Why it’s Worth Paying for “Tax-Free”


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There’s no such thing as a free lunch, but that doesn’t mean that no lunch is the better choice. When people hear about options that will be tax-free, it sounds too good to be true, and in a way it is. Whether you pay taxes now or pay taxes later, the government always wants their money some time. The trick is that you can often pay something now so you can pay nothing later, ending up paying less overall.

Income Tax: 2025 Tax Sunset

Taxes are at a historical low and are scheduled to go up after the end of 2025. There are ways to minimize the impact of tax increases if you are willing to pay something now to pay less later.

Tax Rates are Lower than Ever Before

In 2017 Congress passed the Tax Cuts and Jobs Act (TCJA), substantially lowering tax rates on individual income and estates. Your taxes probably went down, and taxes are currently at historical lows. Good things don’t last forever though – these changes included a sunset provision, and the lower rates are set to expire after the end of 2025.

This chart outlines the current tax rates for each bracket, and how they are scheduled to increase:

Click on the chart to enlarge

In the past, you could expect to pay higher taxes while you were working compared to retirement: your earned income would put you into a higher tax bracket, and therefore your taxes would be higher. This meant that tax-deferred (no tax now, pay the tax later) accounts were the way to go. Traditional IRAs and 401(k)s are examples of tax-deferred accounts.

With the current low tax rates though, expectations for many people are flipped – you may be in the lowest tax environment you can expect, regardless of if you are still working. To account for the expectation that taxes will only be going up, you should consider making some changes to pay more taxes on your money now, so that money can be counted as tax-free later when rates are higher.

You may wonder why the TCJA included this sunset provision in the first place. The fact is that any time the government gives a tax cut, they have to figure out a way to pay for it – to balance the equation of ins and outs. Without time limits, many politicians would promise cut after cut. By putting a time limit on the cuts, Congress only needs to find the balance for this particular problem for 7 years. No one can predict the future, so we can’t say for sure whether tax rates will increase or what they will increase to. The current administration is discussing raising taxes, but maybe the bill won’t pass. Since we have such low taxes right now though, it is very unlikely that taxes will significantly decrease any time soon.

Hans and Robbie discuss tax planning strategies for when rates are low

Strategies to Consider

One common approach is to move tax-deferred money into tax-free (also known as tax-exempt) accounts. As mentioned above, a Traditional IRA is a tax-deferred account, but a Roth IRA is tax-exempt. Taking money out of a tax-deferred account, whether to spend or to move to a tax-free account, will trigger a tax bill. Whatever money you take out will be counted as taxable. However, once you’ve paid the taxes and moved it into a tax-free account, any future earnings will not be taxable. And since you already paid taxes on the money you put in, that means that account doesn’t trigger any taxes for the rest of your life.

It’s important not to move all the money at once – this will rocket you into a much higher tax bracket and the government will take a huge chunk, not just on the money you are moving, but on all of your other income that year too. Instead, work with an advisor to check how much “wiggle room” you have until you reach the top of your current bracket (or maybe one bracket higher). Then you can “fill” your bracket with a distribution from your tax-deferred account. You’ll pay extra taxes that year than you usually would, but if you do it right, it shouldn’t be anything truly extraordinary.

If you make a small move like this each year over the course of several years, then you will make a big dent in the amount of taxable money you have if and when rates start to increase. Breaking the strategy up over time also allows you to react to changes in tax law as it happens, instead of trying to play catch up when it’s too late.

Another option is to take your taxable distributions and, instead of putting them into another retirement account, buying life insurance. There are a wide range of these products to fit many different needs and preferences, including many that have benefits while you are still living. Annuities could also be an option. Just like a Roth IRA, the money you and/or your heirs get from these products at the end is tax-free.

There are a lot of things about taxes we can’t control, but there are even more that we can. Maybe you don’t set the tax rates or your salary, but you can choose when to take social security, when to sell an asset, or how much of your tax-deferred money to move into tax-exempt accounts.

Don’t get caught thinking you are stuck paying high taxes without consulting with an advisor who understands your options. Cardinal can help you optimize your income strategies to lower your tax bill.

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