Think You Know Your Retirement Assets? Think Again

Tax planning involves taking tax-efficient steps to strengthen a long-term financial plan. The main thrust of traditional tax planning has been to reduce taxes to the greatest extent possible today and worry about it later — in essence, kicking the “tax can” down the road. That is why there is an emphasis on making pre-tax retirement contributions today to lower tax liability in the current year, which is solid advice.

While it is important to keep taxes low on a year-by-year basis, doing so can lead to some of the challenges addressed earlier, such as accumulating substantial pre-tax assets that will need to be taxed at some point.

That is why our preferred approach is lifetime tax minimization, not necessarily year by year. This is taking a bird’s eye view of a client’s taxes.

By smoothing the tax liability over a client’s lifetime — rather than reducing taxes now and then having to pay more later — we can better control a client’s sources of income from the portfolio while also avoiding a potential “tax bomb” in retirement.¹

Here are a couple of planning principles related to this fresh approach to tax planning.

• Required minimum distributions are just the minimum. When the IRS mandates that a certain amount must be taken from an IRA, that mandate is just the minimum — hence the term “required minimum distribution.” But there are reasons to consider taking out more than the required amount. It would mean paying more in tax but would also be reducing the size of a pre-tax IRA. Also, there may be room in the current tax bracket to absorb that extra income before bumping into a higher tax bracket.

Note that whether to take more than the required amount — and how much more — is an analysis that ideally should take place each year in the fall with the help of a tax preparer and your Forum advisor.

• Accepting higher taxes today for future benefits. This goes back to the earlier point about smoothing out tax liability over a lifetime, such as taking more than the required amount from an IRA or doing a strategic Roth conversion (see the next section). Both of these are voluntary actions that will increase current-year tax liabilities. While no one likes paying taxes, if it means a better outcome over the long run to pay a little more today, then it should be considered.

A Roth conversion is the transfer of assets from a pre-tax IRA into a Roth IRA. Income tax is due on the amount that is converted into the Roth IRA. Once inside the Roth IRA, the money grows tax-free and is distributed tax-free. If inherited, beneficiaries do not pay tax either.

Why would someone do a Roth conversion? There are several reasons:

• Prepay the income tax for children
• Reduce the balance of a pre-tax IRA prior to being required to take distributions from it
• Pay taxes now while in a lower tax bracket when likely to be in a higher tax bracket in the future
• Tax diversification — different types of accounts are treated differently for tax purposes — to have flexibility in retirement for drawing income

Roth IRAs can be powerful tools for cash flow, tax and estate planning. What makes a Roth conversion strategic is the use of low tax brackets in low-income years to maximize the value of the conversion.

In other words, there are benefits associated with paying a little more tax now — thanks to a Roth conversion — rather than paying less now and much more later without doing Roth conversions. The goal with strategic Roth conversions is to smooth taxes over a retiree’s lifetime, as opposed to allowing required minimum distributions to push retirees into higher tax brackets as they age.

This is easier said than done. Fortunately, your Forum advisor can help determine what an ideal Roth conversion amount would be year to year.

One area of retirement accounts that has received a lot of attention lately is that of inherited IRAs — accounts created for the benefit of beneficiaries after the death of the original account owner. Between recent legislation passed by Congress and new regulations published by the IRS, the rules for inherited IRAs have become quite confusing. That is the ugly of inherited IRAs — the rules are rather complicated, having changed significantly since 2019, and it can be difficult to understand all the nuances without guidance.

For most non-spouse beneficiaries, with few exceptions, inherited IRAs will have required minimum distributions annually and must be completely distributed by the end of the 10th year following the death of the original account owner. For those with sizable pre-tax inherited IRAs, that could mean large taxable distributions. That is the bad — pre-tax inherited IRAs are not great for tax-paying beneficiaries. (However, pre-tax IRAs are excellent assets to leave to charity.)

The good is that inherited Roth IRAs are great for beneficiaries. While most non-spouse beneficiaries will still have to deplete the inherited Roth by the 10th year following the death of the account owner, none of the required distributions during those 10 years is taxable. To the extent funds remain in the inherited Roth, that money can continue growing on a tax-free basis until required to be distributed.

That is why doing strategic Roth conversions can be so beneficial to the next generation — inheriting Roth IRA assets may provide advantages compared to pre-tax IRA assets.

The complex nature of retirement assets and the various rules that govern them provide some attractive planning opportunities. With the right professionals on your team, you can navigate this part of your financial life with ease, confident that you are managing your retirement assets effectively for yourself and your heirs.