In the midst of the COVID-19 pandemic and the relief measures Congress has passed to ensure the economy’s recovery, markets regained the ground they lost in 2020 and then sailed even higher. If you’re getting ready to retire, these market gains likely help you feel more confident about the sustainability of your post-retirement finances.
Obviously, accumulating sufficient assets for retirement is a critical part of retirement income planning. However, it’s just as important to preserve what you’ve saved over the 25 or 30 years that you may live in retirement. That’s where proactive tax planning comes in.
Retirees are required by law to pay taxes on the money they take out from traditional retirement accounts, such as IRAs. You may be able to avoid taking money out of your traditional retirement account until age 72, but that’s when required minimum distributions kick in. At that point, you must pay taxes on the amounts you withdraw, which will reduce the value of your pre-retirement savings.
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As President Biden’s infrastructure plan begins to make its way through Congress, tax policy is in flux. In addition, large budget deficits spawned by pandemic relief have accelerated a rise in the federal budget deficit, which is estimated to reach the size of the entire economy in 2021, a level it hasn’t breached since just after World War II.
At the same time, the second-most populous generation, the Baby Boomers, are retiring at a rate of 10,000 per day. As boomers retire, they will tap their Social Security and Medicare benefits. This increase in payout for government entitlement programs will strain the federal government’s resources.
The combination of these factors makes it more likely that taxes will increase during your retirement, potentially reducing your income at a time when you need it most. Now is the time to figure out how to create a tax-efficient retirement where you can maximize deductions and credits while minimizing taxes. Here are four strategies to help you position yourself for tax efficiency in retirement:
Strategy #1: Consider a Partial In-Service Rollover from Your 401(K) Plan
Most retirees fund their retirement through ongoing contributions to company-sponsored 401(k)s plans. These plans offer a set menu of limited investment options, which may be optimal for saving for retirement but may not be optimal for retirement tax-efficiency. That’s where a partial in-service rollover comes in.
Through this type of rollover, you can move some of your retirement funds out of your 401(k) and into an IRA — with a multitude of funds to choose from — before you retire and while you are working for your current employer. More than 70% of 401(k) plans allow this type of rollover.
There are two central advantages to a partial in-service rollover:
- Diversifying your traditional stock and bond investments beyond what is allowed in most company-sponsored retirement plans with the goal of seeking out more tax-advantaged options.
- Adding in additional non-traditional retirement savings options, such as permanent life insurance and fixed index annuities.
Keep in mind, though, that you must be 59½ or older, and the rules for in-service rollovers can be complicated. They can also involve a lot of paperwork and can delay access to your funds in the immediate term.
Strategy #2: Consider a Roth IRA Conversion
Roth IRAs are a special kind of IRA funded with your after-tax dollars while you’re still working. They are exempted from RMDs, and you do not have to pay taxes on the distributions you do take in retirement.
Essentially, by converting some of your 401(k) or traditional IRA into a Roth IRA, you can pay the taxes on that portion of your retirement account in advance of retirement itself, leaving more available to you when you need it. Your assets will grow tax free as you approach retirement without having you having to worry about potential taxes on them or your withdrawals in the future.
Roths can be a good option for people who have flexibility now about paying the taxes involved. However, they may not be as suitable for those with limited financial flexibility.
Strategy #3: Consider Life Insurance
Life insurance is not just for your heirs. Permanent life insurance policies are a viable way to reserve funds for retirement because they allow you to withdraw or borrow against the cash value of the policy.
Tapping the value of your life insurance through borrowing or withdrawing cash creates tax-free income. Leveraging permanent life insurance premiums now for lower taxes in retirement can create more flexibility during retirement, especially if you’ve already maxed out the contributions you can make through your company-sponsored retirement plan and/or IRA.
Life insurance proceeds can be especially useful later in retirement when you are likely to encounter higher health care costs. You may be able to access cash value from your life insurance policy through a health care rider, or through death benefits in the case of a terminal illness.
Permanent life insurance policies come in several varieties, including variable, universal, whole life insurance and hybrid policies. In cases of health care emergencies during retirement, the hybrid policies especially stand out, because the money they make available to you for long-term care can exceed the death benefit, in many cases several times over.
Before you buy, you need to know that life insurance policies can carry high premiums, depending on the type of policy and how you plan to use it in retirement. The cash value of a policy tends to be illiquid and difficult to access as it can take time and you may have to pay penalties to withdraw or transfer funds.
Strategy #4: Consider Fixed-Index Annuities
Annuities are long-term investments designed to guarantee you an annual retirement income, much like the pensions of olden days. In a fixed-index annuity, your principal is guaranteed to grow based on how you allocate the funds to market indexes.
Fixed-index annuities guarantee a certain level of income based on participating in the market’s gains but also come with protection against losses — should the markets tank one year, you’ll still receive the inflation-adjusted amount you were guaranteed in advance when you purchased the annuity.
These products also offer long-term care riders that kick in should you become incapable of performing any of “the five daily activities of living,” such as eating, walking and going to the bathroom without assistance. This benefit can help pay for long-term care, which can be a retirement budget buster.
Finally, annuities provide important tax benefits in retirement. The money you invest grows on a tax-deferred basis. Once you begin to make withdrawals in retirement, that income is a combination of the investment you initially made and earnings from that investment. The portion that comes from your initial investment is tax-free, while the earnings from that investment are taxed at your ordinary income tax rate.
Some caveats: Fixed-index annuities can be complex, come with many fees and expenses and are also illiquid, meaning that they are hard to turn into cash should you need it to pay unexpected expenses. Make sure to read the fine print before you decide to buy one.
Avoid Retirement Tax Worries
Many people don’t think that their taxes will be higher after you’ve stopped earning money. However, what you put aside now in retirement accounts creates higher taxes in retirement, especially if the distributions push you into a higher tax bracket.
In-service rollovers to more tax-efficient investment options, Roth conversions, life insurance and fixed-index annuities are four of the strategies that should be in your arsenal of planning for a tax-efficient retirement that stretches your dollars as far as possible in your golden years.
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