Strategize With Clients To Avoid A Nasty Tax Surprise In Retirement

Kiplinger's Personal Finance Magazine Oct 17, 2018

Americans worry a lot about saving enough money for a long and happy retirement. What they don't seem to spend as much time figuring out is how to keep more of what they have managed to save while working so hard.

Here are a few tips on helping your clients prepare for retirement free of crushing tax surprises.

No one can prepare for every expense that might crop up in what could be a 20-, 30- or even 40-year retirement. No matter the timeline, you can always plan for taxes ... and should. Whether your savings are mighty or meager, Uncle Sam is going to want his share and will take as much as you're willing to hand over, so it's up to you to be sure the amount is fair.

To do that, you'll have to think beyond the basics -- beyond today and your tax-deferred IRA or 401(k). Your goal should be to get yourself into the lowest tax bracket possible every year in retirement. That means divvying up your nest egg into different tax "buckets":

The taxable bucket

This includes the investments and savings you pay taxes on upfront and annually on the growth, including your bank accounts, non-qualified brokerage accounts, certificates of deposit, interest on bonds, etc.

The tax-deferred bucket

This holds your IRA and 401(k) accounts. You don't pay taxes when you deposit the money or while the money is growing. However, you will pay taxes on 100% of the money you withdraw from this bucket. Once you turn 70½, you are forced to withdraw according to an IRS calculation through RMDs (required minimum distributions), whether you need the money or not.

You will pay taxes according to your tax rate at the time of withdrawal. This could be a higher rate in the future, meaning you could pay more in taxes than you saved when you initially deposited the funds. Therefore, if you're highly invested in this bucket, you'll have more taxable income on your 1040, which could push you into a higher tax bracket in retirement and cause your Social Security to be taxed accordingly.

The tax-free bucket

This includes Roth IRAs and Roth 401(k)s, along with specially designed life insurance policies and municipal bonds, where you pay the taxes upfront and accumulate the growth tax-free. For older savers who have contributed for years to the popular workplace 401(k), getting those buckets balanced usually includes converting some tax-deferred dollars into a Roth, which has tax-free earnings and withdrawals.

One client's tax-saving strategy

Other strategies can further diversify your income streams and add even more tax efficiency to your retirement plan. Here's how one of my clients recently cut her future tax bill down to size:

Michelle is in her mid-50s and plans to retire at 65. At that time, she'll turn on three income streams: an $18,000-per-year pension benefit, a $30,000-per-year Social Security benefit, and $32,000 from an overfunded permanent life insurance policy. (She'll do the latter through a strategy known as max funding, which allows the owner to withdraw the policy's excess cash tax-free through loans that will be repaid with the owner's death benefit.)

That's $80,000 in income -- but her adjusted gross income will only be $33,000 ($18,000 + half of her Social Security benefit). Assuming a standard deduction of $12,000, that leaves $21,000 of her $33,000 that will be taxed.

She also has a 401(k), which should be worth about $800,000 when she retires. She doesn't need the income, but if she does, she should have a bit of a cushion before she hits the next tax bracket. She also can work on converting some of that money to a Roth account before she's hit with required minimum distributions at age 70½.

The bottom line

Michelle's money should last much longer than it would if it were all being taxed. She'd be taking out at least another $10,000 to $12,000 a year to get to the same net amount -- the amount she's decided she needs to live the lifestyle she wants in retirement.

Tax-deferred investment accounts can be a beautiful thing for savers. But they're not the only way to go. The earlier you start, the easier it will be to find the balance you need with those three tax buckets.

Do your homework and preserve every dollar you can. The next time you meet with your CPA or financial adviser, talk about strategies that could help you avoid a nest-egg-nibbling tax burden in retirement.

Kim Franke-Folstad contributed to this article.

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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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