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.
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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