Preparing for Higher Taxes: How to Build a Low-Tax or Tax-Free Retirement

The United States has now crossed $40 trillion in federal debt, and we are still adding trillions more through annual deficits. At some point, something has to give.

For decades, people have warned about the growing national debt, and for decades it has been relatively easy to ignore because the consequences were not immediately obvious. I think we are getting closer to the point where that is no longer true. We may see the problem unfold slowly through continued inflation, a dollar that buys less, and increasing pressure on the already dwindling middle class. Or we could eventually face a much more serious economic crisis.

Either way, the federal government cannot continue down this path forever. We are borrowing enormous amounts of money just to cover the difference between what the government collects and what it spends. Eventually, Congress will have to do something about both spending and the revenue side of the equation. If a future government seriously attempts to balance the budget, then it is going to mean higher taxes, fewer tax breaks, or both.

The good news is that there are a number of tools available today that can reduce how much of your income is exposed to future tax increases. Some allow money to grow tax-free. Others defer taxes, generate tax-free income, reduce taxable investment income, or allow you to access accumulated wealth without creating taxable income at all. The goal is not to predict exactly what Congress will do. The goal is to put yourself in a position where you have choices when it does.

Assuming taxes are going to go up, below is a list of my preferred tax strategies, generally in the order I would consider them. Once you have fully considered one strategy, you can move on to the next. A lot of accountants would argue with me about which strategies should take priority, but I tend to prioritize the ones that can provide strong investment returns in addition to the tax benefits.

Tax Free Solutions:

Roth IRAs and Roth 401(k)s

Roth accounts are one of the simplest ways to create tax-free retirement income. You contribute money that has already been taxed, invest it, and let it grow. If the rules are followed, the growth and future retirement distributions are tax-free. With a traditional retirement account, you take the tax break today and pay the tax later. With a Roth, you have already settled the tax bill.

High-income taxpayers who cannot contribute directly to a Roth IRA can still have options. A backdoor Roth generally involves making a nondeductible traditional IRA contribution and converting it to Roth. Some employer plans also allow much larger after-tax contributions that can be moved into Roth accounts, commonly called a mega backdoor Roth. These strategies need to be coordinated with existing retirement accounts, but they can allow high-income taxpayers to build a much larger tax-free bucket.

Roth Conversions

A Roth conversion allows you to move money from a traditional IRA or retirement plan into a Roth account by paying the tax today. The key is timing. Someone who retires at 60 may have several years of relatively low taxable income before Social Security and required retirement distributions begin. Those years can be a great time to convert portions of a traditional account at controlled tax rates.

Conversions can also be attractive during a major market decline because you can move the same investments while recognizing less taxable income. The objective is not to convert everything blindly. It is to decide when paying the tax today is better than leaving the tax bill to the future.

Whole Life and Indexed Universal Life Insurance

Permanent life insurance policies can be another powerful retirement-planning tool, particularly for people who are already maximizing more traditional retirement accounts. Unlike term insurance, permanent life insurance includes a cash account inside the policy. Part of what you pay supports the insurance, while another part builds cash value over time.

Whole life generally grows in a more predictable way based on the guarantees in the policy and possible dividends. Indexed universal life, or IUL, works differently. The growth credited to the cash account is tied in some way to an outside market index such as the S&P 500. You do not directly own the stocks in the index. When the market performs well, the policy receives part of that upside. When the market falls, the policy does not directly participate in the market loss, although the costs of the insurance continue.

The idea is to fund the policy heavily while you are working and allow the cash value to build over a long period of time. Eventually the growth inside the policy can help cover the continuing cost of the insurance while the remaining cash continues to accumulate. Later in life, you can borrow against that cash value and use the money for retirement without creating a taxable retirement distribution.

When you die, the life insurance benefit repays the outstanding policy loans and the remaining death benefit goes to your beneficiaries. The policies have to be structured and maintained correctly, and poor policy design can make them expensive or ineffective. But when they are designed correctly and given enough time to work, whole life and IUL can create another pool of tax free income.

Health Savings Accounts

Health Savings Accounts are one of the best tax tools available because they can receive favorable tax treatment on the way in, while the money grows, and when it comes out. Contributions can create a tax deduction, the money can be invested and grow without current tax, and withdrawals for qualified medical expenses are tax-free.

Someone who can afford to pay current medical expenses personally can allow the HSA to grow for decades and use it later as a tax-free healthcare account in retirement. You can even save receipts for qualifying medical expenses and reimburse yourself from the HSA years later. Since healthcare will likely be one of the largest expenses in retirement, building a dedicated tax-free account for it makes a lot of sense.

Municipal Bonds

Municipal bonds can generate interest that is exempt from federal income tax. Depending on the state and the bond, the interest can also avoid state income tax. For someone in a high tax bracket, that can make a municipal bond paying a lower stated rate more valuable than a taxable bond paying a higher rate. The important comparison is what you keep after taxes, not the advertised interest rate.

U.S. Treasury Securities

Treasury bills, notes, and bonds are taxable for federal purposes, but their interest is generally exempt from state and local income taxes. That can make them especially attractive for people living in high-income-tax states. Again, the question is not which investment pays the highest stated rate, but which one leaves you with the best return after taxes.

Tax Deferred Solutions:

Traditional 401(k)s and IRAs

Traditional retirement accounts are still valuable because they can create significant deductions during high-income working years. The money grows tax-deferred, and the tax is paid when it is eventually withdrawn. If you receive the deduction while you are in a high tax bracket and withdraw the money later at a lower rate, that is a very good trade.

The problem is assuming retirement automatically means a lower tax rate. Successful people can accumulate very large traditional retirement accounts, and those accounts eventually create required taxable distributions. Traditional accounts are a good tool; I simply would not want them to be the only tool.

Cash Balance and Defined Benefit Plans

Business owners with consistently high income can often contribute far more toward retirement than the normal 401(k) limits allow by using a cash balance or defined benefit plan. These plans can create very large current tax deductions while allowing an owner to build retirement assets quickly, particularly later in their career. They are more expensive and complicated than a normal 401(k), but for the right profitable business they can be extremely effective.

Annuities

Annuities are primarily tax-deferral and income-planning tools. Money inside a nonqualified annuity can grow without being taxed every year, and taxes are generally paid when the earnings are eventually distributed. Their biggest advantage is often the ability to create predictable or guaranteed lifetime income. Their disadvantages can include fees, restrictions, and less flexibility, so the tax benefit should be considered along with what the product is actually providing.

Real-estate:

Real Estate and 1031 Exchanges

Real estate has several tax advantages that are difficult to duplicate elsewhere. Rental property can produce cash while depreciation reduces taxable income, and a 1031 exchange can allow you to sell qualifying investment real estate and reinvest the proceeds into another qualifying property without immediately paying tax on the gain.

That allows more of your money to remain invested and continue compounding instead of losing a large portion to taxes every time you sell. Under current law, property held until death can also receive a new tax basis when it passes to heirs, which can eliminate a substantial amount of built-up taxable gain.

Your Personal Residence

Your home also receives favorable tax treatment. Under current law, someone who meets the ownership and use requirements can exclude up to $250,000 of gain on the sale of a primary residence, while many married couples filing jointly can exclude up to $500,000. For someone with multiple homes, rental properties, or plans to relocate during retirement, thinking ahead about which property becomes the primary residence and when it is sold can create meaningful tax savings.

Estate Planning:

Revocable and Irrevocable Trusts

A revocable living trust is primarily an estate-planning tool. You continue to own and control the assets, and the income is still reported on your tax return. Its main benefits are avoiding probate, making it easier to manage your assets if you become unable to do so yourself, and controlling how those assets pass to your family when you die.

An irrevocable trust is different. The primary reason a high-net-worth taxpayer uses one is to move assets out of their taxable estate while taking advantage of the federal and, where applicable, state estate and gift tax exclusions. Once the assets are transferred into the trust, the future growth on those assets can occur outside of the taxpayer's estate. This can be extremely valuable when the assets are expected to appreciate substantially over time.

For example, if you transfer a business interest or investment worth $5 million into an irrevocable trust and it eventually grows to $15 million, the goal is to use the exclusion when the asset is worth $5 million and keep the additional $10 million of growth outside of your estate. For someone with a large estate, that can create significant estate-tax savings.

The tradeoff is that assets removed from your estate generally do not receive the same stepped-up basis at death. That makes the decision about which assets to move into an irrevocable trust especially important.

Estate Planning and Stepped-Up Basis

One of the most important decisions in estate planning is determining which assets should remain in your estate and which should be transferred out.

Assets that remain in your estate generally receive a new tax basis based on their value at death. If you bought an investment for $100,000 and it is worth $1 million when you die, your heirs will generally receive a basis close to $1 million. If they sell it shortly afterward, there may be very little capital gain to tax.

Assets transferred into an irrevocable trust to remove them from your taxable estate generally do not receive that same step-up in basis. Instead, the beneficiaries can inherit the lower tax basis. That creates a tradeoff: you may save estate tax by removing the asset and its future growth from your estate, but your heirs may eventually pay more capital-gains tax.

For high-net-worth taxpayers, the goal is to decide which tax is likely to matter more. Assets with strong growth potential are often the best candidates to move into an irrevocable trust because the future appreciation can occur outside of the estate. Highly appreciated assets with a very low tax basis may be better candidates to keep in the estate so they can receive the stepped-up basis at death.

Good estate planning is therefore not simply about moving as much as possible into a trust. It is about deciding which assets should use the estate and gift tax exclusions today and which assets should remain in the estate to receive the income-tax benefits available at death.

Other Planning Strategies:

Taxable Investment Accounts and Capital-Gain Planning

A normal brokerage account is one of the most useful retirement-planning tools because it gives you flexibility. There are no retirement-age restrictions or required distributions, and long-term capital gains receive better federal tax treatment than ordinary income. In lower-income years, some long-term capital gains can even be taxed at a 0% federal rate.

Taxable accounts also allow you to actively manage gains and losses. You can sell investments that are down and use those losses to offset gains elsewhere, or intentionally recognize gains during years when your tax rate is favorable. High-income taxpayers also need to account for the additional tax that can apply to investment income. The point is to manage when gains are recognized instead of simply accepting whatever tax bill happens at the end of the year.

Tax Diversification

One of the biggest mistakes in tax planning is putting nearly everything into the same type of account. Someone can retire with several million dollars and still have very little control over their taxes if almost all of that money is sitting in a traditional IRA or 401(k). Every time they need money, they create taxable income.

A better approach is to build wealth in different tax buckets: traditional retirement accounts, Roth accounts, taxable investments, real estate, tax-exempt bonds, health savings accounts, permanent life insurance policies, and cash; or dare I say, crypto currency. That gives you flexibility. When tax rates are high, you can draw more heavily from tax-free or low-tax sources. When rates are favorable, you can intentionally recognize income. The real objective is control.

Charitable Giving and Qualified Charitable Distributions

For people who already plan to give money to charity, there are more tax-efficient ways to do it than simply writing checks. Donating appreciated investments can avoid the capital gain that would have been created by selling the investment first. Donor-advised funds can also allow a high-income taxpayer to group several years of charitable giving into one high-income year and receive the deduction when it is most valuable.

Later in retirement, qualified charitable distributions can be especially useful. Once you reach the applicable age, money can be transferred directly from an IRA to a qualifying charity, excluded from taxable income, and counted toward a required minimum distribution. The point is not to give money away for a tax deduction. It is to get the largest tax benefit from money you were already planning to give.

State Income Tax Planning

Where you live can make an enormous difference in retirement. Some states have no individual income tax, while others tax ordinary income at significant rates. States also differ in how they tax retirement distributions, investment income, Social Security, estates, and inheritances.

For someone who is already considering moving in retirement, establishing residency in a lower-tax state before a large business sale, Roth conversion, or investment gain can create substantial savings. The move needs to be real; simply changing your mailing address while continuing to live your life in the old state is not enough.

The Real Strategy Is Having Choices

I would not build a retirement plan around any one of these strategies. Each tool solves a different problem. Traditional retirement accounts can create deductions today. Roth accounts can create tax-free income later. Taxable investments provide flexibility. Real estate can create deductions and defer gains. Municipal bonds can generate tax-exempt interest. Health savings accounts can fund medical expenses tax-free. Permanent life insurance policies can create another pool of retirement cash that can be accessed without a taxable retirement distribution.

For successful business owners and high-income professionals, retirement tax planning should begin while you are still making money, building your business, accumulating assets, and have enough time for these strategies to work. The objective is not simply to retire with the largest account balance. The objective is to retire with wealth you can actually use while keeping as much control as possible over when and how it is taxed.

This article is intended for informational purposes only and does not constitute legal, tax, or accounting advice specific to any individual's situation.