One of the most fundamental reasons for saving and investing is to accumulate enough assets to achieve a point of “financial independence,” where there’s no longer any need to work for income, and instead, the individual can support themselves solely from their available assets and other retirement resources. The caveat, however, is that accumulating substantial wealth can potentially accumulate significant tax consequences to go with it.
Not only because sometimes highly appreciated investments produce very significant capital gains taxes, but also due to the fact that much of our savings today are placed into tax-deferred retirement accounts, which are favorable as long as the money stays in the account and the taxes are deferred, but can become very problematic when it’s time to actually begin withdrawing from and liquidating the account (and the taxes come due).
In fact, one of the fundamental problems of tax-deferred retirement accounts, in particular, is that there’s actually such thing as being “too good” at tax deferral, where tax rates are modest for years (or even decades) thanks to the tax-sheltering of the retirement account itself, but then when it’s time to take retirement withdrawals (or distributions are mandated by Uncle Sam’s Required Minimum Distribution obligation at age 70 ½), suddenly so much taxable income spills out of the retirement account at once that the retiree is vaulted into drastically higher tax brackets, never to see lower tax rates again as a tidal wave of pre-tax income comes due. At which point the retiree can only look back fondly on those earlier years when tax rates were lower, now unable to actually use those lower tax brackets anymore.
And while it can be difficult to know for certain what future tax rates will be, the very nature of doing financial planning (and especially retirement projections) is to determine the current trajectory of wealth, which means with some relatively simple and straightforward assumptions about future Social Security and pension payments, RMD calculations, and anticipated interest, dividends, and capital gains, it really is feasible to make a reasonable approximation of an individual’s future tax rates to determine where the ideal equilibrium will be. And then engage in strategies from accelerated retirement account liquidations, to partial Roth conversions, and capital gains harvesting, as necessary to ensure that any currently-lower tax brackets are filled up to reach the equilibrium point.
Find Michael Kitces’s full article, including retirement tax strategies, at www.Kitces.com.