By Tom Walker, for Walker CPG
Concerns about future tax rates have continued to grow in the years since the Great Recession, exacerbated by our ballooning national debt. Then the pandemic threw our nation’s fiscal trajectory for a loop when it reduced both payroll and income tax revenues while simultaneously forcing a dramatic increase in government spending and debt-financed stimulus (meaning we had to borrow from future Americans to help current Americans survive an extremely difficult time).
This was no small blip on the radar. We are currently on pace to add more to the national debt in just the last two years (2020 & 2021) than we had accumulated in total over our first 225 or so years as a nation. Some of that certainly has to do with inflation but in the last two decades alone we have seen the U.S. national debt quintuple, increasing from roughly $5Trillion to nearly $29Trillion today. And yet, even after spending all of that borrowed money, we are still anticipating a collision with the Federal Debt Ceiling again this fall. Congress cannot afford to continue spending significantly more than they generate in tax revenues indefinitely so it is imperative that we leverage the (limited) opportunities we have to create tax diversity in our retirement portfolios.
Now, each of the following tools/strategies could have its own standalone article (or book in some cases!) in order to sufficiently outline all of the potential benefits and pitfalls. But in this piece, we will simply be attempting to provide a high-level overview of the available options, a conceptual introduction to build upon with your retirement planning team or through continued self-study.
The Tax-Free Toolbox
1. Maxing out Roth IRA and Roth TSP contributions
a. By choosing to save after-tax dollars into a Roth TSP or Roth IRA, you will owe tax in that year but would then have the ability to generate gains on your after-tax investment that never trigger a tax bill (so long as some basic Roth timeline rules are followed)
b. The Roth TSP and a Roth IRA can be funded simultaneously so long as you’re eligible to contribute to a Roth IRA (based on household earned income)
c. Both the Roth TSP & Roth IRAs offer the ability to make additional catch-up contributions for participants who are over the age of 50
d. In this approach we are electing to pay taxes on the seeds at a known (historically low) rate today so as not to owe taxes on the harvest at an unknown future rate
2. Tax Bracket Harvesting with Roth Conversions
a. This refers to the process of systematically converting a portion of your tax-deferred assets into Roth IRAs (or CVLI) to defuse the tax-deferred timebomb during this period when “taxes are on sale”
b. To effectively accomplish this, we must coordinate the size and pace of your conversions with the goal of converting the total desired amount as quickly as possible but without dramatically increasing your marginal tax bracket in any single given year
c. Introduced in 1998, Roth IRAs had an earned income limit on Roth Conversions until as recently as 2010 – today there is no earned wages limitations for Roth Conversions, but that may not always be the case
d. This approach allows you to clear your portfolio’s tax liability in manageable pieces while keeping you out of the highest tax brackets which, in turn, creates a lower cumulative tax bill than converting the portfolio all at once
3. Health Savings Account (HSA) for medical expenses
a. Informally known as a Healthcare IRA, HSAs are primarily designed for the investment of emergency funds for those with a High-Deductible Health Plan (HDHP)
b. An HSA creates tax free distributions when utilized towards a qualifying medical expense and the account balance can roll over from one year to the next if no medical emergency is experienced
c. For those eligible to contribute, another popular feature is that an HSA can earn compounding interest that may grow your emergency funds even further
d. Qualifying expenses include: Co-pays & out-of-pocket deductibles, most vision/dental/hearing expenses, FEHB premiums, qualified LTC Insurance premiums, etc.
e. Warning: HSAs can be advantageous but they are complex, with a lot of red tape to ensure an HSA only benefits those with a qualifying medical expense
4. Cash Value Life Insurance (CVLI) can provide tax efficiency in 3 distinct ways
a. Accelerated Living Benefit Riders (ALBRs) – a category of rider that enables the insured to accelerate a policy’s Death Benefit (usually tax-free) while they are still alive should they have a qualifying medical emergency or need assistance with daily activities to age gracefully
b. Death Benefit – the proceeds from a life insurance policy are income tax free to beneficiaries and can offer powerful income continuation options for a spouse or a highly-leveraged legacy to loved ones
c. Tax-Free Distributions – permanent plans allow your excess premiums to earn compound interest and the policy’s cash value can be accessed in some incredibly unique and tax-efficient ways during the insured’s lifetime (without requiring a qualifying medical event as a trigger)
5. Downsizing primary residence
a. The IRS allows individuals to realize up to $250,000 of gains on the sale of the primary residence without being assessed capital gains taxes
b. This means a married couple could generate up to $500,000 of tax-free profit to help assist with other retirement expenses by simply downsizing the primary residence
While this is simply an introduction to some of the key tax planning concepts, it is important to note that tax laws are extremely complex and mistakes can be costly so this information should be used in conjunction with ongoing education and professional guidance.
If you would like to learn more about optimizing your Thrift SPENDING Plan to protect your retirement from higher future tax rates, join our complimentary upcoming webcast!