As a financial and retirement planner, I have learned that people hate paying taxes. The truth is, the history of taxation is a complicated one full of wars, audits, jail time, and factions of society that were created in rebellion to the idea itself. To make things worse, the “rules” laid out by the IRS when it comes to tax are extremely complicated, ever-changing, and leave a ton of room for discretion.
When it comes to taxes, I have found that most people do not structure their retirement investments efficiently. Most retirement-based investments being utilized these days are things like 401ks, 403bs, and IRAs. For the sole proprietors and entrepreneurs, they will utilize things like SIMPLE IRAs, SEP IRA, and SOLO 401ks. The reality of these accounts is that they ALL work the same by providing the ability to “defer” income for tax purposes to a later date. In essence, any dollar amount you can save inside of these types of accounts will NOT be assessed the normal income tax you pay; instead, those monies can be invested PRE-TAX and grow. When you go to take these funds during your retirement years, you will then pay income tax on all monies (including the growth you achieve over that time). The benefit to these accounts is that the money you invest does not count as earned income; therefore you do not owe tax on that “income". The second benefit is that the money you would have otherwise paid the IRS in income tax is now in an account earmarked for your retirement and it is growing. In essence, you are using “house” money to compound interest in the market.
The reality is these short-term benefits can lead to significant long-term erosion and risk from a tax perspective. It can also affect your retirement investments, goals, and plans. Two things we must do in this life are die and pay taxes. The question you should ask concerning tax is “when is the bill the cheapest?” No one really knows that answer long-term, but what we do know is that currently, we are paying historically LOW taxes. In addition, mounting government debt (well into the trillions) along with trillions of “relief” dollars that have been printed both during the recession of 2008 and now recently during the COVID 19 pandemic one must assume and plan for an increase in long term tax brackets over time. Lastly, most assume they will spend less money and pay less taxes during retirement which justifies waiting to pay tax. I have worked with hundreds of people entering and now well into retirement years and, if anything, they are spending more and paying more tax.
Imagine someone approaches you and proposes an AMAZING business idea. You fall in love with the idea, and it is at that point the person presenting that idea offers you a “partnership” in it. They explain that the funding for this idea will be fully funded by you alone and that you will be taking on all the risks. The kicker is that in 20-30 years when you sell the business, they will receive 30-40% from the sale of the business. You do not need to be a business expert to know that is a horribly unfair arrangement. The reality is that this example is how PRE-TAX retirement-based accounts work. You invest your capital; you take on ALL of the risks associated with the investments, and when you sell those investments down the road to take as retirement income, the IRS will take 30-40%!
So, how might one go about reducing or entirely removing the IRS as a benefactor to their retirement investment they have worked so hard to save? The following are a few ideas to consider:
ROTH BASED INVESTMENTS
Roth-based accounts are something in the landscape of retirement-based accounts that are very new. Roth accounts allow a person to invest money AFTER TAX and grow the money inside on a TAX-FREE basis. These accounts were created with the middle to low-income earners in mind. In fact, the IRS established income limits that disallow these accounts to be used by high-income earners who no longer qualify because they make too much money. *Reference annual tax rules to see the income maximums laid out each year by the IRS.
The good news, especially for higher-income earners that recognize the value of tax-free growing retirement accounts, is that legislative changes to the tax code in 2010 opened up several doors for anyone to be able to take advantage of these types of accounts.
BACK-DOOR ROTH, ROTH CONVERSION, and ROTH 401ks
The 2010 tax code changes led to the doors opening for anyone to take advantage of tax-free growth. The “back-door Roth” is a concept that allows those who make too much income to contribute directly to a ROTH IRA, an opportunity to ultimately end up with monies in a ROTH IRA each year. The individual would establish both a traditional IRA (pre-tax) and a ROTH IRA. They would make an annual or monthly contribution to that account. They would then immediately “convert” those dollars into the ROTH IRA and, in essence, would end up with a contribution made to the ROTH now growing tax-free. This strategy is best for those looking to add NEW MONEY to their retirement plan and make it tax-free. A ROTH Conversion (as mentioned above) is the ability for anyone regardless of income to “convert” any portion or ALL the monies in an IRA to a ROTH account. This strategy is best for those who do not want to add new money. Instead, current pretax money can be taken and converted to a tax-free environment. Roth 401ks exist in most employer-based offerings now. This is a great opportunity for anyone regardless of income earnings to contribute to a tax-free account. In addition, a 401k allows for a much bigger annual contribution up to 19,500 (an additional 5,000 each year for those who are 50 years old or older).
LIFE INSURANCE WITH CASH VALUE
This is an investment based primarily on age and health that allows any person, regardless of income, to make any size contribution on an annual or monthly basis that grows tax-free. This account works just like the tax-free strategies listed above with a couple of additional advantages: this provides a permanent death benefit that will pay out to your heirs if you should die prior to using up the investment portion. You are not limited on how much you put in and you are also not limited to when you take it. In ROTH-based accounts, the interest/earnings in these accounts cannot be touched until you reach age 59.5.
Regardless of what strategy makes the most sense for you, considering adding tax-free accounts to your retirement plan is essential and will maximize the amount of money you have, and in turn, the amount of time it will last. An important responsibility you have as a business owner or individual is to be as tax efficient as possible. Reducing, or better yet, removing the IRS as a benefactor from your retirement is not only an option. In my opinion, it is a MUST-DO, sort of like dying and paying taxes.
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Written by: Ronnie Thompson