How to Use the Financial Tools in the Tax-Free Retirement Toolkit
By Tom Walker, for Walker CPG
Concerns about future tax rates continued to grow in the years following the Great Recession, exacerbated by our a skyrocketing national debt. Then the pandemic turned our country’s fiscal trajectory upside down by slashing both wages and tax revenues while simultaneously forcing a dramatic increase in government spending and debt-financed stimulus measures (meaning we had to borrow from future Americans to help current Americans survive extremely difficult times).
It was no small mistake on the radar. We are currently on track to add more to the national debt in the last two years (2020 and 2021) that we had accumulated in total over our first 225 years or so as a nation. Some of this is certainly linked to inflation, but in the last two decades alone, we’ve seen the Quintuple the US National Debtfrom about $ 5,000 billion to nearly $ 29 trillion today. And yet, even after spending all that borrowed money, we still expect a collision with the federal debt ceiling again this fall. Congress cannot afford to continue spending much more than it generates in tax revenue indefinitely, so it is imperative that we take advantage of the (limited) opportunities we have to create fiscal diversity in our retirement portfolios. .
Now each of the following tools / strategies could have their own article (or book in some cases!) In order to sufficiently describe all of the potential benefits and pitfalls. But in this article, we’ll just attempt to provide a high-level overview of the options available, a conceptual introduction to build on with your retirement planning team or through continuous self-learning.
The tax-free toolkit
1. Maximize Roth IRA and Roth TSP contributions
a. By choosing to save after-tax dollars in a Roth TSP or Roth IRA, you will owe tax that year, but then you will have the opportunity to generate after-tax gains on your investment that will never trigger a tax bill (both Roth chronology rules are followed)
b. The Roth TSP and a Roth IRA can be funded simultaneously as long as you are eligible to contribute to a Roth IRA (based on income earned by the household)
vs. The Roth TSPs and Roth IRAs offer the option of making additional catch-up contributions for participants over 50.
D. In this approach, we choose to pay seed taxes at a known (historically low) rate today so as not to owe crop taxes at an unknown future rate.
2. Harvesting tax brackets with Roth conversions
a. This is the process of systematically converting a portion of your tax-deferred assets into Roth IRAs (or CVLIs) to defuse the tax-deferred time bomb during that time when “Taxes are on sale”
b. To do this effectively, we need to coordinate the size and pace of your conversions with the goal of converting the desired total amount as quickly as possible, but without dramatically increasing your marginal tax bracket in any given year.
vs. Introduced in 1998, Roth IRAs had an earned income limit on Roth Conversions until 2010 – today there is no earned salary limit for Roth Conversions, but that’s not always the case.
D. This approach allows you to wipe tax payable from your portfolio into manageable chunks while keeping you out of the highest tax brackets, which in turn creates a cumulative tax bill that is lower than in the one-time portfolio conversion.
3. Health Savings Account (HSA) for medical expenses
a. Informally known as Healthcare IRA, HSAs are primarily designed for the investment of emergency funds for people with a high deductible health plan (HDHP).
b. An HSA creates tax-free distributions when used for a qualifying medical expense and the account balance can be carried over from year to year if no medical emergency has arisen.
vs. For those who are eligible to contribute, another popular feature is that an HSA can earn compound interest which can further increase your emergency funds.
D. Eligible expenses include: co-payments and deductibles, most vision / dental / hearing expenses, FEHB premiums, qualified LTC insurance premiums, etc.
e. Disclaimer: HSAs can be beneficial but they are complex, with a lot of paperwork to ensure that an HSA only benefits people with qualifying medical expenses.
4. Life insurance with cash value (CVLI) can offer tax efficiency in 3 distinct ways
a. Accelerated Living Benefit Riders (ALBR) – a category of rider that allows the insured to accelerate the death benefit of a policy (generally tax-free) during his lifetime in the event of an eligible medical emergency or need help with daily activities to age beautifully
b. Death Benefit – the product of a life insurance policy is income tax free for beneficiaries and can offer powerful income maintenance options for a spouse or a highly leveraged inheritance for loved ones
vs. Tax-free distributions – permanent plans allow your excess premiums to earn compound interest and the cash value of the policy can be viewed in an incredibly unique and tax-beneficial way over the life of the insured (without requiring a medical event admissible as trigger)
5. Reduce the workforce of the main residence
a. The IRS allows individuals to realize up to $ 250,000 in gains on the sale of the primary residence without being subject to capital gains tax.
b. This means that a married couple could generate up to $ 500,000 in tax-free profits to help cover other retirement expenses by simply reducing the size of the primary residence.
While this is only an introduction to some of the key concepts in tax planning, it’s important to note that tax laws are extremely complex and mistakes can be costly. This information must therefore be used in conjunction with continuing education and career counseling. If you want to know more about optimizing your Savings spending plan to protect your retirement against higher future tax rates, attend our next free webcast!