With the sting of tax day fresh in our collective memories, the last thing most of us want to hear is that taxes are at a historical low. Fanning the flame, in 2020 Social Security, Medicare, Medicaid and the interest on the National Debt consumed 92% of the government’s revenue.
As our population’s lifespan increases and Americans draw on these programs longer, it seems the only option to keep them afloat is to increase taxes.
Now, before you start breathing into a paper bag, know that there are moves you can start making now to put you on the path to a 0% tax bracket in the future.
TAX BUCKET BREAKDOWN
First thing is first, let’s get on the same page about the three tax buckets - taxable, tax-deferred and (jazz hands) tax free.
Taxable income is money that you’ve already paid tax on and is invested in things that are subject to being taxed again, such as CDs, Mutual Funds, stocks and bonds. The easiest way to recognize these is as your liquid assets, or money that you have quick access to. Although this is the bucket that takes multiple tax hits, it’s also the one the vast majority uses for growth.
Next up, tax-deferred income. Aptly named, this is money that you do not pay taxes on now or on the deferral, but Uncle Sam will cash in when you take this money out in the future. For most, this is the retirement savings plan, such as 401ks or IRAs.
Side bar, these options often come with company incentives and matches - first rule of financial planning, always take the free money.
However, know that you are on the hook for taxes on your initial investment plus those on your investment’s growth - in short, you’re earning interest for the government’s payday on your money down the line. More so, the government gets to decide when and to what extent you have to take your money out.
Now that your hackles are up, let’s reiterate once again that taxes are at a historical low with increasing pressure to be raised down the line…when Uncle Sam is going to ask *cough, demand, cough* that you make your withdrawals.
Put that paper bag down as it’s not all doom and gloom under tax-deferred options. When pulled in the right amounts under the right circumstances, these levers can still be the leverage in getting to your 0% bracket.
Finally, we have tax free. This is money that you pay taxes on now (ouch), but you do not have to pay taxes again on deferral or, if designated correctly, when accessed in the future. The two options that fall into this bucket are Roth IRAs and Cash-Value Life Insurance.
I’ll be the first to say, I’m thrilled to see Roth IRAs getting the glow-up they deserve. Yes, there are contribution limits, rules around when you can access your money, and, the wildcard, that they are up for election every two years, BUT when, compared to most tax-deferred options, these make for safer bets.
Although a Roth IRA is good, Cash-Value Life Insurance is great. Stay with me as this is the ace few know to play. With Cash-Value Life Insurance, there are no limits on contributions, the cash-value in the policy is yours without age restrictions, and when the insurance is put in place it is a binding contract - meaning, that if the rules change for future policies, they will stay the same for yours.
GETTING TO YOUR 0%
You’re doing great, champ. Now let’s bring it all together with some number crunching and direction on how to tip these three tax buckets in your favor.
In the taxable bucket, you want to have about six months of earnings saved to protect and provide for the unforeseen. Once you’ve met this threshold, stop and shift those contributions to your tax-free bucket.
In the tax-deferred bucket, the goal is to get the required minimum withdrawal (RMD) to be equal or less than your standard deduction for the year you turn 72 (or the current RMD age). Take advantage of employer matches if available (again, always take the free money), but any amount over this should be reallocated to your tax-free bucket.
Your tax-free bucket will deliver that sweet tax-free stream of income in your retirement.
Simply put, once the boxes are checked for your taxable and tax-deferred buckets, all monies should be directed here.
THE WRAP UP
Frankly, we have no idea where taxes will fall in the future, but we are armed with what we know today. This approach intentionally puts money into all three tax buckets maximizing their strengths and, drum roll, allows you to be in control of distribution in retirement.
If taxes are high, only take tax-free income, which puts you in the 0% tax bracket.
If taxes are low, take more taxable income plus your standard deduction, which gets you closer to the 0% tax bracket.
If taxes stay the same, you’re no worse off and can still maneuver your distributions to pay the least tax alongside ensuring your social security is not taxable, which, again, gets you closer to the 0% tax bracket.
LET US HELP YOU NAVIGATE YOUR
Head spinning? Start here. Take a couple minutes to calculate your retirement tax burden - this free tool will give you an instant answer on what your taxes will be if you stay your current course.