Being a high net worth individual typically comes with a price. Does it mean being we have to be in a high tax bracket when we retire?
What you do for a living before retirement can make a huge difference in how much you tax you pay. Business owners, for example, are fortunate to be able to write off more expenses than many professionals and executives. But often, many of those write-offs vanish as we enter retirement.
The majority of financial professionals generally assume a 30% to 40% tax bracket during retirement years. The higher the tax, the less stable and secure your retirement is, and the greater chance of running out of money. So, the question is, how can high-net-worth entrepreneurs lower their tax bill in retirement? The follow example sheds some light to illustrate some possibilities.
Let’s assume John and Sally, from Florida are both 65 and ready for retirement John had a successful business he was able to sell. The couple shared a retirement goal of $500,000 per year. Most of us would agree they are going to be in a high tax bracket in retirement with little chances of reducing their annual taxes each year.
In the old days of higher interest rates, the challenge would have been easy. A typical allocation of 60-50% equities with a 40-50% in tax-free bonds would, in most cases, have worked perfectly to lower their tax bracket. Unfortunately, the current yields on tax-free bonds are extremely low, and the inherent risk of longer maturity bonds going down in value as interest rates rise. The financial team John and Sally had put in place worked toward a goal of having the couple paying less than 10% per year in taxes on $500,000 of retirement income. With the help of the Tax Cuts and Jobs Act of 2017 (TCJA), they learned there are several opportunities to help them achieve their goal. Below is an overview of those options.
- Trying to eliminate ordinary income taxes when possible is the first step. Most retirees are forced to pay some ordinary income (e.g., Social Security and individual retirement account distributions). The truth is the first few brackets are quite low and the team strategized to take advantage of that. The trick is to avoid the top brackets, which start at $160,700 for a married couple. In the example above, John and Sally’s team recommended taking $150,000 of ordinary income, which only had $14,777 of tax liability. (Thus, their tax rate on this was 9.85%.)
- The TCJA improved taxation on capital gains tax, which is also very favorable at lower brackets. The team had John and Sally sell $150,000 of stock with a 50% long-term gain, because only the gain is subject to tax. They would only have a tax liability of $15,250. (10.16%)
- Tax-free income from tax-free bonds was not appealing, so the team had John and Sally use an existing life policy on John’s life, which was originally purchased for business reasons, and do a tax-free exchange into an institutional life insurance contract. This has low fees and was able to improve income projections compared to their old policy. They were advised to take $200,000 per year from the new policy tax-free via withdrawals of original investment, then net zero loans (0%). The same effect could have been achieved with a new institutional policy if they were at least seven years away from retirement.
John and Sally will continue to work with their team each year and react to changes in the economy and tax law changes. Many times, we focus on the wrong things in terms of saving for retirement. Yes, keeping fees to a minimum is important, but so are low inflation rates and earning a good rate of return. At the same time, trying to invest before-tax income to lower one’s current tax bracket leaves a retiree at a higher tax bracket in retirement. Taking the time to plan for lowering your tax bracket before retirement and doing tax diversification is just as important as investment diversification and can make a huge difference. The idea that top earners have no choice but to be in a high tax bracket is no longer true. We can’t control what the stock market and inflation do, but we do have many options to keep our retirement taxes to a minimum. Wouldn’t you like to brag to your friends that you were able to retire at less than a 10% effective tax bracket?
For more information on a strategy designed to work for you I welcome your email at firstname.lastname@example.org or phone call at 973-533-1919.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification and asset allocation does not protect against market risk.