Kick the IRS to the Curb in Retirement

An older man in the distance prepares to run at a soccer ball in the foreground.

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Did you know you can save too much money in your tax-deferred accounts, such as IRAs and 401(k)s? It’s true. I have witnessed this scenario firsthand more times than I care to count — and I count for a living.

A newly retired couple walks into my office intrigued by my holistic approach to retirement. They have been working and saving for 30-plus years for a hopeful 20-plus-year retirement.

They have sacrificed. They have skipped vacations to save. They have even missed grandkids’ baseball games in order to work overtime.

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The plan was to grind it out and provide for their family. They were intentional about saving to ensure they could spend more time with family and enjoy the freedom to travel throughout retirement.

Yet, they find themselves distraught and losing sleep as their looming tax burden becomes a reality in April. They are filled with regret, feeling they have traded memories for uncertainty.

And when I ask them, “What is your biggest expense?” they will tell me it’s their mortgage. Or their travel budget. Or their health care. And then I ask, “What about taxes?”

Sound familiar?

A costly piece of the planning puzzle

People come to me overwhelmed by the burdensome thought or circumstance of outflowing tax dollars invariably crushing the spirit of what was intended to be a “happily ever after retirement.”

Have you ever considered that how much you have saved could be a cause of sleepless nights? It absolutely is. I see it almost every day.

I’m here to tell you it is never too late to kick Uncle Sam to the curb, or at least make him the low man on the totem pole. Many retirees can often do this in their lifetime, and they can most certainly help their heirs do so in theirs.

You see, the root of the problem is planning, or the lack of planning. It is journeying from “hope” as a plan to the certainty of a tax-efficient plan — an often-ignored piece of the robust retirement planning puzzle.

All of us have been sold a “bill of goods,” and it goes something like this: “Put as much money away into your 401(k)/IRA as you can, because when you retire you will be in a lower tax bracket.” If you haven’t saved any money for retirement, that is true.

If you have saved, especially in tax-deferred accounts, it is a lie. Every penny you take out of your tax-deferred accounts is taxable. And, of course, there is also the risk of taxes going up and changing tax brackets.

Do not mishear me. I am not against saving money. If I were, then my list of people seeking financial advice could be written on the back of a matchbook. You simply need a plan so that your savings are taxed at the lowest possible rate. My preferred rate is zero. And, yes, you can do that, too.

So, start effective tax planning today. It’s not too late, I promise.

Shifting from a micro to a macro mindset

There is one significant problem when delving into the issue of “lifetime taxation.” Nobody talks about it. When meeting with accountants, the focus is almost always looking to last year, talking about this year and maybe planning for the next.

It is what we call a “micro” look at tax planning. It is all about what can be done in the near term.

The focus needs to be widened. Taking a “macro” look at taxes over a lifetime will help in planning for the future. Why is it so important to plan for in the future? How about taxation on Social Security?

Up to 85% of your Social Security benefit can be taxed if your income is above a certain threshold. Believe me, those thresholds affect nearly everyone.

The snowball effect of RMDs

What about required minimum distributions? Yes, the infamous RMD. Currently, RMDs begin at age 73, rising to age 75 in 2033.

The percentage you have to withdraw starts at about 3.8% and continues to increase every year — until you die, or your money runs out. For people who have saved, RMDs are probably the biggest concern when it comes to lifetime taxation.

These distributions are required from any deferred account, including traditional IRAs, 401(k)s and 403(b)s. A deferred account is an account in which the funds have been added without paying any tax on them. The tax has been “deferred” until distribution. So, when distributions happen, they become taxable as ordinary income.

Yikes. You can begin to imagine the snowball effect this can have if you have significant savings. It can place you in a higher tax bracket and keep you there and/or climbing for the rest of your life. That stings.

Luckily, for now, the marginal income tax brackets are near an all-time low. However, that could very well change with the sunset of the current income tax laws set to occur at the end of 2025.

Given our national debt, spending and other economic factors, I am persuaded to believe in a high likelihood that taxes will increase in the near future.

Even more, there is a strong possibility that our heirs will be significantly affected.

Speaking of heirs, what about legacy planning for tax purposes? Though it may not be our focus here, it can cause a significant and costly burden.

Roth IRAs to the rescue

A good tax-efficiency plan takes all of this and much more into consideration. There are several tools that can be used to reduce lifetime taxation. The one we will focus on is the Roth IRA.

Others could be varying forms of life insurance and trusts created for a similar goal. The Roth IRA is an account where funds are added after tax has been paid. The funds in the account can grow tax-free. The gains made in the account are tax-free. The distributions in retirement are tax-free.

It is easy to see why these accounts can be a significant advantage to retirees. Yet, there are a couple of hindrances when trying to save for retirement in a Roth IRA.

They have low contribution limits and income phaseouts. You are only allowed to contribute $7,000 ($8,000, if you are 50 or older) per year in 2025. Unless you start very early in life, $7,000 per year is not going to solve most needs in retirement.

Also, if your income is too high, then the amount you can contribute is reduced or even eliminated if you make over a certain threshold. However, some tax-free money is better than no tax-free money.

That does not sound like a good tool, does it? But wait, there is more. You can convert a traditional IRA to a Roth IRA by simply paying the taxes at the time of conversion.

This is the Roth conversion you have probably heard so much about. Conversions can be done at any time, as many times as you want, and any amount that you want.

In my experience, the earlier the better. However, these strategies can take advantage of maximizing certain tax bracket thresholds over a few years. There is a real art to crafting the perfect strategy.

You don't have to be a tax expert

As you are probably beginning to realize, there are a lot of factors in play when doing tax planning. Many we have not even spoken about. Honestly, there are too many to list. But, deciding to plan is the key.

Using a fiduciary financial adviser with a comprehensive approach to planning to help you make decisions in your best interest will unlock a wealth of informed decisions about retirement and tax planning.

You will know the cost of each decision you make, both now and in the future. Knowing how these decisions will affect you now and over your lifetime is critical. This is the case, especially with Roth conversions.

Your goal from the beginning has been clear. You have worked so long and hard to save for a joyful retirement. Sacrifice has happened. Reap the rewards of your labor. It is not too late to enjoy the retired life. Now, let’s get to planning.

Disclaimer

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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Scott came to APO Financial with a wealth of experience in the private business world. He leads APO’s Florida office in Palm Beach Gardens. He has owned and operated his own business for over 10 years, committing daily to bootstrapping and developing a successful business. From sales and operations to finance, Scott has experienced business planning at every level. He can relate to the rigor of building from the ground up and the diligence it takes to protect what you have worked for. He now leverages his experience to help others plan out their retirement, liquidity events and financial legacy.