As you might suspect by now, the solution to your tax problem lies in moving as much money as possible into the tax-free and taxable pools. Doing so has several benefits. First of all, moving money out of your tax-deferred accounts now will minimize your future distributions from those accounts, which will reduce your future taxes. Secondly, distributions from the tax-free and taxable accounts either don't generate taxes or are taxed at much lower rates. So, if in retirement you are primarily living off funds in your tax-free and taxable accounts, you can be living like a king (or at least a prince) while paying taxes like a pauper.
Think about it like this. In retirement you'll wind up pulling cash from all three pools. For example, let's say you want to live off $100,000. You pull funds from your tax- deferred pool up to the top of the 12% tax bracket. You then pull the rest of the money you need from your Roth account at a zero percent tax rate and from your taxable account at a 15% or lower capital gains rate. You're now living at an income level that should put you in the 22% tax bracket. But you're paying taxes at closer to 12%. That means you can:
The key, then, to enhancing your retirement is to create the ability to pull more of your income from the tax-free and taxable pools while minimizing the amount of money you need to pull from your tax-deferred accounts.
Let's start by focusing on the tax-free pool and getting money into a Roth account. There are two main ways to get money into a Roth IRA – contributions and conversions. Let's start by looking at contributions.
There are several different ways that you can contribute to a Roth account. Let's take a look at each of these in turn:
There are several restrictions regarding Roth IRA contributions. First of all, you need to have earned income in order to contribute. Earned income comes from employment, so you need to be working to contribute to a Roth. Alternatively, you can make a spousal contribution if you are married and your spouse is working. Because you need to be working to contribute, retirees generally cannot contribute to a Roth account, unless they have a part-time job. Social Security and pension income, rental income, and investment income do not represent earned income and are not eligible for contributing to a Roth IRA.
Secondly, there are income limits that determine eligibility for Roth IRA contributions. For 2020, if you are single and make more than $124,000 or married and make more than $196,000, your ability to contribute to a Roth IRA begins to get phased out. Once you get above $139,000 single or $206,000 married, you are ineligible to contribute because you make too much money.
If you fall into this category, though, there is a workaround.
Of course, the benefit of making contributions to a traditional IRA account is that you get an immediate tax deduction. If you were just using after-tax dollars to make those contributions, you'd be losing the main benefit of contributing to a traditional IRA. But the strategy doesn't end there.
Once you've made your after-tax contribution, you then immediately take those dollars and convert them to a Roth IRA account. Because you're using after-tax dollars, there's no tax impact to this conversion. You've effectively done in two steps what you would have done in one move if the IRS didn't think you made too much money. And of course the money now resides in your Roth account, where it can forever grow free of taxes.
You might think that the IRS frowns on this strategy. You are, after all, circumventing the income limits on Roth IRA contributions in order to make what is in effect a Roth IRA contribution. But in fact the IRS has come out and said that this strategy is okay, so if you want to contribute funds to your Roth account but are over the income limits for Roth IRA contributions, this could be an important strategy for you to incorporate.
There is one caveat. Remember that the key to this strategy is that you don't pay taxes when you convert those IRA contributions. This is because those dollars have already been taxed. However, this may not be the case if you already have existing traditional IRA accounts with pretax dollars in them.
If this is the case, the IRS will look at the value of your after-tax dollars in the context of all of your IRA dollars (pretax and after-tax). Only a pro rata portion of your conversion will then be free from taxation. In many instance this means that if you have IRAs with pretax dollars, it may not make sense for you to pursue the backdoor Roth strategy.
Fortunately, there are several other ways to get money into a Roth account.
If your 401(k) has a Roth component, you will have an option of contributing to either your traditional plan or the Roth plan. You can also choose to split your contributions between the two plans. The traditional plan would fall within the tax-deferred pool discussed earlier. You get an immediate tax deduction for your contributions, but in the future you'll face all of the challenges and drawbacks inherent in tax-deferred accounts.
With the Roth 401(k), you won't get an immediate tax deduction. In fact, if you've been contributing to your pretax 401(k) and you now switch to the Roth 401(k), the loss of the tax deduction will actually feel like you've been hit with a tax increase. However, once you get past that initial pain, you'll experience the tax-free growth and distributions inherent in a Roth account.
For 2020 you can contribute $19,500 to a Roth or traditional 401(k). If you're over age 50 you can also add a $6,500 catch-up contribution for a total of $26,000. There are no income limitations on eligibility for Roth 401(k) contributions.
It is important to note that even if you choose to participate in the Roth 401(k), any matching funds provided by your employer will always be deposited into the pretax 401(k) plan.
Interested in getting even more money into that tax-free pool? That's great, because you might have access to one additional method of making Roth contributions.
These contributions would then total $63,500, which is the limit for total contributions to a 401(k) in 2020. Let's talk a little more about those after-tax contributions.
Remember, the benefit of putting your 401(k) contributions into the pretax option is that you get an immediate tax write-off. But the drawback of doing so is that all future growth is taxed as ordinary income when you take funds out.
Well, when you make an after-tax contribution, the dollars are deposited in the traditional 401(k), but you don't get a tax deduction (hence the name after tax). But because the dollars are in the traditional account, all future growth is still taxed as ordinary income, even though you didn't receive a tax deferral when you contributed. In that regard, making after-tax contributions is kind of a lose-lose proposition. So then, why am I talking about them?
Because, what you might do is make an after-tax contribution to your traditional 401(k) and then, if your plan allows it, immediately roll those dollars into the Roth component of your plan. Because you're using after-tax dollars, there are no tax consequences to your actions. And once the dollars are in the Roth part of the plan, all future growth is free from taxes.
This after-tax strategy is sometimes referred to as a “mega-backdoor Roth” because it allows you to funnel large amounts of money into your Roth accounts on a yearly basis. However, it is important to note that your ability to take advantage of after-tax contributions to your 401(k) will be dependent upon what your particular plan does and doesn't allow, so make sure to check with your benefits department prior to pursuing this strategy.
Now let's shift our attention to Roth conversions, which can be a powerful tool for accelerating the flow of funds into your tax-free pool. Roth conversions occur whenever you take dollars from your tax-deferred account and move them into your Roth account. There are no income limits for doing a Roth conversion and you don't need to be working or have earned income to process a conversion. There are also no limits around how much you can convert in a given year.
The bad news is that dollars converted from your tax-deferred account are considered a distribution. This means that any funds converted are taxed as ordinary income in the year you process the conversion.
The good news is that the amount you convert, and any future gains, are free from taxes. You've bought back your share of the partnership you've been running with the IRS. Your account is now yours, and you have certainty around how much money you actually have for retirement. Life is grand.
So, the end result of a Roth conversion is tax-free Nirvana. But the process of getting there involves paying taxes. So how do you determine whether a Roth conversion makes sense for you? And if the strategy does make sense, how much should you convert?
Remember, you're going to pay taxes on the assets in your retirement accounts at some point; the goal here isn't tax avoidance. The goal is to minimize your tax bill across your lifetime, to shelter future portfolio gains from taxes, and to give you control over your finances in retirement.
With that in mind, the starting point is to prepare a tax projection. This tax projection should identify your current tax bracket while also forecasting your future taxes. This process will help you to identify what tax bracket you want to be in now and in the future.
Once you've drawn this line in the sand you can then calculate how much of a Roth conversion might make sense this year, next year, and beyond.
One thing to be aware of is that the deadline for completing Roth conversions is December 31 of each year, which means that you might not have a completely accurate picture of what your annual income looks like prior to facilitating the conversion. This situation is exacerbated because since the Tax Reform and Jobs Act of 2017, Roth conversions are irrevocable, which means that you need to be comfortable with the amount you convert, since you can't change your mind and undo a conversion.
It's also important to note that, in order to move as much money as possible at as low a tax rate as possible, you might want to convert each year, which means that you'll need new tax projections each year. So, you can see that although this strategy is a fantastic way to maximize the tax efficiency of your retirement income, it's also somewhat challenging to put into place.
We've been focusing on how to get money into your tax-free pool, but let's shift now and talk about the taxable pool. Moving money into this pool is easy. Another name for the taxable pool is nonqualified. That means that there are no government rules or regulations around putting money into or taking money out of this pool. You are free to contribute when and how and in whatever increments you wish. You are also free to withdraw funds whenever you want. So, the question then becomes why might you put money into this pool?
Well, for starters that lack of rules and regulations is nice. The taxable pool has the most flexibility of any of the pools. So, if your income or cash-flow sources are such that you're ineligible to contribute to retirement accounts, this will be the receptacle for your future savings. Also, remember that retirement accounts (both tax-free and tax-deferred) have rules and restrictions around withdrawals prior to age 59½, and early withdrawals are generally subject to a 10% penalty. There are several potential workarounds to circumnavigate those rules, but for the most part if you're planning to retire prior to age 59½, you'll want to have some money in the taxable pool in order to avoid penalties.
The taxable pool also qualifies for special tax treatment. Depending on how the funds in this pool are invested, they could be subject to either ordinary income tax rates or long-term capital gains rates. As you may recall, long-term capital gains rates are significantly lower than ordinary income tax rates, which you can see in Figure 9.1.
As you can see, the rate you pay on capital gains is lower than the rate you would pay on ordinary income. That makes it important to be aware of what investments generate ordinary income and which qualify for long-term capital gains treatment.
| If taxable income falls below the 22% tax bracket | 0% |
| If taxable income falls at or above the 22% tax bracket but below the 37% rate | 15% |
| If taxable income falls in the 37% tax bracket | 20% |
Figure 9.1 Federal Capital Gains Tax Brackets
SOURCE: Analysis by Brian Perry. Information from the Internal Revenue Service.
If all of that sounds complicated, that's because it is. Strategic tax planning isn't easy, but the rewards are significant. For instance, would you rather pay 24% in taxes on a dividend or 15%? That 9% tax savings is your reward for putting in the effort on tax planning or hiring someone to do it for you.
When it comes to finances, I really like the idea of paying taxes at lower rates. But do you know what I like even more than paying taxes at low rates? My absolute favorite thing is not paying taxes at all. So, with that in mind let's look at how you might avoid taxation on investments in the taxable pool.
When you have funds located in a taxable account, you can utilize a technique called tax loss harvesting (TLH) in order to manage your future taxes. The concept of TLH begins with the basic premise that some financial markets, particularly stocks, tend to fluctuate up and down while also tending to trend higher over longer periods of time.
If you own stocks, you're going to ride that rollercoaster, and so you take advantage of the ride by selling securities when they fall in value and then immediately buying back into the market. Because you immediately buy back in, you continue to participate in the longer-term upward trend, but the sale causes you to realize a “loss.” This loss can be used to offset future gains, allowing you to generate income more tax efficiently in the future.
This is just a basic overview of the technique. In practice, you need to carefully consider what securities you buy and sell. You want to keep your portfolio consistent, but IRS regulations prohibit claiming losses if you buy back the same security within a month of selling it. Therefore, you need to utilize similar but not identical securities.
Furthermore, while many people only harvest tax losses near year-end, you should ideally evaluate the opportunity on a daily basis.
Between preferential tax rates and tax loss harvesting, the taxable pool provides robust opportunities for tax efficient retirement distributions. And we've previously discussed the glorious future you'll face when living off the tax-free pool.
Now that you're convinced that having money in each of the three pools is going to be your key to a low tax future, let's examine how you can marry your investments with your taxes. This next section is important, because it represents an opportunity that is about as close to free money as anything you are ever going to find.
When it comes to investing, the usual way to get higher returns is to take more risk. So when someone tells you they are going to help you earn more, the part they generally don't share is that they are also going to subject you to the possibility of greater losses. Remember, risk and reward are always related in the financial universe. Anyone who tells you otherwise is probably trying to sell you something.
With that being said, I'm now going to tell you how to make more money without taking more risk.
I know, I know. I just said that wasn't possible and that anyone who claimed otherwise was trying to sell you something.
But I promise I'm not trying to sell you something. I'm just going to help you marry your investment strategy with your tax planning in a way that improves your returns.
Here is the caveat. I don't have a wand I can wave to get you higher absolute returns with less risk. What I do have, though, is a magic bullet that can allow you to earn higher after-tax returns with the same amount of risk.
What's so magic about that? It's magic because if you do what I'm about to discuss, less of your returns will go to Uncle Sam in the form of taxes. And if less goes to Uncle Sam, more goes to you and your family. Which means that you are effectively earning higher returns for the same amount of risk, which is magical indeed. Here is how it works.
Because of their characteristics, some types of investments are more or less appropriate to hold in a particular type of account. Therefore, the idea is that you are going to be extremely selective about which investment you own in which account.
Think about it like this. What is the good thing about the tax-free pool of money?
The answer of course is that all future withdrawals are free from taxes. But exactly what is tax-free? Not just the money you put in, but all the future growth on that money, too. Therein lies the beauty of the tax-free pool.
So, if you have a pool of money that is going to grow free from taxes forever and then come out tax free, what kind of investments do you want there?
Well, if every single dollar of growth is tax-free now and forever, you want as much growth as possible. And some investments, such as stocks, have higher expected returns, which means that you expect them to grow more in the future. These investments should therefore go in your tax-free pool (Roth accounts). In fact, you should maximize this concept by owning not just stocks, but the kinds of stocks with the highest expected returns in your Roth accounts.
Continuing with this thought process, what is the downside of the tax-deferred pool? Well, the upside is the immediate tax reduction, but the negative is that the money you put in, plus every single dollar of future growth, is taxed at the highest possible rate. Since that is the case, you aren't as interested in generating growth in that pool, since many of your gains are going to go to your partners at the IRS. Instead, more conservative investments (such as bonds) should go in the tax-deferred pool.
To be clear, growth is always a good thing, and if you have more money but have to pay taxes, that is better than having less money and not paying taxes. Let's not lose the forest for the trees here. Its not like you don't want your tax-deferred pool to grow. But the idea is that in a diversified portfolio, you are going to hold some more aggressive assets and some more conservative assets. And so, relatively speaking, you want to concentrate your future growth where it is most tax advantaged.
What about your taxable accounts? What kinds of investments do you want to hold there? Remember, this is the pool of money where the taxation can vary the most, depending upon what type of assets you hold. Whenever possible in the taxable pool you want to hold assets that produce either long-term capital gains or qualified dividends. Doing this will allow you to take advantage of the special tax rates we discussed earlier.
Furthermore, any price appreciation isn't taxed until the asset is sold, so stocks and other growth assets often make sense for your taxable pool. Then, when the asset is sold, the gains are taxed at the special rate. And as an added bonus, you can also incorporate tax loss harvesting and utilize any capital losses you might accrue. These losses would be wasted in your IRA or other tax-deferred account.
Importantly, while each type of account will have different investments, your accounts will, in aggregate, ultimately reflect your target asset allocation. That allocation doesn't change, because your financial goals and required rate of return haven't changed. The only thing that changes is where you hold each investment.
The goal of everything I've been discussing is to minimize your tax bill and maximize your after-tax returns. Now, as I've already admitted, strategic tax planning and finding synergies between your investments and your taxes are not necessarily easy concepts. In order to take advantage of the opportunities available to you, you'll likely either need to substantially increase your knowledge base and time commitment to your finances, or find a qualified professional to help you incorporate these concepts.
But the bottom line is that by combining an effective investment strategy with savvy tax planning, you can end up keeping more of what you make.
And that, dear reader, is going to greatly enhance your future lifestyle.