Important Tax Planning Considerations
A particular retirement savings strategy has gained popularity over the last few years called the “zero-tax retirement.”
A zero-tax retirement is just what it sounds like — a retirement savings, investment and distribution strategy that means you pay no taxes when you withdraw your savings in retirement. While this may sound like a dream, it may not actually be the most tax-efficient retirement planning strategy.
Pros and cons of a zero-tax retirement
The main pro of a zero-tax retirement is obvious — every dollar you withdraw from your retirement savings falls within the zero-tax bracket and goes directly to you! Not having to pay taxes sounds like a dream, right?
But think about it for a moment: does the IRS really allow you access all those assets without paying any taxes? The answer, of course, is no. Unfortunately, it’s impossible to avoid paying taxes altogether. One thing you can control is when you pay those taxes on tax-deferred retirement accounts, not whether you pay them at all. A zero-tax retirement simply means you’ve already paid taxes on your retirement savings. There will be other forms of income in retirement on which you won’t be able to avoid paying taxes, such as taxable Social Security benefits, pensions, dividends, interest and realized gains in taxable accounts, bank account interest, rent and royalty income, etc.
Oftentimes, striving toward a zero-tax retirement ends up costing more in taxes in the long run. That’s because in order to accumulate enough tax-exempt income to last a lifetime, you must have a majority of your assets in after-tax (i.e., Roth) accounts. And in order to save in a Roth account, you must pay ordinary income taxes during the year in which you contribute to the account, and you can only contribute up to the Roth IRA or Roth 401k contribution limits — if you qualify. If your income tax rate is higher when you make the contribution than it is during retirement, you may end up paying more in taxes over the long run.
The other approach to a zero-tax retirement is to initiate Roth conversions, which is something many people do during the early years of retirement when they have a runway until receiving Social Security benefits and/or required minimum distributions (RMDs). However, doing so can lead to a huge upfront tax liability, ultimately cutting into your net retirement savings.
To gain the full benefit from initiating a large Roth conversion strategy, several variables need to go your way. Such variables include, but aren’t limited to, the following:
- Having many years in retirement
- The markets not drastically declining after completion of the Roth conversion strategy
- Having a large enough IRA to make a large Roth conversion strategy
- Having non-IRA income that’s taxed in the current tax brackets of 20%-24% or lower and/or at the capital gains/qualified dividends rate
- Having a surplus in your financial plan such that you may not need to touch the Roth IRA
- Tax laws not becoming less favorable to Roth IRAs
Instead of striving toward a zero-tax retirement, it generally makes more sense to set a goal of maximizing your after-tax wealth. After-tax wealth is the net amount of income available to invest, save or spend after federal, state and withholding taxes have been applied — it’s what you have available to spend as a consumer.1 This mindset allows you to take steps throughout your working years and in retirement to minimize your tax exposure and maximize the assets available to fund your retirement lifestyle. It also provides you with the flexibility to spread out your tax exposure and alter your approach as your life and financial situation evolve over time.
Tax-diversified savings
One important strategy for lowering your overall tax exposure is to save in a variety of retirement accounts with different tax treatments. Doing so can help reduce your taxable income today while also reducing your tax exposure in retirement.
Different types of savings vehicles are taxed in different ways:
- Tax-deferred accounts – When you contribute to a tax-deferred account, such as a traditional IRA or 401k, you do so with pre-tax funds, which lowers your taxable income during the year in which the contribution is made. You’ll later be taxed on these assets as ordinary income when you withdraw them in retirement.
- Taxable accounts – Assets held in bank accounts and nonqualified investment accounts are continually subject to taxes at either ordinary income or capital gains tax rates.
- Tax-exempt accounts – Assets contributed to tax-exempt accounts, such as Roth IRAs and 401ks, are made with after-tax funds, which means they don’t reduce your taxable income during the year in which they’re made. The benefit is that these assets can be withdrawn tax-exempt in retirement.
When you save in a variety of account types, you have the flexibility to customize your retirement withdrawal strategy as your tax planning needs evolve over time, which can help lower your tax exposure as your situation changes from year to year.
Social Security tax minimization
If your income exceeds certain thresholds, you may be subject to taxes on your Social Security benefits. To minimize your tax exposure, you may want to consider delaying your benefits for a few years. By spending other sources of income throughout your early retirement years, you may be able to lower your combined income enough to reduce the amount of Social Security subject to taxes.
Plus, for each year you delay benefits (up to age 70), you can receive an 8% increase in payments, which can help minimize the amount you need to withdraw from other sources of retirement income once you start receiving benefits.
Tax-efficient portfolio management
In addition to income tax, you may be subject to taxes on your investment gains. That’s why it’s important to take steps to improve the tax efficiency of your investment portfolio. Your wealth manager can help you implement a variety of tax-efficient portfolio management strategies, such as asset location and tax-loss harvesting.
Asset location
Asset location refers to the strategy of dividing assets among taxable and non-taxable accounts according to each asset’s tax characteristics. Essentially, asset location allocates tax-efficient investments to taxable accounts and tax-inefficient investments to tax-advantaged accounts. When implemented correctly, this strategy can help minimize portfolio taxes and enhance returns.
Tax-loss harvesting
Within an investment portfolio, investors are only taxed on net capital gains, which equals gains minus losses. This means any realized losses can be used to reduce your tax liability. Tax-loss harvesting is the process of looking for opportunities to realize losses in order to offset gains.
Tax-loss harvesting works by selling an investment that has declined in value in the short term, a common occurrence in a heavily weighted equity portfolio, and replacing the investment with a highly correlated alternative. If done correctly, your risk profile and rate of return remain unchanged, but the temporary tax losses are extracted in the transaction.
By realizing the investment loss, a tax deduction is generated that can lower your taxes. You can then reinvest your tax savings to further grow the value of your portfolio.
Example Scenario
By understanding the tax laws and having a well-coordinated comprehensive wealth management plan, taxes can become a friend and not be a large infringement on your retirement distributions. Read on for an example of how following tax planning strategies can help lower your tax exposure and maximize your after-tax wealth.
Let’s assume John and Mary, both age 60, are retired and file married filing jointly for tax year 2024. Their assets total $4.2 million and consist of a $700,000 home, a $1,200,000 taxable account, a $1,800,000 traditional IRA, a $400,000 Roth IRA and a $100,000 health savings account (HSA). They don’t yet receive Social Security benefits, they take the standard deduction and they have no other income. They have a spending goal of $190,000 per year (or $15,833 per month).
Then let’s say the taxable account is 50% invested in municipal bonds earning 4% with the other 50% invested in a tax-loss harvesting strategy with stocks yielding 2% in qualified dividends, and the account’s cost basis is about 25% of the account value with realized losses totaling $5,000. The tax-exempt income from the municipal bonds totals $24,000, and the qualified dividends from the stocks totals $12,000. They’re $154,000 short of their annual goal. John and Mary take $40,000 from the municipal bonds, $50,000 from long-term gains (LTG) stocks, $29,000 from the traditional IRA, $29,000 from the Roth IRA and $6,000 from the HSA for healthcare expenses.
The taxation works as follows:
Tax-Exempt Withdrawals ($99,000)
- $29,000 Roth IRA
- $6,000 HSA
- $24,000 municipal bond interest
- $40,000 municipal bond withdrawal
Taxable Income ($73,500)
- $29,000 traditional IRA — taxed at ordinary income tax rates
- Net $32,500 reportable long-term realized gain on sale of $50,000 LTG stocks w/basis of 25% ($37,500) at qualified dividend rate (15%) — Note: realized losses of $5,000 are taken on the sale
- $12,000 qualified stock dividends — taxed at qualified dividend rates (15%)
John and Mary have supplied $99,000 of their annual income tax-exempt. Let’s do the math on the taxes they paid. There’s $73,500 of taxable income, and we can apply the standard deduction of $29,200, leaving $44,300 of remaining taxable income — $0 at ordinary income rates, $12,000 at the qualified dividend rate and $32,500 at 15% on the $50,000 LTG stocks with a 25% cost basis ($37,500 realized gains less realized losses of $5,000 nets $32,500). According to the IRS tax rates for 2024 on $0 income, the tax bill would be 0% or $0 taxes owed. As to the $32,500 of realized LTGs and $12,000 of qualified stock dividends, their taxable income of $73,500 falls below $94,051, so the LTGs and qualified dividends aren’t taxed. So that means, in this scenario, John and Mary owe no taxes.
