If the federal government continues to print more and more money, where are they going to get the money to pay the interest on our national debt? Won’t they have to eventually raise taxes? If they do raise taxes, do you want to pay those taxes? Do you really want to leave a lions share portion of your life’s work to the IRS? What are you to do? How are you going to mitigate your future tax burden? Of course, having a tax-free retirement income is a dream of every about-to-be-retirees!
Don’t worry. In this article we discuss how strategic planning and execution can allow you to achieve the dream of every about-to-be- retiree.
But what you must know is that, without strategic planning and execution you will never be able to achieve this dream.
Let us help you through your journey. In this blog we have provided major strategies and ways of execution to achieve a tax-free retirement income. To do this we have used a hypothetical case example of the Millers.
Let’s dive right into it, shall we?
Background
John and Emily Miller are both aged at 45. They have been teaching for over two decades. They have two children, who are of 12-years and 15-years age.
The combined annual income of Millers is $120,000. They have diligently saved by contributing regularly to their 401(k) plans and IRAs. However, they are concerned about the tax implications of their retirement savings and wish to explore methods to achieve a tax-free retirement income. Let’s look at what they can do!
Initial Assessment
John and Emily conducted a thorough review of their current financial situation with the help of a financial educator. They identified the following key points of their condition:
- Total savings in 401(k) plans: $350,000
- Total savings in IRAs: $150,000
- Annual expenses: $70,000
- Mortgage balance: $100,000
- College savings for children: $50,000
Now, let’s have a look at the strategies they might employ to achieve tax-free retirement income.
Strategy Development
John and Emily consulted with a retirement specialist to develop a comprehensive plan. The advisor proposed several of the following strategies:
- Roth IRA Conversions
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- They can convert their traditional IRAs to Roth IRAs. It would require them to pay taxes on the converted amounts (in the year of conversion). However, qualified withdrawals from Roth IRAs would be fully tax-free.
- Health Savings Account (HSA) Contributions
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- Contributions to an HSA are also tax-deductible. Whilst the withdrawals used for qualified medical expenses are also on zero tax.
- Municipal Bonds
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- For Millers, investing in municipal bonds can also provide tax-free interest income to them. Since the interest earned on municipal bonds is typically exempt from federal income tax and, in some cases, even from state and local taxes.
- Maximizing Tax-Advantaged Accounts
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- If they want, they can also continue contributions to their Roth 401(k) plans (if available). It will ensure that their future withdrawals will be completely tax-free.
- Life Insurance
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- Subject to certain conditions, purchasing a permanent life insurance policy will also provide tax-free loans and withdrawals to Millers. You can take help of a financial educator at Plush Retirement to understand the conditions of such a policy.
Implementation
After learning about the above strategies, John and Emily decided to implement the below steps:
- Roth IRA Conversions
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- They began converting their traditional IRAs to Roth IRAs – gradually over several years. They paid the taxes on the converted amounts from their non-retirement savings. This helped them avoid further tax implications on retirement accounts. Each year, they converted $30,000, which resulted in a total tax liability of $7,200 per year (assuming a 24% tax rate). Over five years, they converted $150,000, thereby incurring a total tax liability of $36,000.
- HSA Contributions
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- They opened an HSA and contributed the maximum allowable amount each year. Currently for families the contribution limit is $7,750. Assuming they contributed this amount annually for 15 years, they would have accumulated $116,250. Please note: This excludes growth from investments that were made within the HSA.
- Municipal Bonds
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- Millers also allocated $100,000 of their non-retirement savings to municipal bonds. This will earn them an average annual interest rate of 3%. Do you know what this means? They will be left with $3,000 annually in tax-free interest income.
- Roth 401(k) Contributions
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- With the help of a retirement specialist, they also shifted their 401(k) contributions to Roth 401(k) accounts. Assuming a combined annual contribution of $19,500, they would have contributed $292,500 over 15 years. With an average annual return of 5%, their Roth 401(k) accounts would grow to approximately $460,000.
- Life Insurance
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- Millers further purchased a permanent life insurance policy with a cash value component. Together, they contributed $5,000 annually to it. Over 15 years, they would have contributed $75,000. Assuming an average annual growth rate of 4%, the cash value of their policy would be approximately $101,000.
Challenges
The ride was not as smooth as it might sound above! John and Emily encountered several challenges during their implementation phase:
- Tax Impact of Roth Conversions
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- Managing the tax liability of Roth IRA conversions required careful planning. They had to ensure they did not move into a higher tax bracket due to the conversions.
- Investment Risk
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- Investing in municipal bonds and life insurance required them to frequently assess the associated risks and returns.
- Healthcare Costs
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- Estimating future healthcare costs to determine appropriate HSA contributions was not at all easy! They had to ensure they did not overfund or underfund their HAS at any cost.
Results
Over the next 15 years, John and Emily successfully executed their plan. By the time they reached 60, they had achieved the following:
- Roth IRAs
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- They had fully converted their traditional IRAs to Roth IRAs. This left them with a total balance of $250,000. All future withdrawals would be tax-free for them now.
- HSAs
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- They had accumulated $116,250 in their HAS. This made sure that they had funds for medical expenses without any tax implication for them.
- Municipal Bonds
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- They had a diversified portfolio of municipal bonds. It generated for them over $3,000 annually – and in tax-free interest income.
- Roth 401(k)
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- Towards the end, they had a total of $460,000 in their Roth 401(k) accounts. It will be available to them at tax-free withdrawals.
- Life Insurance
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- Their life insurance policy had a cash value of $101,000. This provided them an additional safety net of a fully tax-free income.
Conclusion
John and Emily Miller’s journey demonstrates that achieving a tax-free retirement income is completely feasible. All you need to do is – strategic planning and well-disciplined execution of this plan. The strategies in this blog are those advised by the best of retirement specialists and financial educators.
However, if you still find it difficult to strategize and implement, then you can contact us and our trust and estate advisors will help you out in your entire financial journey.
