The Pre-Retirement Game Plan to Reduce Taxes

Financial Advisor, Wealth Management,
Posted by Matthew Grishman
· 5 December, 2022

There are three specific tax savings strategies for people to consider in their 50’s and early 60’s to avoid paying higher taxes throughout their retirement. All three are predicated on the belief that taxes are going to be higher in the future than they are now.

Income tax rates and capital gain tax rates are at historic lows. Given the record levels of federal government spending during these historically low tax rates, and the fiscal stimulus that has been dumped on society as a result of the pandemic, it is hard to envision anything other than tax increases in the years to come.

Strategy #1 – Repositioning low basis stock holdings into laddered tax-free municipal bonds.

One of the best tax breaks of all time is something called the “step up in basis”. When you die and pass on assets to your heirs, most investment assets receive a “step-up”, or a reset of the cost basis of that investment to the price of that investment on the day of your death. For example, if you bought ABC stock in 1995 for $10 per share, and on the date of your death, the stock is priced at $50 per share, instead of your heirs’ paying taxes on those gains, they get to “step up” the cost basis of your shares to the $50 price. And if they were to subsequently sell those shares, no capital gains taxes would be owed.

One might deduct from this step-up that your relationship with your stock portfolio should be ’til death do us part. However, most people I meet in my private practice need their assets, including their stock portfolios, to replace the paycheck they gave up upon retirement. One could hold onto their stock if they pay dividends and try to replace as much income as they possibly could from those dividends. However, the average historical dividend yield for stocks in the S&P 500 averages around 2-3%. And those dividend payments are taxable, usually at federal capital gains rates of 15-20% plus state capital gains taxes which vary by state (in CA capital gains are treated as ordinary income and are subject to CA ordinary income tax of up to 12.3% in addition to your federal capital gains tax liability).

If you believe you will need your stock portfolio to replace some or all the income you need for retirement, consider selling your stock positions, locking in your tax liability today at historically low long-term capital gains rates (0-20% depending on your total adjusted gross income). With interest rates on the rise, yields in the municipal bond market have become much more attractive. You could purchase a laddered Muni bond portfolio yielding north of 4% tax-free. Laddering municipal bonds simply means buying a mix of individual bonds that mature over different time frames, so as your shorter-term bonds mature, those proceeds can be reinvested back into longer maturing bonds, offering you the opportunity to earn more interest over time, especially if rates continue to rise. Did I mention that the interest paid to you by owning municipal bonds is tax free?

If you live in a high tax state, like NY or CA, you might want to consider buying bonds issued within your state of residence. By purchasing bonds within your state of residence you generally get to enjoy an income stream that is tax free both federally and at the state income tax level.

Strategy #2 – Repositioning future savings from tax deferred investments to tax free investments.

Another strategy to consider in your 50’s or early 60’s, especially if you are still employed and saving money in your company 401k, 403b or 457 plan, is to stop doing that immediately. If you believe taxes will be higher in the future, ask yourself one question, “if I was a farmer and I had to pay taxes only once, would I rather pay taxes on my seeds or on my harvest?”

If you continue to max out your company 401k ($20,500 in 2022 if over age 55), you are receiving a small tax deduction today (remember, historically low taxes), to only see that contribution grow and create a larger income tax liability later, when you choose to withdraw the money, or are forced to withdraw money from that retirement account through IRS mandated Required Minimum Distributions (RMDs).

Consider investing your $20,500 into either a laddered Muni bond portfolio, or if you have the guidance of a trusted financial advisor, consider purchasing a permanent life insurance policy where you will not receive a tax deduction today. However, down the road you could use that growing cash value you saved inside the policy to create a tax-free income stream. Some policies will even offer mutual fund-like investment options within the life insurance policy, as well as the biggest potential benefit of them all: tax free lifetime income.

Strategy #3 – Roth Conversion

Once of the smartest money moves I have ever seen was with a client of mine who converted his big taxable 401k into a Roth IRA a few years before we met, while he was in his early 60’s. Now in his late 70’s, after enjoying the nearly 14-year uninterrupted bull market (that ended in January of 2022) this client is enjoying tax free withdrawals from a much larger Roth IRA, with no government entity mandating how much he withdraws each year via RMD’s. He can create hundreds of thousands of dollars of tax-free income each year as he needs it.

This strategy works best if you have the cash in a non-retirement account to pay your tax bill upon the conversion.

However, if you believe as I do, that taxes will likely be much higher in the future than they are today, the economic benefits to a Roth conversion might make sense. By converting your current 401k or IRA to a Roth, you eliminate two financial pain points: income taxes on withdrawals in the future, and no longer are you required by law to take Required Minimum Distributions. Upon a conversion, you pay your taxes but maintain your ability to continue growing that asset. You could pass on the entire remaining value of your Roth IRA to your heirs without any income or capital gains tax liability. However, should you choose to take withdrawals to supplement your retirement income, those withdrawals would also be 100% income tax free.

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