By Justin Fundalinski, MBA | March 20, 2018
Considering the reader base of this newsletter, I assume most reading this are attempting to be good savers for retirement and are patting themselves on the back each year for peeling off portions of their earned income to save into 401(k)s and IRAs, all while reducing their current year’s tax bill. I commend you for your discipline and urge you to look even deeper into the future. As we all know the only thing guaranteed in life is death and taxes. While we can’t help you with death (perhaps my wife could as a Board Certified Palliative and Hospice Nurse Practitioner), I do think we can help reduce the tax liability you are creating for yourself in the future when you defer those taxes by saving into accounts like 401(k)s and Traditional IRAs.
What Is the Tax Void?
We have coined another term in the office called the “tax void.” As eloquently as possible, it is defined as the period of time between retirement and age 70 when retirees have the most discretion over where their income sources are coming from and thus they have the most control of their tax liability. By “where” I mean what type of account they are debiting from(qualified or non-qualified, taxable or not taxable, etc…) as well as whether or not they are deferring income from Social Security, Pension, and/or annuities.
As an extreme example, if somebody could delay taking withdrawals from 401(k), Traditional IRAs, or other similar tax deferred retirement accounts as well as defer their taxable income sources like Social Security and pension income, then they would enjoy a temporary luxury of not having to pay any taxes between retirement and age 70. While most people don’t have the ability to have such complete discretion, most people do have some discretion and such discretion can create a tax void (although maybe not as deep as the one made in my extreme example). However, simply avoiding paying taxes during this time period is the worst choice a retiree can make because of how short sighted it is (more on that soon).
Creating a Bigger Tax Void
Creating the opportunity to have a large tax void is probably the most difficult step in this type of tax planning, but it essentially comes down to one thing – tax diversification of retirement savings. Tax diversification simply means how one is allocated between different types of accounts based on how withdrawals will be taxed when they take distributions from the account.
All income from a Traditional IRA will be fully taxed as ordinary income; however, income from a non-qualified account is taxed based on how much gain was taken (as well as taxes at capital gains rates), and funds from a Roth IRA or 401k are not taxed at all. Unfortunately, because everybody does such a good job of avoiding taxes today by saving into their 401(k) and/or Traditional IRA, the vast majority of people tend not have much in the way of tax diversification later. If it makes sense from a long-term tax perspective, saving into other types of accounts such as Roth IRA’s or Non-Qualified (Taxable) accounts will enhance your tax diversification when you retire and provide the opportunity for a greater tax void.
Filling the Tax Void
As most know, we are taxed in a tiered fashion. The first chunk of taxable income is taxed at 10%, the second chunk of taxable income is taxed at 12%, the third at 22%, and so on. As I mentioned earlier, simply avoiding paying taxes during a tax void is a bad idea. Knowing which of these tiers (or tax brackets) will be filled up entirely by income that is not discretionary once you reach age 70 is very important when it comes to filling your tax void appropriately.
If you know that your Social Security and Pension income will fill up your 10% and 12% brackets fully at age 70 then you also know that all your Required Minimum Distributions (forced distributions for tax deferred retirement accounts) will be taxed at least at 22%. Now if you know that all your withdrawals or Required Minimum Distributions from your Traditional IRA’s or 401(k)s is going to be taxed at least at 22%, it’s probably a great idea to get any money out of those accounts at a lower tax rate whenever possible. When is it possible? During the tax void!
Roth Conversion strategies combined with other withdrawal strategies make this very achievable. The effect is that you will have less money in tax deferred retirement account, causing you to have smaller Required Minimum Distributions. This in turn causes you to have less income taxed at higher rates as well as more overall tax diversification.
Trust me when I say that while there seems to be a lot of moving parts here this is only a 30,000-foot view of the amount of detail that must be accounted for when trying to create and fill a tax void. If you are looking for ways to ultimately decrease unnecessary Required Minimum Distributions and the associated taxes, or are just simply looking to minimize taxes in retirement please reach out to me for additional information.
 Why age 70? Age 70 is the longest you can delay your Social Security benefit. At age 70½ Required Minimum Distributions on tax deferred retirement accounts begin.