If you’re a functional adult and working for a living, taxes are always somewhere in the background of your financial well being. We don’t have to like it, but it’s a fact of life for most of us living today in America.
At some point, you’ll stop working for money and money will start working for you. In other words, at some point the money needed to pay your bills will come from earnings you saved in years past and/or from work credits like Social Security.
To some extent, you’ll still have taxes to pay. So let’s talk about ways to minimize those taxes. To the extent you can do this, it either leaves more on the table for you to spend, or allows you to shrink the amount needed to pay your other bills.
As we age through adulthood, we increasingly worry about saving enough money for retirement. We’re mindful it could easily become a 25 to 35 year journey into an uncertain financial future. The target age for retirement planning is increasingly age 100. As the years rolled by and retirement becomes a reality, how much time did you spend focused on paying fewer taxes?
The elephant in the room is the Internal Revenue Service (IRS) whose job it is to collect money from us so the government can pay it’s bills. But it’s not their job to tell us how to send them less money. That responsibility belongs to us.
And just to be clear, many of us are also confronted by state income taxes, sales taxes, property taxes and there are more that may or may not surface and interfere with your financial freedom. It’s up to us to figure this out.
For most of us, the IRS offers an opportunity to set aside money from current earnings and not have it taxed as income until later. The generic mechanisms for doing this are called tax-deferred accounts or before-tax accounts. Most of us know these as 401(k) plans, 403(b) plans and IRAs. Then there are Health Savings Accounts (HSA) and other hybrid solutions.
The idea behind these is to incentivize people to set aside money now to be used later. Typically, the money remains before-tax money until you take a distribution which then becomes a taxable event. If we’re now in a lower tax bracket, we’ve gained an advantage.
In contrast with before-tax alternatives, there are also opportunities for after-tax money. If you earned $1000 and have already paid, lets say $250 in income taxes, you now have $750 of after-tax money. Most of us reaching retirement have most of our retirement nest egg money in before-tax buckets. That may prove to be an expensive alternative once retirement arrives.
One of the newer approaches to making sure you have enough money coming is once you retire is to shift the focus from investment planning to income planning. The common goal before retirement is to grow your buckets of money so that at retirement your buckets are as full as possible. More money always seems to be a better outcome than less money.
Income planning involves transitioning your traditional investment allocation with before-tax dollars to make the resulting income stream more favorable from a tax perspective. To the extent you’ve used this approach long before the work/don’t work day arrives, your retirement days may be better days.
The IRS has long had what are known as ROTH IRAs. They also have a flavor called ROTH 401(k)s but that for another time. These accounts allow you to set aside after-tax money where it will grow tax-free and can be withdrawn tax-free. Established early, the after-tax income opportunities can be significant. Don’t forget to use HSAs if you are eligible.
Now comes an interesting point. Once you start drawing Social Security retirement benefits, some of that “income” is subject to income taxes. How much is largely a function of how much earned income you have to go along with it. Money withdrawn from before-tax accounts, the 401(k) like accounts and IRAs is treated as earned income. Money withdrawn from ROTH IRA accounts is not treated as earned income for purposes of treating Social Security benefits as taxable.
In the overall scheme of things, and the uncertainties of life in retirement, nothing should be left off the table when it comes to planning for retirement income with fewer taxes to pay.
Tony Kendzior, CLU, ChFC \ April 29, 2020