Because taxes never die, we're re-sharing this post on tax strategy to help you think differently about total tax. Originally posted March 2023.
Paying more taxes in some years could result in paying less Total Tax over your lifetime.
It’s tax filing season, and most of us are busily gathering forms and searching for financial data to send off to our tax professional, or to use in preparing our own taxes if we are do-it-yourselfers. And of course when it’s all ready for filing, and we see the number on that final “Total Tax” line, it often brings up the question: “What can I do to pay less in taxes?”
It’s a fair question, but one that is often answered by looking at the past year and trying to tweak things so taxes this year will be lower. But what if we change the focus from this year and next year to your whole lifetime? Will those decisions to reduce taxes now result in paying more taxes later?
A great example of this nearsighted approach to tax planning is using nothing but tax-deferred accounts like Traditional IRAs or pre-tax employer 401(k) plans to save for retirement. Since you get to deduct your contributions now, the more you put away of your current income in these types of accounts, the lower your taxes will be in the present, and you will also not owe taxes as the investments grow. But in exchange for all those immediate tax advantages, the IRS will take its share later, and that could actually be larger. You will owe taxes on all of the money you withdraw, contributions and earnings, calculated using income tax rates even though you may no longer be working. In addition you will be subject to Required Minimum Distributions (RMDs), so you won’t be able to avoid paying those taxes, even if you don’t need to take the money out.
Conventional wisdom says that your income tax rate will drop when you are in retirement and no longer working. But what if that isn’t the case?
Income tax rates may feel high now, but as you can see in the graphic above, they are actually historically fairly low, and it’s not too hard to imagine them rising in the future to support an aging population and ongoing government deficits.
Many provisions in the 2017 Tax Cuts and Jobs Act (TCJA) that benefit individual taxpayers are due to “sunset” at the end of 2025.
Even if tax rates don’t go up, a couple using the Married Filing Joint status may have a lower effective tax rate today than the survivor who files as Single after one of them passes away.
If large pre-tax accounts are passed down to children or other heirs, they may now be required to empty those accounts within 10 years. This is due to the SECURE Act 2.0 passed at the end of 2022. And if those heirs are still working? Well those large distributions could end up in higher tax brackets.
Paying some extra taxes now could be a way to actually pay less in taxes in the future. That is what tax planning is all about: reducing your lifetime Total Tax!
There are many strategies that can be used in a lifetime tax plan; here is one common example that could reduce your lifetime tax bill if you have all your retirement savings in Traditional IRAs or pre-tax employer retirement plans. You can use “Roth conversions” to move some of the funds from those pre-tax accounts to a Roth IRA, where withdrawals are tax free, and there are no RMDs. While this involves paying taxes now on the amounts converted (1), if the conversions are done in the lower tax years between retirement and starting either social security or RMDs, the near term costs can be minimized.
Running a very simple scenario in my financial planning software allows us to see the effect of this Roth conversion tax planning strategy. Here’s what I started with:
Jane is 67 today and has just retired.
She has a Traditional IRA balance of $1,000,000, invested fairly aggressively because she expects to live until 95.
She’s waiting to take social security at 70 to maximize the benefit.
She wants to live on $60,000 a year.
Under current laws, Jane will be forced to start taking RMDs at age 73, even though she may not need the money to live on. If she just leaves things as they are, the orange line in the graphic below, she will pay less in Federal taxes in the near term, but end up paying more and more as her investments grow, increasing her RMD amounts.
But if Jane converts just enough of her Traditional IRA account to a Roth IRA to fill the 25% tax bracket in the years between her retirement and starting RMDs, the blue line, she will pay more now, but end up paying significantly less over her lifetime. And even if Jane doesn’t make it to 95, her heirs will benefit from tax free withdrawals from the Roth IRA account.
It doesn’t matter how big the numbers are in single years, it’s the total area under the curve that counts!
This is a very simple analysis of one tax planning strategy, so it is not meant to be an example of a complete tax planning process. Stay tuned for my next post where I talk about other approaches that can be used to minimize lifetime Total Tax. And like good financial planning, tax planning must be customized to each individual’s situation, there are no “cookie-cutter” approaches. Be sure to consult with your financial professional to get answers about what tax planning strategies might work for you. If you’d like to talk about how I do tax planning, be sure to reach out and schedule a free 30 minute call here.
If there’s a topic you’d like to see me Ann-splain, let me know.
Footnote:
1 - Taxation of a Roth conversion can be somewhat complicated. Before you do a Roth conversion, please consult with your tax professional to be sure you understand what the tax consequences would be.