Reduce your taxes throughout retirement with the Perennial Income Model™

Scott Peterson |

“You must pay taxes. But there is no law that says you gotta leave a tip.” -Morgan Stanley

How can any retiree make a good decision about reducing taxes in retirement, or any financial professional recommend a proper course of action, without first mapping out, and projecting a future income stream? The answer is . . . they can’t. Retirees often end up making only short-term, immediate tax-saving decisions, while missing out on more advantageous, long-term tax reduction opportunities because neither they nor their advisor project income streams across a full retirement. Focusing only on the current tax year ends up costing retirees many thousands of dollars because they fail to recognize, and then to organize, their finances to take advantage of long-term opportunities to reduce taxes.

A comprehensive retirement income plan must consider a lifetime tax reduction strategy that focuses on how today’s decisions to withdraw money from the various types of accounts will impact their tax liability years into the future. The Perennial Income Model™ is the ideal tool to help retirees recognize and organize long-term tax-saving opportunities to keep more of their wealth.

Three retirement account tax categories

Before looking at strategies to maximize your lifetime tax savings, you must first understand the categories of retirement accounts and the tax implications of each. How your investments are taxed depends on the type of account in which they are held. There are three categories of accounts to consider:

Tax-deferred retirement accounts

The money in IRAs/401(k)s and a variety of other company-sponsored retirement saving plans are 100% taxable upon withdrawal unless you use the Qualified Charitable Distributions exception (to be explained). Non-IRA annuities can likewise be lumped into this category with the exception that only the interest earned on the non-IRA annuity is taxed upon withdrawal, not the entire value of the annuity.

Tax-free retirement accounts

The funds in Roth IRAs and Roth 401(k)s can be withdrawn tax-free.

Non-retirement accounts (after-tax money)

Investments that are individually owned, jointly owned, or trust owned have their dividends and interest taxed annually. They are also subject to capital gains taxation in years when investments are sold at a profit.

Three strategies to reduce your taxes in retirement

At Peterson Wealth Advisors we use our Perennial Income Model to provide the organizational structure to recognize and benefit from major opportunities to reduce your taxes. Let’s consider three of these tax-saving strategies that can benefit you in retirement:

1. Managing investment income according to tax brackets

Thankfully, your retirement income stream can come from a mix of tax-deferred, tax-free, and non-retirement accounts used in combination to lower your tax liability. Even though income stemming from tax-deferred accounts is 100% taxable, Roth IRA funds can be withdrawn tax-free and money coming from non-retirement accounts hold investment dollars that can oftentimes be withdrawn with limited tax consequences.

The key is to determine which of the above categories of accounts should be tapped for future income needs . . . and when. Tax-efficient income streams that are thoughtfully mapped out at the beginning of a retirement, as we do with the Perennial Income Model, can be extremely effective to help minimize your lifetime tax burden.  With advanced planning, you can avoid the costly mistakes of conventional wisdom: paying almost zero tax from retirement date to age 72, then paying high taxes and higher Medicare premiums until death. The Perennial Income Model shows us that it is better to pay minimal taxes from retirement date to age 72, along with how to be able to pay minimal taxes and minimal Medicare premiums from age 72 to death. When you structure your retirement income streams from a variety of tax locations within your portfolios, thoughtfully planned out, you can experience a higher standard of living while still paying very low tax rates.

2. Qualified Charitable Distributions

The most overlooked, least understood, and one of the most profitable tax benefits recognized by forecasting income streams through the Perennial Income Model comes from the use of Qualified Charitable Distributions. A Qualified Charitable Distribution, or a QCD, is a provision of the tax code that allows a withdrawal from an IRA to be tax-free if that withdrawal is paid directly to a qualified charity.  Our clientele consists of retired people who regularly donate generous sums to charities. By simply altering the way contributions are made to charity, you can make the same charitable contribution amounts and reduce your taxes at the same time. 

The ability to transfer money tax-free from an IRA to a charity has been around for a while, but the doubling of the standard deduction from the 2018 Tax Cuts and Jobs Act, was the catalyst that brought this valuable benefit to the forefront. With larger standard deductions, only 10% of taxpayers itemize deductions. Here is the catch: you only get a tax benefit from making charitable contributions if you itemize your deductions, and with the higher standard deduction, fewer of us will be itemizing. So, a 65-year-old single taxpayer, with no other itemized deductions, could end up contributing up to $13,000 and a 65-year-old couple could end up contributing up to $27,000 to charity and it would not make any difference on their tax returns, or their tax liability, because both generous charitable contribution amounts were lower than the standard deduction. So, they will just end up taking the standard deduction. Another way of saying this is that these charitable donors will not receive a penny’s worth of tax benefit for giving so generously to charity.

Doing a direct transfer of funds to a charity by doing a QCD versus the traditional writing a check to a charity, can restore tax benefits lost to charitable donors. QCDs are only available to people older than age 70 1/2, they are only available when distributions come from IRA accounts, and a maximum of $100,000 of IRA money per person is allowed to be transferred via QCD to charities each year.

3. Roth IRA Conversions

Converting a tax-deferred IRA into a tax-free Roth IRA can be a valuable tool in the quest to reduce taxes during retirement. Unfortunately, few retirees get it right deciding when to do a Roth conversion, deciding how much of their traditional IRA they should convert, or even deciding if they should convert any of their traditional IRAs at all. Without a projection of future income that the Perennial Income Model provides and the subsequent projection of future tax liability, it is virtually impossible to determine whether a Roth IRA conversion is the right course of action. Perhaps the greatest unanticipated benefit that we have observed since creating the Perennial Income Model is its ability to clearly estimate future cash flows and subsequent future tax obligations for our retired clients. Given this information, the decision whether to do a Roth conversion becomes apparent.

As advantageous as Roth IRA conversions can be, they are not free! The price you pay to convert a traditional IRA to a Roth IRA comes in the form of immediate taxation. 100% of the conversion amount is taxable in the year of the conversion. For this reason, investors must carefully weigh whether doing a Roth conversion will improve their bottom line.

Too much of a good thing usually turns a good thing into a bad thing. So, it is with Roth conversions. Excessively converting traditional IRAs into Roth IRAs without fully considering the tax consequences, can cause some investors to pay more tax than they otherwise would if they didn’t do a Roth conversion in the first place. So, it’s important to recognize when, and when not, to do a Roth conversion.

The Perennial Income Model™ as a tax planner

We first designed the Perennial Income Model to provide the structure to reinforce rational decision-making. It started with a focus on helping retirees match their current investments with their future income needs. Now, we see that the Perennial Income Model’s role is much bigger, including providing the benefit of reducing your taxes throughout the entirety of your retirement.