Don’t Let Taxes Erode Your Retirement: Smart Strategies for Keeping More of Your Hard-Earned Money

As a fee-only independent fiduciary advisor and a proud member of Ed Slott’s Elite IRA Advisor Group, I’m always looking for ways to help my clients maximize their retirement savings and minimize their tax burden.

Ed Slott, a renowned IRA expert, recently emphasized the importance of long-term tax planning in a ThinkAdvisor article. He encourages investors to shift their focus from short-term tax deductions to strategies that will minimize taxes throughout their retirement years.

Here are some key takeaways that can help you make the most of your retirement savings:

1. Rethink Your 401(k) Contributions

While the immediate tax deduction of a traditional 401(k) can be tempting, it’s essential to consider the long-term implications, especially if you anticipate being in a higher tax bracket in retirement. This is particularly important if you have a large 401(k) balance, as those funds will eventually be subject to taxes when you take distributions.

Instead, consider contributing to a Roth 401(k). You won’t get an immediate tax deduction because you’re contributing money you’ve already paid taxes on. However, qualified distributions in retirement will be completely tax-free. This means you won’t owe any taxes on the earnings it accumulates over the years.

And don’t worry about missing out on your employer match! The tax law now allows employer matching contributions to go into your Roth 401(k) as well.

By contributing to a Roth 401(k), you’re essentially paying taxes on your contributions now, and then enjoying tax-free withdrawals after years of portfolio growth. This can result in significant tax savings over the long run.

2. Don’t Delay Roth Conversions

With the possibility of current tax cuts being extended, now is an ideal time to consider converting some of your traditional IRA funds to a Roth IRA.

Why Convert to a Roth IRA?

• Tax-Free Growth: One of the most compelling reasons to convert is the potential for tax-free growth. Once the funds are in a Roth IRA, any investment earnings accumulate tax-free, and qualified withdrawals in retirement are also tax-free. This means you could potentially double your money (or more!) without ever owing taxes on those gains. 
  
• Higher Tax Bracket in Retirement: If you anticipate being in a higher tax bracket during retirement, conversions can be particularly advantageous. You’ll be paying the taxes now while you’re in a lower bracket, rather than later when your tax rate might be higher.
  
• Flexibility and Control: Roth IRAs offer more flexibility and control over your retirement funds. Unlike traditional IRAs, Roth IRAs are not subject to required minimum distributions (RMDs), giving you more freedom to decide when and how much to withdraw. 

How to Convert to a Roth IRA

You can convert all or a portion of your traditional IRA to a Roth IRA. We can help you determine the optimal conversion amount and strategy for your specific situation.  

Caveat:

Keep in mind that Roth conversions are taxable events. The amount you convert will be added to your taxable income for the year, which could potentially push you into a higher tax bracket. Therefore, it’s crucial to carefully consider the timing and amount of your conversions to minimize your tax liability.  

Spreading Out Conversions

One strategy to mitigate the tax impact is to spread out your conversions over several years. This can help you stay within lower tax brackets and avoid a large tax bill in a single year.  

By strategically planning your Roth conversions, you can potentially save a significant amount in taxes over the long run.

3. Spread Out Inherited IRA Distributions

If you’ve inherited an IRA from someone other than your spouse, the 10-year rule applies, meaning you have 10 years to withdraw the entire amount. Don’t make the mistake of withdrawing everything in the first year or waiting until the 10th year to take it all out. Both strategies can result in higher tax bills.

Instead, consider spreading out your distributions over the entire 10-year period. This allows you to take advantage of lower tax brackets and potentially save thousands of dollars in taxes.

Example:

Let’s say you inherit a $500,000 IRA from your parent. As a non-spouse beneficiary, the 10-year rule applies. We’ll consider you’re currently working with an annual income of $100,000. By using a consistent base income of $100,000, we can more accurately illustrate the tax implications of each scenario. 

If you withdraw the entire $500,000 in one year, it will significantly increase your taxable income and push you into higher tax brackets. By spreading out the distributions, you could potentially save a significant amount in taxes.

Lump-Sum Scenario

Total Tax Paid Over 10 Years (Lump Sum): $181,666 (Year 1) + ($17,790 x 9 years) = $341,776

Spread Out Scenario (Years 1-10)

With a $50,000 annual distribution added to your $100,000 base income, your total taxable income would be $150,000. Here’s how the tax would be calculated each year:

Income Range	Tax Rate	Portion of $150,000 Taxed	Tax Paid on this Portion
Up to $11,600	10%	$11,600	$1,160
$11,601 – $47,150	12%	$35,550	$4,266
$47,151 – $103,350	22%	$56,200	$12,364
$103,351 – $197,300	24%	$46,650	$11,196
$197,301 – $250,525	32%	$0	$0
$250,526 – $501,050	35%	$0	$0
Over $501,050	37%	$0	$0
Total			$29,086 (Each Year)

Total Tax Paid Each Year (Spread Out): $29,086

Estimated Total Tax Paid Over 10 Years: $290,860

As you can see, while the lump-sum distribution is taken in the first year, its impact on the beneficiary’s tax situation is greater than if the distributions were extended over the entire 10-year period. This highlights the importance of spreading out distributions to minimize the overall tax burden.

Lump Sum Scenario: $341,776 total tax paid over 10 years

Spread Out Distributions Scenario: $290,860 total tax paid over 10 years

Important Note: These calculations assume that your income and the tax brackets remain relatively consistent over the 10-year period.

The Bottom Line

By taking a proactive approach to tax planning, you can keep more of your hard-earned retirement savings. Remember, it’s not just about how much you save, but also how much you keep after taxes.

If you’d like to discuss how we can craft a retirement income strategy that helps you maximize your income and minimize taxes, please contact us. 

Source: Ed Slott, “Big Moves Clients Should Not Make Before Year-End,” ThinkAdvisor, December 4, 2024.