Retirement Planning: 3 Strategies to Reduce Your Retirement Taxes and Save $70K

Casey Weade: You're looking for the most tax-efficient way to save for retirement to generate as tax-efficient of income as you can in retirement. That's what we're going to talk about today. We're going to be talking about the different places that you can possibly save those hard-earned dollars. Then we're going to take an example of someone that's saving a pretty substantial amount of money, and how we implemented three strategies to help them save even more in taxes in retirement.

This whole discussion starts in one place. That is understanding what we like to refer to as your tax buckets. We want to understand all the different places that you can possibly save and how all those different places are taxed. This is one of the things that we'll walk through almost every single person that comes into our office through. Talking through these different tax buckets helps us set the foundational understanding of where we can possibly save, the different pros and cons of each one of these different places.

There really are only four different buckets when it comes to how we can save for retirement. Now, there's some nuances that we want to talk through in each one of these buckets. However, we're just trying to get a high-level conceptual understanding of how we can most efficiently save, to save money on taxes today, but most importantly, for the rest of our lives.

We have four different buckets. That first bucket is our taxable bucket. Then we have our tax-deferred bucket. Our tax-free bucket. Then our income tax-free and estate tax-free bucket. We want to start all the way over here to the left. Typically, the more money that you have, the more you'll feel a push to push more of those dollars further over here to the right, especially to that estate tax-free bucket.

Let's start with the taxable bucket. This is probably the most nuanced of all of these different buckets. In that taxable bucket, sometimes it's referred to as the 1099 bucket, or what I like to refer to as the I'm-telling-on-you bucket, because every year, you'll get a 1099 for the investments that you have in this world. That could be things typically you would think of as stocks or bonds or mutual funds inside of a brokerage account, maybe held individually. Every single year, you get a 1099, and you have to pay typically some degree of taxes on your dividends, maybe on your interest, or your capital gains. These things are taxed whether you spend them or not.

The important thing here, one of the things we're trying to do is something I always heard from Warren Buffett, and that was never spend money on money you're not spending. This particular couple we're looking at here, they have a pretty good chunk of change over here in this taxable bucket, about $400,000, not including their primary residence. This is just their savings vehicles here, and they're getting those 1099s every year. They want to see how they can move more money over here to the right.

Where I start talking about the nuances of this bucket, is one easy stop is to talk about stocks and mutual funds and bonds, for that matter. If you think about these as typically capital assets, so all of these real estate stocks and mutual funds being capital assets, upon death, there's a step-up in basis to your heirs. Now, you want to check the laws in your individual state to see how that step-up in basis works, but that can mean this is a pretty tax-efficient place to save money if your goal is to leave it behind to the next generation.

You can also invest in worlds here, such as mutual funds, where you can have very tax-inefficient vehicles, kicking out a lot of short-term gains or even kicking out gains on money when you didn't even make a gain for yourself. When we look at this world, it's important for us to understand these nuances, especially when it comes to dividends, then, too, right? When it comes to dividends, we have qualified dividends, we have non-qualified dividends. Non-qualified dividends are going to be taxed like your short-term capital gains, ordinary income, and then you have qualified dividends, which are going to be taxed at more preferential rates, which are your long-term capital gains rates.

When it comes to stocks or some of these capital assets, if we hold them for longer than a year, then we're going to get taxed at that long-term capital gain rate, which could even be a 0% tax rate. If your income's low enough, it might not be taxed at all, or it might be taxed at 15%, or it might be taxed at 20%. Maybe we include some Medicare surtax, maximum being 23.8%. That's where I say it's nuanced, and you can also talk about real estate. Of course, you own real estate, you have capital depreciation, you're depreciating that asset. If you never sell it, pass it on to your heirs, it may end up being a tax-free asset.

Some of these, if structured appropriately and built into the plan most appropriately for your unique situation, they may end up being tax-free altogether. Unless you have a substantial amount of assets, tens of millions of dollars, then they're probably going to be estate tax-free as well. This is where it's important to sit down and work with a financial planner that has comprehensive tax knowledge and can really understand all of these nuances and how they apply to your unique situation, which may be a lot different than the couple that we're going to be looking at here today.

Now, let's take a look at this next bucket. This next bucket is our tax-deferred bucket, and this is one that we're all familiar with. It's going to be one of the oldest that you're used to using outside of maybe saving in some brokerage accounts and money markets and CDs and things like that. Most of us think of this as our IRAs or 401(k)s. Those IRAs, your defined contribution plans, as I've written up here, because defined contribution plans encompass your 401(k), 403(b), 457 plans. Your IRAs could be SEP-IRAs, could be simple IRAs. There's a lot of different saving limits when it comes to each one of those different savings vehicles.

If we look at a SEP or a simple, those are going to have different savings limits than we're going to see with a 401(k) or an IRA for that matter. Those are the vehicles that have been created for us by the government to allow us to save today, saving money on taxes today by taking a tax deduction. Then those assets growing into the future, where at some point in the future, we start taking those assets out or in the case of IRAs, tax-deferred retirement accounts like 401(k)s. Eventually, we're forced to take those distributions in the way of required minimum distributions.

All tax at ordinary income. That's one of the big downfalls of tax-deferred savings vehicles. which is why, honestly, I would prefer that we're saving either in a taxable account very efficiently or we're saving in a tax-free way, which is what we're going to be doing with this particular couple. In addition, in this world, you'll find vehicles like annuities. Annuities will allow you to put dollars into them, but you don't get a tax deduction. It's taxed much like you would find an IRA.

If we take dollars and we put it into an annuity, we're not going to be taxed on our gains year after year, but eventually, when we take the money out, it's going to be taxed. It's going to be taxed as what is known as LIFO. That is last in, first out. Whatever the gains were in there, those are going to come out first. If you put $100,000 in and it grew to $200,000 and you take a distribution of $10,000, it's all taxable. It's because those gains come out first.

Now, with annuities, you do have, again, a little nuance there. You have the ability to do what's called annuitization. You can annuitize the dollars that you have in that account. In that example, it went from $100,000 to $200,000, $100,000 is your cost basis. Now, you could annuitize that over a 10-year period, and you're going to get, say, 20,000-year-plus interest. Maybe you're getting $25,000 a year. At that point, it's going to spread out all of those gains equally over that period of time, reducing the overall taxable, increasing tax efficiency. That is our tax-deferred world here, annuities, IRAs, defined contribution plans.

Then we move further to the right, and we want to keep moving to the right. We all love the world of tax-free. When it comes to the world of tax-free, the first thing that probably comes to your mind is a Roth IRA. We have Roth IRAs, or today we have widespread usage of Roth 401(k)s, which has been a huge boon to retirees and savers over the last decade, is now most people have the opportunity to save those dollars on a tax-free basis.

Now, there's a catch there. You have to pay the taxes today. If it's going into a Roth IRA or a Roth 401(k), you're going to be paying the taxes today, locking in that tax rate and funding an account that doesn't have required minimum distributions and is now going to grow tax-free, and when you take it out, it's going to be tax-free as well. Those are your Roth IRAs. Those are those defined contribution plans where you have access to a Roth.

Another vehicle that falls under the same tax code as Roth IRA is life insurance. Properly structured, we know, of course, life insurance death benefits are tax-free, but the cash value that accumulates inside of those policies, whole life policies, variable universal life, index universal life. All of those cash values are growing tax-free if you take loans from those policies. Some call this the be-your-own-banker concept. For instance, you would take a loan from that policy and use it for income and allow it to continue to credit interest inside the policy.

Also, life insurance is going to be taxed differently than annuities. It's not going to be LIFO. It's going to be FIFO, and that is instead of last in, first out, it's first in, first out. If you save $100,000 in that life insurance policy, it grows to $200,000, and then you take out $20,000. It's going to be tax-free because it's going to be treated as a return of basis. Maybe you want to take out that basis and then start taking loans. There's a lot of ways that you can use life insurance for tax-free income, but it's very important that these policies are structured appropriately to minimize the cost to the individual as much as possible.

In addition to that tax-free world, we have 529 plans and HSAs. In your 529 plans, you're going to be putting those dollars in, and it's very state-dependent on what the tax benefits are going to be. In the state of Indiana, for instance, it's a tax credit. In some states, it's tax deduction. When you put those dollars in, you might have some tax benefits on the front end. Some states don't have those same tax benefits on the front end, but they allow those assets to grow tax-deferred. As long as they're used for educational purposes, they'll come back tax-free to the individual that's taking those distributions.

Then you have health savings accounts or HSAs. These are the triple tax-free happy land that is another nuance here. When you put money in your HSA, you're going to receive a tax deduction just like you would if you put money in an IRA. When you take money out of that account, it's growing tax-deferred, and then when you take it out, as long as you use it for qualified health expenses, then it's also going to be tax-free. It's getting a tax deduction on the front end, growing tax-free, and then distributed tax-free as well.

If you end up not using it for health care expenses, then you could face a penalty if you're younger than 65, but after 65, you can use it much like you would a traditional IRA. You just have to pay ordinary income taxes on those dollars. There's also the ability for us to consider doing some transfers or one-time transfers of an IRA over to an HSA. These are all things that we want to consider as we're building out that tax-efficient retirement income strategy and tax-efficient strategy for you saving for retirement.

Then we go all the way over to the right. All the way over to the right, we have estate tax-free. Now some states, state by state, you might have a state inheritance tax, and that's different than our federal estate tax. You have to pay attention to the individual laws inside of your state to know if you're going to have a state inheritance tax, and those levels are usually substantially lower. If you have a state inheritance tax, it's substantially lower typically than what you would see in the federal estate tax level. Typically we don't need to worry about this until we get over $10 million in investable assets or net worth for that matter.

At that stage, then we have to start looking at different type of trust structures in order to minimize any estate taxes. These are a lot of acronyms. You have your CRITs and CRATs and CRUTs. You have your ILETS. These vehicles up here are charitable remainder trusts. Those charitable remainder trusts, you put the dollars in, you get a tax deduction when you put those dollars in that account, and you get income for the rest of your life or a period of time. You're getting income back from that trust. You're getting a tax deduction for the remainder interest. What the federal government expects to be left in that trust, it's going to pass on to charity.

Now, the income that you get from that CRIT, CRAT, or CRUT could be tax-free, it could be taxable, depending on how it's invested inside of that trust. The tax deduction may mitigate or even eliminate the ongoing taxes from the income you're getting from that trust, but it's going to be estate tax-free. An ILET is an irrevocable life insurance trust. If we are trying to get dollars outside of the estate, we may want to find an irrevocable life insurance trust, or an irrevocable trust for that matter, that gets those dollars outside the estate. Then the death benefit or whatever is in those irrevocable trusts passes on to heirs without having to worry about getting hit with an estate tax.

Let's take a look at this individual situation. We have a pretty high income earner. That high income earner is currently saving about $40,000 a year in this taxable bucket, doing so in traditional brokerage accounts. They're really only doing that because they couldn't find any other place to save on a tax-efficient basis. They just felt they were making too much to contribute to a Roth, and they were unaware of some of the other opportunities that they had. All of their tax-deferred savings was going right here into their 401(k).

Now, they are over the age of 55, so this couple is nearing 60. Given that they're nearing that age, they're able to contribute on a catch-up basis. Not only are they contributing their $23,000 a year, they're also getting a catch-up contribution of $7,500 a year in 2024. Those contribution limits are going to change every year, so you want to pay attention to make sure you're maxing those things out year after year.

What were they saving? $40,000 here, $30,500 here, saving a total of $70,500. They wanted to evaluate what are some other options that we could leverage in order to move more of that savings to the right. One of these things that's very, very important is creating some tax diversification. There's nothing really inherently wrong with any one of these individual buckets. As we talked about, the taxable bucket may be the perfect vehicle. Tax-deferred bucket may be the perfect vehicle, depending on your tax situation. The tax-free bucket. The estate tax-free bucket. It really depends on the individual here.

Let's look at what we did for this couple to move this $40,000 over to here. Not that we're going to move anything else, which we could. We could start moving all of these chunks further down to the right, but what they really wanted to do is create tax flexibility through tax diversification. Giving them more options on how to create that retirement income. Giving them the ability to blend different sources to meet different thresholds in retirement to maximize their after-tax income, because that's what it's all about. Most of the time you hear people talking about the gross return or gross income. At the end of the day, it's all about the net.

Now we're taking a look at where they're moving some of those dollars. The first stop was they had a Roth option inside their 401(k) that they just forgot about and they said, oh, I forgot that we had that. We ended up moving those 401(k) dollars they were putting in the tax-deferred portion of their 401(k), over to the Roth side of their 401(k). $30,500 just moved from that tax-deferred bucket over to the tax-free bucket.

They also had access to a high-deductible plan for health insurance, which with that access to the high-deductible plan, it also gave them access to a health savings account, that HSA. With that HSA, they are contributing $8,300 as the max family contribution, plus another $1,000 catch-up contribution because of their age, giving them an additional $9,300. That's giving them a tax deduction today on $9,300. It's growing tax-free. It's going to come back to them tax-free as well.

Then we have our backdoor Roth. This is one that I find that a lot of high-income earners are just unaware of. It hasn't been introduced to them, they say. In this case, they say, well, we can't contribute any more to a Roth because we're just making too much money. If you're over those income limits, there are ways that you can still get money into a Roth IRA via something called a backdoor Roth IRA. What we do here is we take those dollars, take that contribution of $8,000, move it into a non-deductible IRA, because regardless of your income, you can always contribute to a non-deductible IRA. There isn't a tax deduction, just like there isn't a tax deduction when you put money into a Roth.

Then, we can take the dollars in that non-deductible IRA, immediately convert them over to a Roth IRA. Now, we took a high-income earner that didn't think they can contribute to a Roth IRA, and we got that same amount of money over into that Roth IRA. This couple, what I also often find is something that happened here, where they didn't realize that she could be contributing because she wasn't working. She wasn't working. They didn't feel she could contribute. The reality is she could contribute because he was working, and that's all based on his earnings record, so she was able to also contribute.

We took $8,000 going into a backdoor Roth for him, doubled it, got $16,000 into a Roth IRA in addition to their $30,500 into their Roth 401(k) and $9,300 into that HSA. We already moved about $25,000 of that savings in addition to the 401(k). Now, we got about $55,000. We moved from the tax-deferred, taxable buckets over to that tax-free bucket, and we're creating some tax diversification.

Further, they wanted to create not just tax diversification, but risk diversification as well. We ended up using a life insurance policy funded at an additional $15,000 a year, because they wanted some dollars to be those safe dollars. They wanted to start building up some safe money for their future retirement that they could use as supplemental retirement income, and again, tax diversification. You have Roth IRAs, why not incorporate a life insurance, incorporate a little health savings account as well, all at the end of the day, allowing them tax-free savings of over $70,000, and there's more that could have been done.

You might be asking yourself, how does this apply to your own unique situation? If that's the case, then give us a call and we'll run a free tax analysis for you to show you how you could be saving more money on taxes today and in the future. Call the number on your screen and schedule a visit with one of our fiduciary financial planners.

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