Question: If you have the choice of investing $750 at an 8% rate of return for 10 years, or investing $1000 at an 8% rate of return for 10 years, then paying a 25% tax on the ending value, which should you prefer?
Answer: Neither. The ending value in each case is exactly the same.
In other words, if you have the choice between taking a 25% tax-bite out of an investment at the beginning of a period or at the end of a period, there’s no difference (because of the commutative property of multiplication).
However, anytime you have the choice to pay a tax of a certain percent now or a tax of a different percent later, then we have an opportunity for tax planning. That is, by planning carefully, you can reduce your total tax bill and leave more money in your wallet/bank account/IRA/mattress.
Retirement Tax Planning Opportunities
If you’re like most people, when you retire, your taxable income will decrease, as will your tax bracket.
And when you reach age 70½, you must start taking required minimum distributions (RMDs) from your traditional IRA. When that happens, your tax bracket is likely to increase.
End result: There’s likely to be a period between the date at which you retire and the date at which you turn 70½ during which your tax bracket is both lower than it’s been in recent years and lower than it will be in the future. And that means…
Tax Planning Opportunities!
Spend Down Taxable (and Tax-Deferred) Accounts
Each year during retirement, you’re likely to have to sell some of your investments to pay your bills. By properly choosing which assets to liquidate first (or more specifically, which accounts to liquidate first), you can lower your overall tax bill.
In years in which you’re in a lower tax bracket than you expect for later years, it makes sense to spend from your 401(k), traditional IRA, and taxable accounts first. This way, you can save your tax-free money (Roth IRA money) for years in which you expect to be in a higher tax bracket.
Roth Conversion
When you convert an amount from a traditional IRA to a Roth IRA, the amount of the conversion counts as taxable income, and when you later take it out of the Roth, the money comes out tax-free (assuming you satisfy a few rules).
If you’re in a lower tax bracket when you execute the Roth conversion than you expect to be in later (once your RMDs kick in, for example), this can be a great way to cut down your overall tax bill.
Pay Off Your Mortgage
Lastly, if you haven’t done it yet, it probably makes more sense than ever to pay off your mortgage. Being in a lower tax bracket makes the tax deduction from mortgage interest less valuable, thereby making your after-tax interest rate higher.
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We keep hearing how little people have saved for retirement. I doubt the vast majority will have a large balance in their IRA when they reach 70-1/2, large enough to make RMD a problem. For people with a defined benefit pension plan, they are able to keep their money in the IRA. When they get to 70-1/2, the additional RMD can make their taxable income go up. For the generation without a pension, the IRAs will have been drawn down long before RMD hits.
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