It’s been a little over a year since I published my paper on Lifetime Tax Reduction, which promotes our long-held position that tax-diversification is one of the most powerful tools available to build and preserve wealth. One of the challenges with this strategy is the large number of families that engage us in this process only when they are near retirement and have already “failed” to achieve good tax diversification. The paper addresses this contingent of readers in the list of recommended strategies, specifically #7.
In response to this challenge, we have deeply refined the process of optimizing retirement income to achieve tax-diversification late in the game, and the impact on lifetime taxes and ending portfolio values are dramatic!
In one example this week, we were able to restructure income sources and the timing of tax payments to decrease lifetime taxes by 40%! In the following graph, you can see the year by year taxes owed with a conventional withdrawal strategy (orange) versus our optimized strategy (blue).
Importantly, when you reduce taxes paid by 40%, you keep more of your own money every year for continued compound growth and income. In this case, the final portfolio value at the end of life is A) more than double (226%) what it would otherwise be, and B) completely tax free to heirs by strategically using the tax-deferred retirement assets to keep taxes as low as possible. Since the new tax laws eliminate the ability for heirs to use the “stretch-IRA” strategy, this is a huge win for the family.
The nuances are many, but here is how we accomplished this. First, we delayed Social Security in order to create “gap years” — or a period of years where taxes are nearly zero due to a lack of earned or distributed income. During these gap years, we triggered taxable Roth conversions at just the right amounts to prevent bumping up the client’s Medicare premiums, but still taking advantage of today’s low tax rates. Needed income during this period is derived from no- or low-tax sources that had intentionally been set aside for this purpose. And to really max this out, the conversions can be paired with charitable gifts (not illustrated) to further offset the taxes.
As the years progress, we’ll be doing micro Roth conversions each year for the purpose of making the best use of the lower tax brackets, and preventing the application of higher tax brackets with later required minimum distributions. As assets are shifted from tax-deferred retirement accounts to tax-free retirement accounts, you can see the impact on future taxable distributions in this chart. Again, orange is the default path most retirees take, blue is our optimized approach.
There is a final and significant benefit to our strategies. While we all love the idea of paying less in taxes and passing greater wealth onto heirs, perhaps the greatest benefit here is a higher degree of certainty in our own lifetime planning. The savings that result from optimizing your income, tax, and wealth accumulation strategies serves to increase the margin of safety in your financial plan — creating a higher degree of confidence in a world where higher confidence is sometimes hard to come by.