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Going Beyond IRAs & 401(k)s to Build a Tax-Advantaged Retirement Strategy

by
Steward Financial
on
12/23/2016
Going Beyond IRAs & 401(k)s to Build a Tax-Advantaged Retirement Strategy

If you're nearing retirement age and fretting about the state of your 401(k) and the lingering threats to Social Security, there are various measures you can take to build a tax-advantaged retirement strategy that go beyond making catch-up contributions to your 401(k) or rolling your funds into an IRA. Whether your priority is to have a comfortable retirement or to provide a legacy for your children and grandchildren, you can take advantage of the following strategies to figure out a retirement plan that works for you.

1) Open a health savings account (HSA):

You can max out contributions (including catchup contributions available if you are aged 55 or older), but do not touch the funds until you are 65. 

HSAs are an oft-overlooked stratagem in retirement planning. They allow individuals with high deductible health insurance plans to establish and make tax-deductible contributions to an HSA. Congress created these plans to help individuals pay for medical expenses not covered by insurance.

HSAs allow tax-free distributions to pay for unreimbursed medical expenses. Distributions taken that are not used to pay for unreimbursed medical expenses are taxable and subject to a 20% non-qualified distributions penalty.

However, after reaching age 65, the 20% penalty no longer applies. In addition, post-age 64 distributions are taxable if they are used to fund retirement but can still be non-taxable if used to pay for otherwise unreimbursed or deducted medical expenses. Thus, HSAs can be a secondary source of retirement benefits if contributed funds are left untouched until reaching age 65.

It's best to open a tax-deferred HSA as early as possible, since the money will grow tax-free if you don't withdraw it.

For 2017, the contribution limit is $3,400 (up from $3,350 in 2016) for individual plans and $6,750 (same as in 2016) for family plans with a catch-up contribution of $1,000 if you are 55 or older. Contributions are not allowed once you enroll in Medicare, generally at age 65 for most people.

There is a quirk in the law that allows an account beneficiary to defer to later years distributions from an HSA to reimburse (tax-free) himself or herself for qualified medical expenses incurred in prior years, as long as the expenses were incurred after the HSA was established. Thus, paying otherwise unreimbursed medical expenses from funds other than your HSA and then waiting until after you are age 65 to reimburse yourself for these expenses would allow you to receive tax- and penalty-free distributions from the HSA during your retirement years.

This strategy would require substantial record keeping to show that (1) the distributions were made exclusively to pay or reimburse qualified medical expenses, (2) the qualified medical expenses have not been previously paid or reimbursed from another source, and (3) the medical expenses have not been taken as an itemized deduction in any earlier year. This is perceived by many to be a loophole in the law, and there is always the chance Congress will close it.

2) See if it's worth it to convert your IRA to a Roth if you are nearing age 70½ but not ready to take distributions yet

Does the prospect of having to make required minimum distributions (RMDs) from a traditional IRA make you nervous? Roth IRAs don't have RMDs for account owners and distributions that are taken generally are not taxed, but a Roth IRA may not have been available to you in your prime working years if your income exceeded the annual limit for making contributions. If you want to convert your traditional IRA to a Roth, there's no income cap. A Roth IRA is the best way to ensure your retirement assets will grow indefinitely.

While you will pay income tax on the amount you convert, you can mitigate the resulting tax burden if you do this in a year that you have little or no income (like if you stop working or slow down significantly). Your Roth assets will continue to grow; you can take distributions when you're ready, and enjoy tax-free income. It is also a common misconception that you must convert your entire IRA in one go; in fact, you can convert your balance over several years to minimize the impact and potentially save thousands of dollars in taxes.

3) If you have a traditional IRA, are age 70.5 or older, and are worried about RMDs and also want to support causes you care about, consider making a qualified charitable distribution

Qualified charitable distributions (QCDs) are donations to the charities of your choice made directly from your IRA assets. QCDs must be paid directly to the organizations, not to you or any beneficiaries. They can also only be made to qualified public charities (not private foundations, trusts, or donor advisor funds).

QCDs of up to $100,000 per year can be made to any qualified charity, and large QCDs can help you avoid the massive excise taxes that come with not taking timely RMDs after you turn 70½. If you are married, and your 70½-or-older spouse also has an IRA, each of you can make a QCD of up to $100,000. In addition to supporting causes that you care about, you solve two unique tax problems by making a QCD: The QCD portion of your distribution is tax-free, but it still counts towards your RMD for the year so it's more effective than making cash donations. This option isn't available for employer-sponsored retirement plans like 401(k) plans, so if you would like to take advantage of QCDs, you'd need to roll your employer plan over to a traditional IRA.

4) If you are worried about outliving your retirement funds, a qualified longevity annuity contract (QLAC) might be the answer.

IRS Regulations provide some relief for individuals who want to stretch out their retirement funds by generally allowing taxpayers to use up to the lesser of 25% or $125,000 of their retirement account to purchase a QLAC within the account. The amount used to purchase the QLAC is subtracted from the account balance and would thus reduce the RMD from the retirement account each year until a specified time in the future when distributions must begin from the annuity.     

Although not a perfect solution to not taking distributions, a QLAC can, in effect, delay the distributions associated with funds used to purchase the QLAC until as late as the pre-determined date for the start of the annuity payments, but no later than age 85.

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Steward Financial

Steward Financial

Jon Osborn is a tax preparer based in San Dimas, California. His company, Steward Financial Services, offers a broad range of tax preparation, accounting and business consulting for small businesses. He loves to work with clients who are looking for answers to complex tax and business planning issues. He has owned several small businesses and worked with over one hundred small business owners. He helps his individual and business tax clients find the best ways to spend their money in order to minimize IRS tax. Small businesses looking to grow, sell or just increase cash flow are one of Jon's specialties.

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