Fight Inflation with Tax Efficiency

Friday, May 18th

Many of our clients are old enough to remember clearly the staggering inflationary days of the late 1970s — they’re hard to forget.

My memories of that time mostly include waiting in line for gas and my parents having discussions about making the switch from whole to dry milk. Thankfully, that was a line we never had to cross. At the time, my parents were in the process of buying their first home; I was shocked when my dad later told me that his interest rate was over 9%. In conditions like that, it’s nearly impossible to stay ahead.

Since the recession in 2008, we’ve heard talk of another looming inflation. Over the last couple of years, we’ve seen slight rises in inflation, just under 2%. This is a concern for numerous people in retirement or approaching retirement since many receive a fixed amount from Social Security or their pension that does not adjust with the cost of living.

As inflation rises, your dollars don’t go quite as far as they used to. Additionally, bond returns generally decrease as interest rates rise, and as the Federal Reserve watches inflation, they make upward adjustments to the interest rate.

What can you do?

Before you switch to dry milk, we have a few strategies that can help.

Improve your tax efficiency.

If you can improve your tax efficiency by 4-6%, you can keep more of your money and offset some of the negative effects of inflation on your pocketbook.

For those of you still working toward retirement, we recommend taking the following actions:

  1. If your employer offers a match for 401(k) contributions, contribute the full amount to receive this match. This money is invested tax-free until withdrawal, resulting in less taxable income and a lower tax bill today.
  2. More and more employers are offering Roth options in their 401(k) plans. You can strategically decide to allocate some money to a “Roth bucket.” This, of course, will not reduce your taxable income today, but it will allow money to grow that can’t be taxed when pulled out of the vehicle. It’s wise to have some tax diversification since we can’t predict what tax rates will do in the future.

We do know today’s tax rates are among the lowest they’ve ever been; there’s a good chance this will eventually change to pay for our country’s growing debt. If tax rates do go up in the future, it will give you added peace of mind to know that some of your retirement savings can’t be taxed when withdrawn.

  1. Another option is to take some of the money in IRAs or 401(k) plans and do a Roth conversion. This will require you to pay taxes at your current rate on anything you convert, so it’s important to be strategic as you do this. You don’t want to inadvertently place yourself in a higher tax bracket by converting too much. But, in years when your earned income is low, it may make sense to pay some of the taxes now, at a potentially lower rate, so you can withdraw the money tax-free when taxes may be higher.Because you probably won’t be able to withdraw large sums without tax consequences if you are still working, it’s important to start early, withdrawing small amounts every year as your bracket allows, and build a small holding of Roth investments.

If you’re already in retirement, there are still things you can do to increase your tax efficiency:

  1. You, too, can take advantage of Roth conversions by executing this strategy. This money will grow without tax consequences, regardless of what happens in Washington. However, executing Roth conversions can become even trickier in retirement due to the potential impact of taxes on your Social Security benefits.
  2. Carefully manage your income streams in retirement, so you withdraw the right amount of income to stay in your desired tax bracket.For example, you could defer your Social Security benefits or pension during the first few years of retirement, dropping your income level very low or even to zero, and fund your retirement with IRA or 401(k) accounts. Not only does this allow your Social Security and pension benefits to grow, but it also puts you in a very low tax bracket, so your tax-deferred savings are taxed at the lowest possible rate, allowing you to diffuse a potential tax bomb.
  3. Finally, keep in mind that, after you turn 70 ½, the government will demand you to take required minimum distributions (RMDs) from your tax-deferred accounts. However, money that grows in tax-free Roth accounts is not subject to RMDs. It’s wise to have your money in several different types of accounts (taxable, tax-deferred, and tax-free) so you can access the money you need, despite any changes in the tax code.

Regardless of where you are on the road to retirement, increasing your tax efficiency can help you keep more of your money, helping you offset any potential rises in inflation. It’s important to have a strategic plan so your money will last well through your retirement in any economic climate. At Acute Wealth Advisors, we are solely dedicated to helping you develop that plan.

Matt Deaton & Damon Roberts