The latest proposals to reform current tax laws have been atop the headlines for quite some time. How the rules may or may not change is yet to be determined. Furthermore, how those rules change throughout the rest of your life is highly unpredictable. Therefore, taking a tax-sensitive approach to your retirement plan could potentially reduce your tax bill by thousands. Below are a few strategies you might consider looking into.
Multiple Tax “Buckets” During Your Accumulating Years
You’ve probably heard about diversifying your investment portfolio to reduce market risk. Well, the tax environment is unpredictable over the long-term. Preparing for that uncertainty by saving in a combination of pre-tax accounts, such as a 401(k) or IRA, after-tax accounts such as a Roth 401(k) or Roth IRA, and regular investment accounts is an effective way to navigate future tax environments. Regardless of the tax rules down the road, these different tax “buckets” can be utilized to manage taxes during retirement.
Consider the Location of Your Investments
Growth-oriented investments, such as stocks, have a higher expected rate of return than income-producing investments, such as bonds. If you have an after-tax account, such as a Roth IRA, consider positioning more of your stocks in this account to maximize the tax-free growth. At the same time, it may make sense to position more of your bonds in tax-deferred accounts such as a 401(k). The interest bonds pay will not be taxable to you in the year the interest is paid since they are in a tax-sheltered account, and the lower expected rate of return may lead to lower required minimum distributions when you turn age 72. Therefore, potentially lowering your future tax bill.
Roth Conversions in Low-Income Tax Years
It is a bit counterintuitive to voluntarily pay taxes before you need to, but it may make sense to do so when your income is lower. For example, consider John and Mary who are 65 and just retired. They have built up enough cash to live on for the next two years and decide to delay collecting Social Security. They also decide to voluntarily convert a portion of their IRA (pre-tax) investments into their Roth (after-tax) IRA. By doing this in years where they have no other income, the tax bill on the conversion can be limited to the lowest tax brackets.
For individuals that are charitably inclined, donating cash or appreciated stock to a donor-advised fund can be a great strategy. Donations to this type of account provides a reduction in taxes today. The donor can make the contribution during a high-income tax year to maximize the tax benefit, and then direct the fund to distribute the amount to their selected charity in later years.
Qualified Charitable Distributions
If you are age 72 or older the IRS requires you to distribute a minimum amount from your pre-tax accounts, such as an IRA, each year. If you are charitably inclined, you can instruct your IRA provider to directly transfer all or a portion of your required minimum distribution to a charitable organization. The entire amount donated is deducted from your gross income that year.
Plan for a More Confident Financial Future
These are just a few of the many different strategies you might consider to navigate the current tax environment in an uncertain future. Not all strategies make sense for everyone and are highly contingent on your personal circumstances. If you want to talk more about how you can create and implement a tax-sensitive retirement income plan give Midwest Capital Advisors a call.
Disclosure: Please note that you are advised to consult your tax professional for your individual tax situation. This information is designed to provide general information on the subject(s) covered and is not intended to be tax advice. This information cannot be used to avoid tax penalties or provide recommendation toward any tax plan or arrangement.