Planning for a Tax-Friendly Retirement in the USA

Although we often complain about taxes, as of 2024, the tax rates in the USA are historically on the lower side. With the country debt at 34+ trillion and counting, the taxes can only go up in the future. The upcoming tax increase is scheduled for January 1, 2026. This is due to the Tax Cuts and Jobs Act (TCJA) expiring at the end of 2025. TCJA has reduced taxes since 2018. Unless Congress intervenes, TCJA will expire by end of 2025 and taxes will be back to pre 2018 levels.

With these increasing taxes, is Tax free/friendly retirement possible?

There are 3 things to do in retirement to legally pay zero taxes.

• Withdraw only up-to standard deduction from tax deferred accounts.
• Manage provisional income under social security tax thresholds.
• Fund all other retirement expenditure from tax advantage/free accounts.

Withdraw only up-to standard deduction from tax deferred accounts

Standard deduction is the amount that you can reduce from your income to get to the taxable income. Another way to say is, if your income is under the standard deduction amount, then, you will not pay any taxes. For year 2024, for married filing jointly, this is $29,200 per year. The good news is this number gets adjusted to account for the inflation. Considering a 3% inflation, if you are retiring in the year 2040, this standard deduction is projected at $46,857.

What happens if you manage to withdraw only up-to $46,857 after your 59 and half years age from tax deferred accounts like 401k? You will not pay any taxes.

You need to fund the rest of the money you need in retirement from tax advantage/free sources.

Manage provisional income under social security tax thresholds

What is the full retirement age for withdrawing social security?
As of writing this article, It's 67 years. Though you can have access to social security money earlier than this age, you will receive reduced benefits. When you start withdrawing your social security, you need to maintain your provisional income under $44,000(for married filing jointly) to avoid 85% of your social security money getting taxed. IRS hasn't adjusted this threshold to account for the inflation.

If you don't understand what is provisional income and social security taxation, I would encourage you to read previous week's article on this website.

For our discussion here, just note that your 401k withdrawals plus half of social security will be counted part of provisional income. This becomes bit challenging because you need to bring down your 401k withdrawals drastically to avoid social security tax.

From 59 and half years, you can withdraw up-to standard deduction from your 401k as mentioned in the first section above. But when you hit 67 years, you need to bring down 401k withdrawals drastically to keep provisional income under $44,000.

If you have smartly contained your 401(k) accounts and moved money to tax advantage/free accounts, then, keeping provisional income under $44,000 is possible.

Fund all other retirement expenditure from tax advantage/free accounts

These are the accounts you have built with post tax dollars. IRS has no interest in these accounts because they got their taxes already. Withdrawals from these accounts won't be considered part of your provisional income. These accounts are mainly your ROTH and Cash Value Life Insurance(CVLI) accounts. It doesn't matter how much money you withdraw from these accounts. They are not taxed and doesn't count against provisional income.

If you don't have much in these accounts and all your money is concentrated in tax deferred accounts, then, you need to plan to convert them paying taxes now. I understand it's bitter pill to swallow. But it's a choice to make whether you want to pay tax when you know the exact number or pay in future when you don't know that number and can be much higher than today.

Also plan to build your HSA(Health Savings Account) . When you fund all your medical expenditure from HSA account during retirement, you will not pay any taxes. So, when money is going into HSA account you are getting tax benefit and in retirement when you use them for medical expenditure, you won't pay tax!

That's a wrap this week. I know it's a lot to digest. But thinking through and planning a tax friendly retirement is worth it.

Happy learning!