How to Reduce Your Tax Liability While Saving for Retirement

When it comes to your finances, there are three wealth destroyers to be aware of: taxes, inflation, and fees. Today, we will be looking more closely at taxes in relation to traditional retirement vehicles like a 401(k) and IRA. Keep reading to find out how you can reduce — or even eliminate — your tax liability while saving for retirement.

Taxes and Retirement Savings

For many, saving for retirement means utilizing a 401(k) offered through an employer. This type of investment account allows you to put tax-deferred money away to grow your retirement funds. The money you contribute remains untaxed until you take a withdrawal from the account. At that time, you’ll be required to pay taxes on the total balance of the account at whatever the tax rate is when it’s withdrawn.

For most of the 70s, the highest marginal income tax rate held steady at 70%. By 2018, that rate fell to 37%, where it remains today. With a much lower tax rate than in the past, it may seem worthwhile to invest money now and pay taxes later, after you’ve accumulated a decent amount of wealth.

The problem with a tax-deferred retirement account is that people are encouraged to believe that not paying taxes now is better than paying taxes in the future. But there’s no guarantee the future tax rate will be the same or close to today’s tax rate. If we’re totally honest with ourselves, we know that taxes are more likely to increase over time. While you’ve (hopefully) built up wealth inside your 401(k), there is a significant possibility the tax rate will skyrocket and you’ll lose a large chunk of it to taxes — drastically impacting your life in retirement.

Reducing Your Tax Liability

To protect your financial future, we need to begin looking at financial vehicles that are tax-free forever and start implementing them while tax rates are historically low. These products include HSA accounts and permanent life insurance, as well as taking advantage of highly incentivized methods offered by the U.S. tax code.

It’s shocking to many people that the government wants you to reduce your tax liability, but it’s true. The tax code is written in a way that can be used as a roadmap to help you lower your tax liability, and in some cases, even create a “taxed-never” strategy. Real estate investing, making charitable contributions, and improving your business or property are examples of incentives the tax code offers for reducing tax liability.

Washing your tax liability also works with retirement vehicles, but it requires some careful planning. You have to inspect the tax code to identify the available incentives that make sense for your specific situation. A certified wealth strategist can help you identify the right options for your situation and goals, which may include converting your retirement account to a Roth IRA.

Converting to a Roth IRA

Investing in a Roth IRA is one of the most popular methods for reducing tax liability while saving for retirement. It’s typically where people start accumulating a taxed-never bucket. Many people believe that they make too much money to qualify for a Roth IRA, and while that may be true on the surface, the tax code is written in a way that allows just about anyone to access a Roth. Regardless of how much money you make, you can open a Roth IRA by taking money that’s already sitting in a traditional 401(k) or IRA and converting it to a Roth.

Converting existing funds from a traditional retirement account is a taxable event during the year the transfer takes place. After paying taxes on the amount you converted, your money is allowed to grow tax-free until you withdraw it. Best of all, it could be tax-free as long as you follow the simple rules of the account. Among other things, these rules include waiting until you’re 59 ½ to withdraw it.

This isn’t our preferred way of storing money because you don’t have liquidity, use, and control of the money while it’s in a Roth. This is also a government-sponsored program, which means the government can change the rules on the plans whenever they want. This is just one of the strategies available for reducing your tax liability while saving for retirement. If you want to know more about the tax liability of traditional retirement vehicles and developing a taxed-never bucket, tune into Wade’s podcast. He and his guest, David Babinksi of TrueNorth Resources, talk more in-depth about this topic in a recent episode. Click here to listen.