Have you ever received a discount on an invoice by making an early payment?
Think of car insurance, most insurers offer a discount if you make an annual premium payment instead of quarterly or monthly payments. What if you could do the same thing with income taxes for retirement?
A common approach for most peoples’ lifetime has been: reducing current income taxes; deferring income into IRAs, 401(k)s, or other qualified plans—to pay the taxes later on in retirement;and, planning on withdrawing money in lower brackets in the future, when income will be lower.
In retirement, most will only bewithdrawing enough money to cover spending, while also trying to limit withdrawals to stay in a lower bracket and using after-tax savings to cover the difference in spending. Then, required minimum distributions begin at 72, and the decision on how much to withdraw is, for all intents and purposes, decided by the government.
In general, this approach has served individuals well. As an example, a married couple making $275,000 per year would have been paying 33% on their top dollars, and today that same income amount would be taxed at a top marginal rate of 24%,which is a remarkable 27% discount in taxes owed on top dollars!
As Benjamin Franklin eloquently stated,“In this world nothing can be said to be certain, except death and taxes.” Taxes are a certainty, if we delay paying them today the IRS will get their share in the future subject to future tax codes.
I get it, taxes are complicated, and the future is difficult to predict, but that isn’t an excuse to avoid considering paying some tax today if that means you will be able to pay less tax tomorrow—like car insurance.
Unless Congress passes additional legislation to make the current tax code permanent in the next 5 years, the tax code is scheduled to revert back to an inflated version of the 2017 tax code.
So, there is an opportunity with today’s tax code to ‘prepay’ taxes at lower rates than are scheduled to exist in the future. Below is a table for the federal marginal tax rates for a married couple under the different tax regimes.
As you can see in the figure above, tax rates are scheduled to go up and the size of the brackets will be reduced. It takes less income to get to higher brackets in the future tax code, a double-edged sword.
How do you take advantage of today’s tax rates to save money on taxes you would pay in the future?
In cases where the opportunity to pre-pay taxes exist, an individual or couple will have a significant amount of their savings in a pre-tax IRA or qualified account. In concept, the strategy is to proactively increase income in current tax brackets to decrease future income in the higher brackets. The concept is simple, but it gets complex very quickly.
How do we accelerate income to take advantage of current tax rates without missing the opportunity to earn additional dollars from the investment of dollars paid to taxes?
Convert pre-tax IRA dollars to a Roth IRA. In a Roth IRA, you can still invest for future balance growth and, subject to certain rules, all earnings and qualified distributions are tax free in the future!
There are seemingly endless variables that go into planning Roth conversions, and there are no do-overs. From Medicare premium thresholds to the impact on Social Security benefits being taxed, there are considerations involved in the planning to make Roth conversions that go beyond the marginal federal tax rates.
If you are interested in learning more, just ask! I’ve put together a case study on how it’s possible for a couple retiring today with a combined savings of $2.5 million to save over $1.5 million in taxes over the next 35 years,which I’d be happy to share!
Timing is critical for these decisions, and we have no way of slowing the clock. If you are interested in saving money on taxes in the future by taking action today, contact us to start the discussion.
Thanks for reading!
Charlie
