path to Wealth.