best tax strategies for retirement

Best Tax Strategies for Retirement

Best Tax Strategies for Retirement

What are the best tax strategies for retirement?

First, we will discuss the tax planning window, the optimal time to do tax strategies in retirement.

Next, not infrequently, that tax strategy is a yearly series of partial Roth conversions. These pre-pay future taxes.

Finally, let’s tall all things After-Tax in the IRA. You won’t be disappointed!

There are my best tax strategies for retirement. Let’s start with the tax planning window.

And don’t forget to read why Roth conversions are like a Deferred Income Annuity.

 

 

The Tax Planning Window

The Tax Planning Window is defined as the time after you stop earning income and before you are required to start social security and required minimum distributions. This is the optimal time for the best retirement tax strategies: tax planning for retirement.

For the tax-savvy individual, The Tax Planning Window is a glorious time! There is no other window in time where you have such control of how and when you recognize income. During your tax planning window, you decide exactly how much you will pay in taxes!

Do not ignore your tax planning window for retirement: the goal is to pay the least in taxes over your lifetime. A dollar less you spend in taxes is a dollar more you can enjoy in retirement or leave as a legacy.

The tax planning window is the best retirement tax strategy. A Window is a good analogy because it opens and closes.

Open Window For Retirement Tax Planning

The window opens when you have access to your 10 and 12% tax brackets (or sometimes 22 or 24%). This usually is due to retirement, but you can often earn less later in your career and take advantage of this retirement tax strategy.

Even better, below the $12,950 or $25,900 (in 2022) standard deduction for single or joint filers, you can access income-tax-free!.

Use this Tax Planning Window wisely because it closes when you are forced to take income again.

Close Window for the Best Retirement Tax Strategy

There are several ways your tax planning window closes.

First, when you take social security. Depending on your “provisional income,” you will pay taxes on up to 50 or even 85% of social security. Of course, half the money you get from social security counts for provisional income, so most high earners should assume they will have to include 85% of their social security as fully taxable. Regardless, at least the high earner in a couple should plan on delaying social security for the longevity benefit, especially if you want a more significant tax planning window.

Second, you will be forced to take required minimum distributions (RMDs) from your pre-tax accounts. Thanks to the SECURE Act, you are forced to take ever-increasing RMDs at 72.

Finally, other sources of income can be recognized as ordinary. For Example, pensions and annuities are familiar sources of partially (say, annuities from your brokerage account) and fully taxable income (pensions and annuities from tax-deferred accounts). Remember, there are good annuities that are very worthwhile to consider.

But wait, there’s more! Of course, more sources of income can fill up your brackets!

Alimony (before 2018-after that it stops being a tax deduction), business income (Schedule C), Schedule E income, Schedule F income, Form 4797… even Capital Gains!

Capital Gains Stack on Top of Ordinary Income but can negatively affect your Tax Planning Window.

I know this is a lot to take in, but the Tax Planning Window is very important! Let me tell you why.

The Tax Planning Window: the Best Tax Strategies for Retirement

Why?

Control. Yes, you can control how much you pay in taxes.

For a traditional retiree who retires at 65, you have less than five years to access your low tax brackets.

For Financial Independence, the glory of being FI is prolonged access to your Tax Planning Window. But, of course, this leads to a whole host of other issues (like what income is most tax-advantaged to live on) that are the bread and butter of FIRE.

Beyond control– flexibility. You get to decide when to do partial Roth conversions.

Partial Roth Conversions: Best Tax Strategies for Retirement

 

The next best tax strategy for retirement: partial Roth Conversions.

Some people get confused and think there is an income limitation on Roth conversions. There is not. There are limitations on contributions, but not conversions.

If you have money in your pre-tax account, you can (usually) just press a button and convert that money to Roth money, paying taxes now.

These partial Roth conversions are amazingly powerful! They are among the best tax strategies for retirement.

Having at least some money in Roth accounts is essential for good tax diversification. It gives you control of future income. Remember the question: to Roth or not to Roth depends on tax rate arbitrage.

An example of partial Roth conversions and visualize the Tax Planning Window:

Some folks only use their brokerage account during this time and allow their tax-deferred accounts to grow. This is usually a bad idea, as you will increase the taxes you pay later via RMDs. But, again, the goal is to pay the least amount of taxes over your lifetime. Use the standard deduction and the 10 and 12% tax brackets to pay some tax now, so you pay fewer taxes in the future and overall.

Partial Roth conversions can shift this money into tax-free Roth accounts during the tax planning window.

An Example of Partial Roth Conversions

best tax strategies for retirement Roth conversions

(An example of partial Roth conversions best tax strategies for retirement)

Note there is now a dark blue shape filling the 10 and 12% tax brackets during the tax planning window. These are the partial Roth conversions!

Also, note that this decreases RMDs and keeps them out of the 24% tax bracket in the future (which is the 28% bracket once TCJA expires after 2025).

You might think that this isn’t a big deal, going down two percent from 24 to 22. But you would be wrong! And don’t forget, 22 becomes 25, and 24 becomes 28 when Tax Cut and Jobs Act expires in 2026.

Remember, you are paying taxes at very low effective rates during your tax planning window. When you are forced to take RMDs, all of the money comes out “on top” of everything else, at your highest marginal tax bracket. Keep your effective tax rate low over your whole life by decreasing the amount of income included at your highest marginal tax brackets.

 

Non-Deductible IRA vs. Brokerage Account

 

After tax contributions to a traditional IRA are a common problem. This results in basis in your IRA. That is, you have money that you have already paid taxes on in a usually pre-tax account!

You get basis in your IRA if you contribute to an IRA even though you make too much to take a tax deduction. Every year you get to file a Form 8606 to track the basis in your IRA. And remember, due to the aggregation rule, all of your IRAs (not Roth IRAs) are considered a single account for IRS purposes.

After-tax contributions are in the news right now, as there is a proposal to end Roth conversion of after tax contributions to a traditional IRA (the Backdoor Roth) AND to after tax contributions to a 401k (the so-called Mega Backdoor 401k to Roth IRA Rollover).

If this proposal goes through, this might be your last opportunity to liberate to a Roth these after tax contributions to a traditional IRA.

Let’s dig in deep regarding basis in an IRA and see what you can do about it, and talk about the future of after tax contributions to your IRA.

 

What is an After-Tax Contribution to an IRA?

Not infrequently, high income folks continue to contribute to an IRA even though they earn too much to take a tax deduction. Since this money cannot be deducted for tax purposes, it is considered after-tax basis in your IRA.

Anyone can contribute $6000 a year ($7000 if older than 50) if you have earned income (or a spouse that does—a spousal IRA contribution).

What is an after tax contribution to an IRA? It is simply a contribution you make that you are unable to deduct on your taxes because you phase out of the MAGI income limits. If you are unable to deduct the money (and have it be “pre-tax”), then it is basis or after tax basis in your IRA.

Not infrequently, CPAs don’t know what to do about this situation. They allow clients to continue to make non-deductible contributions and they may file form 8606 every year to track the after tax basis. And sometimes form 8606 gets lost which means you might wind up paying taxes on the after tax money! Double taxation! Also, many CPAs are not familiar with the Backdoor Roth so they haven’t been talking to their clients about converting those after tax contributions to the traditional IRA into Roth—which is a tax-free event.

After tax contributions to a traditional IRA are likely going to be around for a while even if the Backdoor Roth goes away. Many folks contribute to the IRA every year regardless of MAGI.

Since there is some urgency to convert after tax basis in the IRA to Roth (as you might not be able to do it next year!), let’s talk about that first and then discuss investing in a non deductible IRA vs a brokerage account.

 

Pro Rata Rule and Getting Basis out of an After Tax Traditional IRA

Unfortunately, all growth of after-tax money in your traditional IRA is taxable! If you could convert it to Roth, future growth is tax free!

As I mentioned above, due to the aggregation rule, the IRS considers all of your IRAs as a single account and values them once, on December 31st.

What is the pro-rate rule? It states that if you have after tax and pre-tax contributions in your IRA, any withdrawal or Roth conversion comes out in proportion to the after- and pre-tax amounts.

This means if you have a small amount of after tax contributions in your traditional IRA, you cannot do a Roth conversion of just the after tax amounts, you must convert it pro-rata.

Ed Slott describes this as the cream-in-the-coffee problem. The after tax “cream” is equally distributed through the pre-tax coffee.

How can you separate the after tax money in your IRA and get it into your Roth?

 

Do you have after tax contributions (also called basis) in your traditional IRA?

First thing to check is your most recent tax return. Do you see form 8606? This is a form that you (should) file every year with the IRS to show how much basis you have in your IRA.

It is common for people to forget to file form 8606, or drop it after a few years. Remember that form 8606 is not “proof” to the IRS that you have basis in your IRA, it is merely a work sheet to keep track of it.

You can go back and reconstruct your basis in your IRA if you have lost form 8606 or you are missing a few years. It is worth your time to do so now. Keep records of the basis you report on 8606 as, again, this form is just a work sheet, not evidence in case of IRS audit.

 

What happens if you forget to record your basis in a traditional IRA?

When you take a distribution from an IRA, it is fully taxable at ordinary tax rates unless you use form 8606 to show you are taking a pro-rata tax deduction due to basis. The same issue affects a Roth conversion—they are fully taxable unless you have form 8606 to demonstrate that part of the contributions are after tax.

If you don’t report that a distribution contains after-tax (basis) via the 8606 on your taxes, you will owe taxes on money that has already been taxed.

Remember, in the eyes of the IRS, you only have one IRA.

You may have a SEP and a SIMPLE and a rollover and three different other traditional IRAs. But the IRS doesn’t care about separate accounts. It is all one. This is called the IRS Aggregation Rule; you only have one IRA in the eyes of the IRS. If you have basis in one IRA (or even if you keep one IRA separate just for your after-tax contributions) and try to convert it to a Roth, you are going to bump against the pro-rata rule.

The Pro-Rata Rule

The pro-rata rule is used to determine how much of a distribution is taxable when your IRA has both pre-tax and after-tax (basis) dollars. You take the ratio, and then determine the amount that is taxable.

As a simple example, say you have 6k a basis and 6k of pre-tax in your IRA (as you might if you had a non-deductible IRA one year and deducted your IRA before). If you distribute the money (or do a Roth conversion), you will pay taxes on 6/12 or 50% of the money (as long as you use 8606 to show your basis).

If you have a SEP or a rollover IRA with 600k of pre-tax money and 6k of after tax contribution, then only 6/606 or about 1% that escapes taxation.

This is the pro-rata or proportion you have in after tax vs. pre-tax.

The pro-rata rule is what keeps many people from doing a yearly Backdoor Roth IRA. (It does not prevent you from doing the Mega Backdoor 401k to Roth IRA because this is done in a 401k and not an IRA.)

 

Cream in the Coffee (How to separate after tax contributions in your traditional IRA)

If you have just a bit of basis (cream) in your large IRA (the coffee), it is all mixed together. You can’t take a sip (a distribution or conversion) without getting both!

How can you get the cream out? After all, the basis grows in your IRA but you owe ordinary taxes on the growth. It would be nice to separate the cream from the coffee so you can Roth convert the basis and get tax-free growth. In order to get the cream out, you take advantage of the fact that you can only roll-over pre-tax money into a 401k. By law, 401k plans will only accept roll-ins of pre-tax money.

Say you have a 401k at work, or a solo 401k from 1099 income. Most of the time (read the summary plan document), 401k plans allow roll-ins of pre-tax IRAs (or other retirement plans).

So, if you have 6k of basis and 6k of pre-tax money in your IRA, you could roll in 6k to your 401k and then do a Roth conversion tax-free with the remaining after tax contribution. Or if you have 600k of pre-tax money from a separate rollover, you could roll that money back into a current 401k to get that messy 6k of basis in a Roth. This also gets form 8606 out of your life for good.

As long as you have a zero pre-tax IRA balance on December 31st (the only time the IRS applies the aggregation rule is on December 31st every year), you have done it! You separated the after tax basis in your IRA.

Cream in the Coffee

After-tax IRAs can be converted to Roth tax free! Many run into trouble, however, with Roth conversions on after-tax IRAs.

Not infrequently, high income folks continue to contribute to an IRA even though they earn too much to take a tax deduction. Since this money cannot be deducted for tax purposes, it is considered after-tax or basis in your IRA.

Also, not infrequently, CPAs don’t know what to do about this situation. They allow clients to continue to make non-deductible contributions which they can’t Roth convert due to the pro-rata rule.

Unfortunately, all growth of after-tax basis in your traditional IRA is taxable! If you could convert it to Roth, future growth is tax free!

How can you Roth convert your after-tax IRA and get it into your Roth in order to get tax-free growth?

Welcome to after-tax IRA Roth Conversions!

 

After-Tax IRA (Basis) and IRS Form 8606

Do you have after-tax money (also called basis) in your traditional IRA? This is an after-tax IRA.

First thing to check is your most recent tax return. Do you see IRS form 8606? This is a form that you (should) file every year with the IRS to show how much basis you have in your IRA.

It is common for people to forget to file IRS form 8606, or drop it after a few years. Remember that the 8606 is not “proof” to the IRS that you have after-tax IRA, it is merely a work sheet to keep track of it.

You can go back and reconstruct your after-tax IRA if you have lost IRS form 8606 or you are missing a few years. It is worth your time to do so now.

after-tax IRA roth conversion 8606

Above, you can see an example of IRS form 8606. The form is cut; I just wanted you to see what the top looks like so you can pull it to review from your most recent tax returns.

Next, pay attention to line 14. Line 14 of IRS form 8606 has the basis (after-tax IRA) for this year and all earlier years. If this line is not correct, fix it or you will pay tax again on money you already paid taxes on. Double taxation is not fun! You should avoid double taxation whenever possible!

 

Avoid Double Taxation

What happens if you forget to record your after-tax IRA?

When you take a distribution from an IRA, it is fully taxable at ordinary tax rates unless you use IRS form 8606 to show you are taking a pro-rata tax deduction due to basis.

Don’t let Money you have already paid taxes on be taxed again! Avoid Double Taxation!

This is important. If you don’t report that a distribution contains after-tax (basis) via the 8606 on your taxes, you will owe taxes on money that has already been taxed.

Next, remember, in the eyes of the IRS, you only have one IRA.

You may have a SEP and a SIMPLE and a rollover and three different other traditional IRAs. But the IRS doesn’t care about separate accounts. It is all one. This is called the IRS Aggregation Rule; you only have one IRA in the eyes of the IRS. If you have after-tax in one IRA (or even if you keep one IRA separate just for your after-tax contributions) and try to convert it to a Roth, you are going to bump against the pro-rata rule.

 

The Pro-Rata Rule and After-Tax IRA

The pro-rata rule is used to determine how much of a distribution is taxable when your IRA has both pre-tax and after-tax (basis) dollars. You take the ratio, and then determine the amount that is taxable.

As a simple example, say you have 6k after-tax and 6k of pre-tax in your IRA (as you might if you had a non-deductible IRA one year and deducted your IRA before). If you distribute the money (or do a Roth conversion), you will pay taxes on 6/12 or 50% of the money (as long as you use 8606 to show your basis).

If you have a SEP or a rollover IRA with 600k of pre-tax money and 6k of after-tax contributions, then only 6/606 or about 1% that escapes taxation.

This is the pro-rata or proportion you have in after-tax vs. pre-tax in your IRAs. (All of the them aside from Roth IRAs!)

The pro-rata rule is what keeps many people from doing a yearly Backdoor Roth IRA. (It does not prevent you from doing the Mega Backdoor 401k to Roth IRA because this is a 401k and not an IRA.)

Another way to think about the Pro-Rata Rule:  cream in the coffee.

 

Cream in the Coffee After-Tax IRA Roth Conversions

If you have just a bit of basis (cream) in your large IRA (the coffee), it is all mixed together. You can’t take a sip (a distribution or conversion) without getting both!

How can you get the cream out? After all, the after-tax IRA growth means ordinary income taxes.

It would be nice to separate the cream from the coffee so you can Roth convert the basis and get tax-free growth. You can, via the cream in the coffee After-Tax IRA Roth Conversion. 

Sometimes called the “cream in the coffee rule” (but it isn’t really a rule), this is a great way to separate the cream from the coffee. This is how to Roth Convert your after-tax IRA.

How to Do the Cream in the Coffee After-Tax IRA Roth Conversion

With the cream in the coffee after-tax IRA Roth conversions, you take advantage of the fact that you can only roll-over pre-tax money into a 401k. By law, 401k plans will only accept roll-ins of pre-tax money!

Say you have a 401k at work, or a solo 401k from 1099 income. Most of the time (read the summary plan document), 401k plans allow roll-ins (because they want your money). They only, however, by law allow pre-tax money to be rolled in, never after-tax or Roth money.

So, if you have 6k of basis and 6k of pre-tax money in your IRA, you could roll in 6k to your 401k and then do a Roth conversion tax-free with the remaining after-tax IRA!

Or if you have 600k of pre-tax money from a separate rollover, you could roll that money back into a current 401k to get that messy 6k of basis our of your 8606 and out of your life.

As long as you have a zero pre-tax IRA balance on December 31st (the only time the IRS applies the aggregation rule is on December 31st every year), you have done it! You Roth converted your after-tax IRA via cream in the coffee rule!

 

Some Caveats to Consider Regarding After-Tax IRA Roth Conversions

Remember, you only have one IRA. It doesn’t matter how many different accounts you have as they are all aggregated in the eyes of the IRS. And it doesn’t include your spouse, as the “I” stands for “individual.”

If you have mixed up after-tax and pre-tax money, you need to keep IRS form 8606 up to date. Go check your tax return right now if you think you have an after-tax IRA.

The IRS only looks once (December 31st) every year to check on your total basis in order to calculate your taxes on any IRA distributions. A Roth conversion is a roll-over, so the same pro-rata rules apply.

Roth IRAs are not subject to the aggregation rule and are not pro-rata. They are always after-tax. It is a little trickier with Roth 401k plans, since employer contributions are always pre-tax, but we won’t go there now.

Finally, also remember you can do a once in a life time HSA roll over (a QHFD) to get rid of a small amount of pre-tax money from your IRA as well. Fun fact.

Summary: Cream in the Coffee IRA

Using the Cream in the Coffee After-Tax IRA Roth Conversion, you can liberate after-tax IRA and then convert to a Roth tax-free. This allows all subsequent growth of your Roth to be tax free! We love Roth money. Partial Roth Conversions are a very important part of retirement planning.

This is important to consider if you want to do a yearly backdoor Roth IRA, or if you have been contributing to your IRA over the years and unable to deduct it.

Simply separate the coffee out by rolling the pre-tax money into a 401k, and then Roth convert the after-tax IRA.

Now you know, and you can get your December 31st pre-tax IRA balance to zero and avoid the pro-rata rule. The cream in the coffee after-tax IRA Roth conversion scores again!

Avoid double taxation and the messy IRS form 8606 with the after-tax IRA Roth conversion.

 

 

Get After Tax Contributions out of your IRA!

As I mentioned above, there are proposals before congress to end Roth conversions of after tax contributions. This means if you have cream in your coffee (after tax contributions in your traditional IRA), you must get them out before the end of the year!

If you don’t, you might be stuck with cream in your coffee for the rest of your life.

As a final note, remember you can do a once in a life time HSA roll over (a QHFD) to get rid of a small amount of pre-tax money from your IRA as well. Fun fact.

 

[update: of course the day I publish this, I get forwarded a bit  by a reader that describes that the prohibition of Roth conversions on after tax contributions has been removed from the proposed legislation. I’m not sure this will stick, after all there is no downside for congress to do this. They already have their taxes and they just get more taxes in the future through this prohibition. If it doesn’t make it this year, I expect it will soon!]

 

Next, since people will no longer be able to Roth convert after tax contributions to a traditional IRA, let’s discuss investing in a non-deductible IRA vs a brokerage account.

 

Non Deductible IRA Vs Brokerage Account

Are there advantages to using a non deductible IRA vs a brokerage account?

Should you use a non deductible IRA or a brokerage (after tax) account for investing? Is there a significant advantage to the tax-deferred growth over time which limits tax drag, or is it much to do about nothing?

Let’s look at a small $10k investment in either a regular investment account or a non-deductible IRA and see what happens over time.

What about someone who is 40 years old and earns $200,000 a year. She puts 6% in her 401k, and then invests in a non deductible IRA vs a brokerage account. Everything is invested in a total stock market index fund paying 7% with 2% yearly dividends.

 

Results of Investing in non deductible vs brokerage account

After Tax Contributions to a Traditional IRA

Above, you can see the results over time of investing in a non deductible IRA vs a brokerage account.

When she is 65, she has 58k of money in her IRA, of which only 10k is basis (the original 10k of after tax contribution she make to her traditional IRA). Look at the total and you can see that the account with the TIRA (traditional IRA) has 14k more due to savings on tax drag over the 25 years. Tax drag is why you would invest in a non deductible IRA vs a brokerage account.

However, once you start taking RMDs at age 72, the money is forced out of a traditional IRA but not a brokerage account. Note at age 90, the TIRA account is still larger due to the continued deferral of taxes in the (originally) small non deductible IRA.

 

Conclusion for Non Deductible IRA vs Brokerage Account

Small tax differences over 50 years make a big difference in the end. Even a small contribution to a non-deductible IRA provides benefit after a long period of time.

The tax-deferral decreases tax drag. Even when using a very tax efficient total stock market index fund (with 2% yearly dividends exposed to your capital gain rate), there is a difference. If we used tax-inefficient funds in our asset location (such as REITS, or bonds, or actively managed funds, etc), the difference would be even more pronounced.

In addition, taking Required Minimum Distributions can spread out the pain (tax payments) over time. This is why you should almost never take a lump sum out of your tax-deferred accounts.

Take advantage of every dime of tax-protected space you can. Who knows what the future will be like with tax reform, but even a year or two’s investment into tax-deferred space makes a big difference over decades.

 

After Tax Contributions to a Traditional IRA

After tax contributions to a traditional IRA used to be a great idea because you could count on converting them to Roth via a Backdoor Roth. Considerations included the pro-rata rule, the aggregation rule, and form 8606.

However, since it looks like after tax Roth conversions are going away, is investing in a non deductible IRA vs a brokerage account better? I like to keep it simple and not track basis in my after tax and pre-tax IRA. If you have a large amount of pre-tax money already (401k, 403b, 457b, etc), then consider skipping after tax contributions to your IRA. Avoiding tax drag is important, but so is keeping things simple.

 

Finally, remember to check out my end of the year tax planning guide for physicians.

 

 

Best Retirement Tax Strategies 

What do the best retirement tax strategies offer you? Tax Control and Flexibility!

Reduce future RMDs. Accumulate Roth money (so you can pull the money out without any implications for your taxes). Efficient tax planning for your Heirs.

What about health care? Controlling your income can get your premium ACA tax credits for Obama Care plans. And when you get to Medicare age, IRMAA is a huge deal. Medicare plans B and D are subject to hefty surcharges if you make too much money.

In the end, it is all about control. Who knows what the future will hold, especially regarding tax rates set by Congress?

The Tax Planning Window is the best retirement tax strategy. Partial Roth conversions and tax rate arbitrage complete the list. Finally, there are a mess of After-Tax IRA issues which can make all the difference to an individual.

Tax Planning for Retirement is your best chance to keep the money you earned rather than paying through the nose in taxes.

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3 Comments

  1. Remember that the ordinary taxes are not affected by dividends and long term capital gains. K1, W2 and 1099 (and some other types of income) will fill up the lower brackets.

    Some people, if they have enough pre-tax money, will easily be pushed into 32%/35/37+% tax brackets by RMDs and doing Roth conversions in the 32/35% tax brackets can make sense. It just depends on the amount of pre-tax money you have and your sources of on-going income in retirement. You need to project what your RMDs are into your 80’s. Don’t just do a tax projection at age 72, do one for the next 20-30 years!

  2. You would need to plan a large cash/ cash equivalent in order to live on during the multiple years of Roth conversion.

    • Correct! Cash, or stocks in a brokerage account, or some other source of after-tax money (rents from RE, HECM, cash-value life insurance…). It is expensive to keep your ordinary income tax low and then pay all those taxes, but it can save a ton in taxes over your (and your heir’s) lifetime.

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