From Tax-Deferred to Tax-Free: Navigating Taxes in Retirement

If you envision the ideal retirement plan, you will likely imagine an exclusively tax-free income, but for many Baby Boomers who have for decades saved money in tax-deferred accounts, the opposite may be true.

After many years of deferring taxes, retirees are facing a sizable tax bill on distributions taken from their retirement accounts that could be a third or more of what has been accumulated. Though you may wish that you had done things differently, there is hope, but before we jump to the solution, it is important to understand what you are trying to accomplish.

When you are saving for retirement, you are growing assets for your future. I have to assume you understand that, but what many retirees lose sight of is that once retired, growing assets is no longer the priority. Yes, of course it is important — everyone wants their assets to grow — but it is not the priority. The priority is creating sustainable income to support you through retirement while minimizing taxes.

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In my experience, many retirees realize there are taxes owed on their tax-deferred assets, but most do not understand the full extent of the problem. There is this propensity to focus on growth, searching for the “best” investments while ignoring the tax issues until they are faced with the bill.

The rules change once your retire

In retirement, the rules are different than when you were working. There are more tax considerations: Social Security taxation and Medicare premiums on top of the taxable income on retirement account distributions.

The icing on the cake here is that you most likely have fewer deductions in retirement to help offset the tax burden. When you were working, you deferred taxes in retirement plans and may have had children to write off and mortgage interest to itemize, but those are gone for most people by the time they retire. So, this makes the tax problem more complex, considering many retirees we work with tend to have the same income goals in retirement but with fewer deductions.

And if you think you can kick the can down the road by not taking distributions, keep in mind that as the account continues to grow, the tax problem becomes bigger, and required minimum distributions (RMDs) will eventually force you to take distributions. There is no hiding from what is owed. The IRS has been waiting patiently for you to accumulate this money, and it will ultimately push to get its share of your pie.

Taxes now, taxes later

Once you are in retirement, there are two tax issues you face: taxes you must contend with today and taxes you will be burdened with in the future.

The thought of what tax liability you may be facing today is enough, much less thinking about what those tax liabilities could be over the next 20 or 30 years if account values grow and tax rates increase.

In 2024, we know what the tax rates are, but we also know that the current rates sunset December 31, 2025, and are scheduled to increase on January 1, 2026. So, it isn’t a question of whether taxes are going up; rather, it is a question of when (unless, of course, there are legislative changes under the next administration).

One of the most common references people make to me is regarding government spending. According to usdebtclock.org, our government is currently deficit spending by $1.7 billion, and that number increases by the second. And knowing that government revenue is our tax dollars, I’ll ask you: Do you think taxes are going down or going up in the future? We all have our opinions, but we have to focus on what we can control now.

So, there are two possibilities to help minimize the level at which you participate in paying your fair share toward the government’s future revenue increases. You can either complete a Roth conversion or, through tax-deferred withdrawals, contribute to an overfunded permanent life insurance policy. Both options provide the ability to grow and access the money on a tax-free basis.

But deciding to do one or both options is the easy part. The trick is completing this process with minimal tax liabilities today, and that is a much more complex issue that requires a fair amount of knowledge about tax laws and strategies. In other words, this is not what I would consider a DIY process for most people, and I believe you could benefit by working with an experienced team of professionals.

Progressive tax code

The first consideration for converting to tax-free is understanding the tax code and how it works. In the United States of America, we have a progressive tax code. A portion of taxable income may be taxed at one rate, while another portion of the income may be taxed at another.

For example, if you’re married filing jointly in 2024 with taxable income of $94,000, the first $23,000 would be taxed at 10%, and the other $71,000 would be taxed at 12%. In this example, if you were to add a taxable distribution on top of the taxable income, any amount converted would breach the next income tax bracket and would be taxed at 22% up to $201,000 of taxable income.

The progressive nature of the code makes this complicated, and miscalculating this could result in having a larger tax liability than anticipated.

Social Security taxation

The other consideration for a taxable distribution is the taxation on your Social Security. Depending on your income level, a taxable distribution can subject your Social Security to additional taxes. This is a separate calculation from the income tax brackets and uses a two-step process to determine how much of your Social Security will be subject to taxation.

The first step is to calculate what is known as provisional income. To calculate provisional income, you add together your adjusted gross income, tax-exempt interest and 50% of your Social Security benefit.

The next step is to use this provisional income sum to determine what percentage of your Social Security that will be subject to income taxes. Falling into the first tier would result in having 50% of your Social Security subject to income taxes, and the highest tier is 85%. The good news is that Social Security isn’t 100% taxed, and if your provisional income falls below certain amounts (based on whether you are filing single or married jointly), there is no tax at all.

This is important to note because a taxable distribution may not only push you into a higher income tax bracket, but it could trigger additional taxes on your Social Security, which could result in a higher effective rate.

Medicare premiums

If the income tax brackets and Social Security tiers aren’t enough, you should also be aware of the impact a taxable distribution can have on Medicare premiums. This typically isn’t an issue unless your income is above $103,000 if single and $206,000 if married in 2024, but keep in mind that these figures would also include any taxable distributions from retirement accounts.

The impact of any possible premium increase is typically delayed by two tax years. So, if you were to make a taxable distribution in 2024, that premium adjustment wouldn’t be realized until 2026. This is one of those things that often comes as a surprise when people make decisions about distributions without understanding all the rules.

Offsetting taxes

There are multiple things to consider before taking a taxable distribution (including a Roth conversion), but there are things you can do to help reduce the tax burden of switching from tax-deferred to tax-free.

The goal in this process is to find ways that are both legal and ethical to help offset the additional income you show on your tax return resulting from a taxable distribution. The antidote to taxable income is deductions, credits and losses, which can help reduce the net income subject to tax.

There are a few ways to approach this, but not all options are appropriate for everyone. Some things may work, and some may not, which underscores the need to have an experienced professional team of advisers guiding this process.

• A donor-advised fund (DAF) allows you to contribute future charitable donations into a fund that you control when distributions are made but can receive the tax benefit of the donation in the year you make the contribution into the fund. By making multiple years of donation in a single year into the fund, you have the potential of offsetting a taxable distribution from your retirement account in that year.
• A charitable remainder trust (CRT) allows you to contribute future charitable donations into the trust that you control when distributions are made (typically at death) but can receive the tax benefit of the donation in the year you make the contribution. You can also receive income from the trust while you are living within IRS limits. Like a DAF, making multiple years of donation in a single year could potentially help offset a taxable distribution from your retirement account. A CRT is a more complex arrangement than a DAF, with many options, and requires an attorney to draft the trust.
• A qualified charitable donation (QCD) allows for anyone over the age of 70½ to make a direct donation from a qualified account to a charity, which bypasses the standard deduction limits and allows the donation to be a tax-free transfer.
• Intangible drilling costs (IDC) allow accredited investors to participate in the drilling expenses of an oil and gas company that could provide reportable tax losses that can help offset all forms of income as well as the potential for cash flow back to the investor once the wells are operational. The tax benefits of this can be significant, but there are risks to consider that are best discussed with a financial adviser who is familiar with all the intricacies of these types of investments.
  

Of course, this is not an exhaustive list of available options, but these are common strategies that can be used to help offset tax liabilities when converting tax-deferred assets to tax-free. It is important to recognize that orchestrating these types of strategies requires careful planning, and understanding the details of the strategies being deployed is a must to help limit the potential risks that are inherent when using complex tax strategies.

To get assistance with moving tax-deferred assets to tax-free, you can request help from my team by booking a consult through my website, Skrobonja Financial.

Securities offered only by duly registered individuals through Madison Avenue Securities, LLC. (MAS), Member FINRA &SIPC. Advisory services offered only by duly registered individuals through Skrobonja Wealth Management (SWM), a registered investment advisor. Tax services offered only through Skrobonja Tax Consulting. MAS does not offer Build Banking or tax advice. Skrobonja Financial Group, LLC, Skrobonja Wealth Management, LLC, Skrobonja Insurance Services, LLC, Skrobonja Tax Consulting, and Build Banking are not affiliated with MAS.

Skrobonja Wealth Management, LLC is a registered investment adviser. Advisory services are only offered to clients or prospective clients where Skrobonja Wealth Management, LLC and its representatives are properly licensed or exempt from licensure.

The firm is a registered investment adviser with the state of Missouri, and may only transact business with residents of those states, or residents of other states where otherwise legally permitted subject to exemption or exclusion from registration requirements. Registration with the United States Securities and Exchange Commission or any state securities authority does not imply a certain level of skill or training.

Investing involves risk, including the potential loss of principal. This is intended for informational purposes only. It is not intended to be used as the sole basis for financial decisions, nor should it be construed as advice designed to meet the particular needs of an individual’s situation.

A Roth conversion is a taxable event. Consult your tax advisor regarding your situation.

Investments in securities are subject to investment risk, including possible loss of principal. Prices of securities may fluctuate from time to time and may even become valueless. Gas and oil investments are speculative in nature and are sold by Private Placement Memorandum (PPM). Carefully read the PPM before investing. Certain accreditation requirements may apply.

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