3 Retirement Wealth Protection Tactics

Don't let taxes derail your retirement and estate planning strategies. Consider these strategies, involving maximizing Roth IRA possibilities and health savings accounts, to keep more of what you saved over the years.

You’re ready for retirement. You’ve successfully saved for decades, and now you and your spouse are prepared to ride off into the warm sunset of retirement. Plump tax-deferred retirement account balances are likely to translate into significant income each month.

Wait a minute! What about taxes?

If your wealth is largely confined to tax-deferred retirement accounts, you are likely to owe a significant amount of tax once you turn 72, the age at which you must begin to take required minimum distributions (RMDs). That means you aren’t as rich as you think you are, a disquieting prospect given the uncertainty of future tax rates.

Fortunately, there are a number of proactive tactics you can employ not only to minimize the amount of taxes you pay in retirement, but to also ensure that as much of your estate as possible passes to your heirs. These include converting traditional retirement accounts into a Roth IRA, contributing additional money to a Roth IRA and contributing to a health savings accounts.

Start by analyzing your retirement savings

If you’re like many Americans, you probably have a number of different retirement savings accounts. Some of those may be tax deferred, while others may be taxable or tax-free, such as a Roth IRA or a Roth 401(k). Add up all of your accounts and determine how much retirement savings you have in total.

For couples, this involves your IRAs, 401(k)s, 403(b)s, SEPs, Roths, etc. Don’t forget any accounts that you have at former employers — make a list of everything. If you are single, the process is easier, because there are just your accounts to keep track of.

Next, assess your retirement tax liability

The second step is to assess your retirement tax liability. That’s based on how much of your retirement savings is held in tax-deferred accounts, such as traditional IRAs, 401(k)s, 403(b)s and SIMPLE or SEP self-employment retirement accounts. Why? Because you took a tax deduction when you contributed to these accounts, the tax on these accounts becomes due at retirement.

Think about it this way: Say you contributed $5,000 a year to your traditional retirement account and that amount grew, compounded over 30 years, to $510,395, (an average annual return of 7%). By taking the tax deduction up front, you saved yourself taxes on your $150,000 in contributions. But in retirement, you’ll pay taxes on that original investment, plus you’ll have to pay taxes on your $360,395 in gains as well.

You can see how taking an up-front tax deduction is much less advantageous than paying taxes up front and avoiding taxes on the entire balance, decades later.

Now figure out your estimated required minimum distributions

The higher your balance is in tax-deferred accounts, the more tax you will pay in retirement. While Congress recently pushed back the date at which you have to take RMDs, anyone born on or before July 1, 1949, still must begin to take their RMD at age 70.5. At whatever date your RMD kicks in, you must take out a specific amount each and every year, based on your estimated lifespan, as calculated in IRS tables.

It doesn’t matter whether you need the money or not. You’re required to withdraw a specific amount from your traditional retirement account each year and pay the taxes you owe on that balance.

However, due to the Coronavirus Pandemic, Congress has approved the CARES Act, which allows you to skip taking an RMD this year.

Let’s say you’ve got a traditional IRA balance of $664,466.30, which you rolled over from your employer’s 401(k) plan. When you turn 72, you must withdraw $25,955.71. If you are in the 24% tax bracket, that means an approximate federal tax bill of $6,229.37, which drops the value of your distribution down to $19,726.34. Ouch!

Perhaps your RMD will push your income up to the next highest bracket of 32%, which would bring you an even bigger tax bill of $8,305.83.

Wealth Protection Strategy No. 1: Consider a Roth conversion

This is where the value of a Roth conversion comes in. A Roth conversion involves moving some or all of your traditional IRA funds into a Roth by paying the taxes now. The result? A reduction of your retirement tax bill.

Qualified withdrawals from a Roth IRA, unlike traditional IRAs, are federal income tax-free and state income tax-free as well. This is because the contributions to a Roth IRA are taxed in the year you made them rather than when you take the payout. As long as you’re over 59½ and have had a Roth account open for five years, you don’t have to pay tax on the distributions. Having a Roth IRA, therefore, is a way of insuring yourself against tax increases that may be passed in the future — and it might be awhile before another 2017 across-the-board style tax cut policy is enacted into law.

The period of time between when you retire and when you take RMDs represents a golden opportunity to engage in Roth conversions, because that’s when your taxable income is at a temporary low. The low is temporary because you’re not making income from work anymore and you haven’t yet had to take RMDs.

For example, if you retire at 65, that gives you seven years to convert your traditional IRA, or part of it, into a Roth. Converting over a period of time makes sense, because you have to pay taxes on your traditional IRA as part of the conversion process.

Back to the example of an IRA of $664,466.30. Let’s say that you and your adviser decide you can afford to pay taxes on $30,000 worth of Roth conversion a year. That translates to converting a total of $210,000 during the seven years between your retirement and when you need to begin taking RMDs. If you are in the 12% tax bracket, the approximate federal tax would be $3,600 a year.

That amount is manageable and will set you up for lower tax bills when you retire, because you will only then have $454,466.30 left in your traditional IRA after the conversions. That lowers the amount of your RMDs and also gives you a pool of tax-free money that you can use. In contrast to the RMD of $25,955.71, the post-conversion RMD is significantly lower, at $17,752.59. That’s a difference of $8,203.12 a year, which creates a lower tax bill and might even keep you in a lower tax bracket.

Traditional IRA Balance$664,466.30$454,466.30-$210,000
Roth IRA Balance$0$210,000+$210,000
RMD at 24% bracket$25,955.71$17,752.59-8,203.12

Tax rates are historically low because the celebrated Tax Cut and Jobs Act (TCJA, or “Trump tax cut”) of 2017 dramatically changed effective marginal tax rates, thus creating very low rates for many more affluent seniors and middle-aged Americans. This means that converting now means paying less tax on your conversion and reaping the benefits later in retirement.

The current environment is even more favorable for a conversion, considering the CARES Act, which allows you to skip your RMD for this year. The fact that you don’t have to take an RMD will lower your tax bill. In addition, because stock valuations are lower due to the falloff in economic activity, your tax bill for conversion is also likely to be lower.

In effect, there’s a sale on Roth IRA conversions right now due to the combination of these two factors.

Implement your plan before the end of 2025

Unless the Trump tax cuts are extended by Congress, the individual tax provisions described above will sunset at the end of 2025. This creates a unique opportunity in 2020 and the following couple years to change up retirement planning to squeeze the most juice you can out of the current law.

It’s important to consider your options if you’ve got a significant amount of wealth tied up in tax-deferred accounts. It’s imperative to review your situation and decide how much you want to convert and when to start doing it.

Wealth Protection Strategy No. 2: Save more in a Roth

If you don’t want to pay the taxes on a conversion and you still have some time before you retire, you can make an effort to save within a Roth and pay taxes up front. There are some income limitations on contributing to a Roth, but if you qualify, you can contribute up to $6,000 if you are under age 50 and $7,000 a year if you are 50 or older. Building up the value of a Roth over time helps decrease your tax liabilities in retirement.

Wealth Protection Strategy No. 3: Contribute to a health savings account

While many use a health savings account to cover current health care expenses, there’s another way to use an HSA: to save for health care expenses in retirement. As long as you are enrolled in a high-deductible health plan, you can contribute to an HSA and invest that money for retirement. (See Health Savings Account Limits for 2020.) Health savings accounts are triple tax deductible as long as they are used in connection with health care expenses:

  1. You can take a deduction on an HSA contribution when you make that contribution.
  2. HSA contributions grow tax-free.
  3. HSA funds can be taken out of an account tax free as long as they are used for qualified health care expenses.

A final word

The new rules enacted by the TCJA and the SECURE Act can seem like a headache in the waiting for high-net-worth individuals, anywhere from those who are already retired to those who haven’t really even started planning for retirement.

Fortunately, proactive and strategic tax planning can help high-net-worth individuals make this transition and come out the other side with much more favorable outcomes than what was possible under the old law. Now is the time to involve you, your family, retirement, tax and estate planners and your attorney in a plan for what this can mean for yourself and for future generations.

Investment advisory services offered by duly registered individuals through ChangePath, LLC a Registered Investment Adviser. ChangePath, LLC and BAM Advisory Group are unaffiliated entities.

Amy Buttell contributed to this report.

About the Author

David Afraimi, IAR

Principal, BAM Advisory Group

David Afraimi is a highly energetic financial professional who appreciates the opportunity and unique challenge of working with a variety of clients in order to help them meet and exceed their financial and retirement objectives. David's certifications and licensing include the Series 7, 66, 24, Life & Health, Long-Term Care, and The National Social Security Advisor Certification.

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