By Keith Whitcomb

Unless you are locating assets in a Roth account, when you build your IRA or 401(k) balance you are also building a tax bill. That's because tax deferred accounts only postpone the payment of taxes.

At the recent Investments & Wealth Institute conference, Michael Kitces described this delayed tax obligation as an "Embedded IRA Tax Liability" and placed it on a household's balance sheet. The net effect of including the taxes ends up reducing the value of traditional 401(k) and IRA balances.

It's like owning a house with a mortgage - your equity is the net of the value of the house and the size of the mortgage. However, unlike a mortgage, instead of declining over time, the tax liability just continues to grow until you withdraw money from your account.

Recognizing accrued taxes more fully describes the value of assets available for generating your retirement income. It also serves as a basis for measuring the tax implications of different account location strategies in order to help you determine what best fits your financial circumstances.

Measure It

So how big is your embedded tax liability? In order to figure that out you need to measure it. While there are a number of ways to do that, perhaps the easiest method is to assume you remove the funds from the account with one withdrawal. This is basically a worst-case scenario that estimates the maximum tax impact. The only part of the evaluation subject to debate is the tax rate used in the calculation. Your average tax rate (not marginal) may work well when making the calculation.

The formula is: (Account Balance) x (Tax rate). Yeah, pretty simple.

An enhancement of the calculation is to discount the withdrawal to today's dollars as shown in the table below.

Another method for calculating the tax looks at the expense created when making Required Minimum Distributions (RMDs) from the account. This basically establishes the minimum tax payment and is likely more realistic than assuming a complete account liquidation at age 59 ½.

Several assumptions enter into this calculation (see footnote in table below), which makes it less definitive than the previous "simple" calculation, but it will allow you to evaluate a range of expected outcomes. The table below summarizes example results that illustrate the two valuation techniques.

Unlike the illustration above, your calculation will use your own account location strategy, i.e. where you will be saving money, budgeted retirement cash flows, and retirement account draw-down strategy. Once the calculation is performed, you will be able to evaluate taxable and tax-free accounts (like Roth, HSA, and bank demand deposits) on an apples-to-apples basis, given the inclusion of both assets and liabilities within your household balance sheet.

Can You Retire from Taxes?

We're not talking about tax evasion here, or merely tax deferral, but intelligent tax avoidance that could conceivably eliminate federal income taxes during retirement.

Before you get too excited, let's take a look at some tools, techniques, and limitations involved with attempting to accomplish this feat:

  • Health Savings Account (HSA) - Pay all qualified medical expenses (QME) with "triple tax-free" (when deposited, on growth, and when withdrawn) HSA savings during retirement. QME's not only include doctor, pharmacy, and healthcare facility expenses, but also Medicare and long-term care insurance premiums. Check out IRS publication 502 for a complete QME listing. Downside: contribution limits apply.
  • Roth - Use Roth accounts for retirement income. By definition, withdrawals from a Roth account are tax free. Downside: you have to pay tax on contributions into the account and contribution limits apply.
  • Tax on Social Security - Keep provisional income below Social Security tax trigger points. Downside: the provisional income threshold is low.
  • Standard Deduction - Taxable income up to the standard deduction is tax free. Downside: while the standard deduction was significantly increased this year, it can (will?) be changed in the future.
  • Home Equity Conversion Mortgage (HECM) - Pay down your current mortgage to minimize expenses and also provide a financial resource (the HECM) for tax-free cash flow in retirement. There is no downside to reducing expenses, but HECMs can be costly.
  • 0% Capital Gains Tax - There is no tax this year on brokerage account capital gains for tax payers in the 15% marginal tax bracket and below. Downside: you need investments that will throw off significant capital gains and not ordinary income.
  • General Expense Reduction - Lower your need for retirement income. This will allow you to live within some of the constraints shown above. Consider living in a more modest home or moving to a tax-friendly state. Downside: you may not want to modify your lifestyle or move away from family.

So, while the short answer to living tax free in retirement may seem to be an obvious yes, the real question is whether you should retire from taxes. That depends on whether you can achieve the account mix to accomplish it, and if it makes economic sense. Bottom line here is that for some middle-income earners, there may be a pathway to an income tax-free retirement. For higher compensated folks, you are likely still going to be on the hook.

Reducing Taxes with Account Location

Even if you can't fully retire from taxes when you retire, you may be able to reduce your tax bill. Let's take a look at what you can do to lower your taxes by modifying what accounts you are using to save for retirement (account location). This is a "saving smarter" alternative to the typical call for "saving more" that is part of most efforts to improve retirement funding. Here are some age-based strategies for you to consider.

If you are younger than age 50: During this accumulation phase of your life, you have the ability to materially impact your post-retirement tax profile by proactively structuring what accounts you are using for retirement savings. If you are early in your working career and in a relatively low tax bracket, it may be advantageous to use a Roth account. Of course, the problem when you are in a low tax bracket is that you also have limited resources to save. That said, check to see if your 401(k) plan offers a Roth option. This can be a great way to take advantage of any company match while also positioning yourself for tax free Roth withdrawals in retirement.

The other account you should be considering for retirement savings is the Health Savings Account (HSA). If you are enrolled in a High Deductible Health Plan (HDHP), you can save money in a HSA. Unlike the "pay me now or pay me later" tax question associated with using a Roth account, the HSA is a "no-brainer" when it comes to figuring out if it is advantageous from a tax rate standpoint. The tax rate is ALWAYS 0% when withdrawals from the account are used for Qualified Medical Expenses (QME). Let's face it - you can't beat a 0% tax rate. However, start early because not only will you likely draw on the account to pay for any current medical expenses, there are significant limitations on the size of the contributions you can make to the account.

Pre-retirement, age 50 to 70: This retirement "red zone" is where the investment horizon (or "field") is shortened and the "goal line" of retirement is close. You are still a long-term investor, given you could live another 30 years, but your portfolio will likely need to generate income in addition to growth in the relatively near future. Similar to football, a different investment process needs to be implemented to account for this "field position". Fortunately, the government has recognized this too. Starting at age 50, restrictions on retirement savings begin to soften. As a result, you can substantially increase your contributions and more easily adjust the account locations where your assets are housed. Here is an age-based listing of some important rule changes:

  • 50 - Catch up contributions to 401(k)s and IRAs ($6,000).
  • 55 - Penalty free withdrawals from employer-sponsored plans if you leave a job. Catch up contributions to HSA accounts ($1,000).
  • 59 ½ - Penalty-free withdrawals from employer-sponsored plans and IRAs.
  • 62 - HECM eligibility.
  • 65 - Loss of HSA eligibility unless still covered by a qualifying company plan.
  • 70 ½ - RMDs begin for deferred retirement accounts and IRAs.

Your "red zone" strategy is particularly important if you have an overweighted position in taxable account assets. Changing the account destination of your contributions and income harvesting from traditional 401(k)/IRA to Roth using partial Roth conversions to fill lower tax brackets are two ways you can alter your retirement tax profile while you are still working. Both methods look at the financial advantages of paying tax now instead of later in retirement. One driver for making this determination is looking at projections of your RMDs when you reach age 70 ½. Vanguard has a nice calculator that helps with this estimate. For those entering the RMD phase of their lives, a Qualified Longevity Annuity Contract (QLAC) may be a product that can reduce or postpone taxes associated with an unfavorably large IRA balance. While this product isn't for everyone, for those with the correct profile (higher net worth individuals) it may be a slam dunk.

Maximizing After-Tax Income

The key to success in funding your retirement is all about understanding, controlling, and maximizing after-tax income. It is not the mindless accumulation of assets in taxable or tax deferred savings vehicles. That means analyzing whether it is best to pay taxes when Roth contributions are deposited into an account, or when taxes are levied on withdrawals from a traditional account. Of course, if you have access to a 0% tax rate on the round trip into and out of an account, like with HSAs, try to take advantage of it because tax rates can't go below 0%! Finally, use a household balance sheet that includes both assets and embedded tax liabilities to monitor your retirement funding efforts. Measuring your ongoing results in this manner will help you figure out how to win the retirement tax bill game.

About the author: Keith Whitcomb MBA, RMA is the director of analytics at Perspective Partners and has more than 20 years of institutional investment experience.

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