A Framework for a Tax-Free Retirement

Achieve a near ≈0% income tax during retirement by optimally allocating your savings between various tax buckets. A result of this tax allocation strategy is also the generation of market risk-free income streams to meet basic living expenses during retirement.

We discussed the income and expense profile of a high earner in “Life of an Engineer: Cash Flow Analysis.” A high earner has the potential to save $2M+ over his career if he maintains a healthy savings rate of 25%. We will look at how to optimally allocate these savings between various tax buckets in order to achieve a ≈0% tax at retirement.

Tax buckets may be categorized as Taxable, Tax-Deferred, Pre-Tax, or Post-Tax accounts. Account examples and their tax treatments are summarized in the table below. For a primer on tax buckets, please read “Tax Treatment of Investment and Retirement Accounts.”

Asset Allocation @Working: When the annual contribution limits to retirement accounts are added up, they max out at ≈$1M over a 35-40 year work span. The employer match is generally made to a Pre-Tax account, and most of the employee contribution should be made to a Post-Tax account. Limiting build up of Pre-Tax accounts is an important measure to take in achieving a tax-free retirement. The remainder of the savings will still go to Taxable accounts. A substantial portion of the Taxable bucket will likely be used as a down payment for buying a house. A small portion of these savings can be set aside to fund a Term Life Insurance policy that can effectively replace the insured’s future earnings, if the insured dies unexpectedly.

Investment Options: Many investment options are available to grow the savings in the tax buckets. A diversified portfolio of stocks is a common one. However, IUL and Annuity, though less common, are just as significant in providing investment growth and reducing portfolio volatility. They both mimic the market’s growth (subject to some caps) while not being directly invested in the market. They protect the principal by shielding the account from negative market returns. An IUL asset grows and can be distributed tax-free just like a Roth IRA. An Annuity bought within a Roth IRA also enjoys similar tax benefits. Refer to “How IUL Works” / “How An Annuity Works” and “Mechanics of an IUL” / “Mechanics of an Annuity” for a deeper dive on IUL and Annuity.

Asset Allocation @Retirement: The relative sizes of tax buckets in this framework is a first order approximation of where one needs to be asset allocation-wise by retirement. Most of the assets should be in Post-Tax. Pre-Tax assets should only be built up to a level where when you withdraw an amount equal to the standard deduction each year, because this bucket is completely depleted by the time you reach your life expectancy. Your primary residence should almost be paid off, hopefully, with a sizable equity from its appreciation in the real estate market. Your Taxable bucket should have grown too, with a well-diversified portfolio but should be smaller than Post-Tax, unless you are an HNW (High Net Worth) individual.

Retirement Spending Needs: There are 4 types of spending needs during retirement which we give here in order of their priority, starting with the highest. Basic living needs are your everyday non-discretionary expenses. Lifestyle spending needs are your discretionary expenses such as travel or gift-giving. Liquidity needs cover unexpected expenses such as a surgery or a life changing event. Legacy is the remaining assets we intend to leave behind as inheritance.

Tax-Free Income Streams: This framework not only allows you to achieve ≈0% tax rate at retirement, but also helps establish multiple stable income streams to meet your various retirement spending needs. Even though distributions taken from Pre-Tax accounts are fully taxable, a distribution just under the standard deduction limit will not generate any taxable income, making income from Pre-Tax account tax-free. A good Roth Annuity will provide a lifetime of inflation-adjusted pension that is tax-free. With a tax-free retirement strategy, the Social Security benefits will also be tax-free, as the provisional income will be less than the taxable limit. Using this framework, you can generate multiple tax-free income streams that can add up to ≈$100K annually and easily meet your basic living needs during retirement.

Additionally, the cash value from an IUL policy and the diversified portfolio in the Post-Tax account can provide additional tax-free income to meet your lifestyle spending needs on a consistent basis, so you can better enjoy your retirement! Any spending shocks may be absorbed by tapping into your HELOC (Home Equity Line of Credit) or by dipping into your regular bank/brokerage savings in your Taxable accounts. Even though the remainder of all your assets will transfer as inheritance, a permanent life insurance policy will ensure a guaranteed legacy for your estate. As a follow up, see “Modeling a Tax-Free Retirement Scenario” to gain further insights on this topic.

We specialize in tax-free retirement strategy and investments such as IUL, Annuity and LTC. Prefer a quick and complimentary consultation? Just email us at Karthik@FinCrafters.com

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