Strategies to Save on Taxes Efficiently Throughout Your Life

Madison Wealth Management does not provide tax planning advice. The following information is for illustrative purposes only. Please consult your tax planning professionals. 

For many of us, a typical goal of tax planning is to pay your tax bill while in the lowest tax bracket to try to minimize your lifetime tax bill. A traditional strategy to accomplish this is to defer income into retirement plans such as 401(k)s, deferring taxes on that income until retirement. The idea is marginal tax brackets would be higher in income-earning years than in retirement, so deferring taxes would result in less overall tax paid. However, the larger one’s taxed deferred savings, the more nuanced this strategy becomes, due to Required Minimum Distributions (RMDs), surcharges on Medicare premiums, singles brackets, and financial legacy considerations. So, what should you be considering regarding savings and taxes? We at Madison help our clients consider many factors.

Would you rather pay taxes now or later? Your answer may change after reading this.

Most of us vividly recall looking at our first paycheck. Tearing the envelope open excitedly, followed by a wave of shock and disappointment washing over you. Social Security, Medicare, Federal, State, and local taxes… You may have had (or still have) a similar experience. Maybe yours happens in April.

The reality is the IRS is going to take its cut of your income, but in some cases, you can decide whether to pay now or later. We can’t predict the future- tax laws, investment returns, life events, etc. We can, however, take control and make an informed plan for our futures. In some cases, this may mean paying taxes now rather than deferring.

Saving for Retirement- Traditional vs. Roth:

Traditional Tax-Deferred Savings: Most income earners have the option to make tax-deferred savings into a retirement account. These savings are often taken out of one’s paycheck and lower one’s taxable income for the year. The idea behind tax-deferred retirement savings seems straightforward: avoid paying taxes while earning income (higher tax bracket) and pay taxes when withdrawing the money (lower tax bracket). This strategy can be very effective, but as we all know, with the IRS, nothing is straightforward.

Roth Savings: Another type of retirement savings account is a Roth. Assets contributed to a Roth account are saved after taxes are paid or withheld. Roth accounts are essentially the opposite of tax-deferred accounts: you pay the tax upfront, and withdrawals are tax-free.

Hidden Downsides to Tax-Deferred Savings:

Deferring income can reduce one’s tax bill during high-earning years. However, in addition to ordinary income tax on withdrawals, there may be some not-so-obvious consequences in later years for those with significant tax-deferred savings.

Required Minimum Distributions (RMDs): At age 72-75 (depending on birth year), those with tax-deferred assets will be required to withdraw a minimum distribution, based on age and account balance. This distribution will be taxed as ordinary income. For those with sizeable distributions, coupled with Social Security benefits or other retirement income, marginal tax brackets can potentially be similar to those in income-earning years.

Medicare Premiums & Surcharges:  Higher income from tax-deferred distributions can result in higher Medicare premiums and surcharges. Medicare premiums are based on tiered income brackets, and based on income two years back. For example, a married couple on Medicare with a 2021 taxable income over $306,000 will pay an additional “tax” of over $7,500 for their 2023 Medicare premiums and Part D surcharge.

Singles Brackets: While sometimes deemed the “widow’s penalty”, this can apply to any single retiree. Tax brackets, as well as Medicare premiums and surcharges, have much lower thresholds for single filers than married couples. Required distributions from tax-deferred accounts, including inherited accounts, plus Social Security benefits, can more easily push single filers into higher taxes, higher Medicare premiums, and higher surcharges. For a surviving spouse who has or inherits significant tax-deferred assets, the result can be the individual paying higher taxes and higher Medicare premiums and surcharges, with less Social Security income and the same amount of assets.

Legacy Assets: If your goal is to leave a legacy, you may want to consider the tax status of the assets you are leaving. When leaving tax-deferred assets to non-charity beneficiaries, the IRS will still expect the taxes to be paid. These assets do not receive the same “step-up in basis” tax treatment that inherited taxable assets receive, or the tax-free treatment that inherited Roth assets receive. Non-spouse beneficiaries are typically required to take taxable RMDs and empty the account (pay taxes on the entire inherited tax-deferred account) within ten years of your passing. This can push these beneficiaries into higher tax brackets themselves.

Roth Conversions:

Now you might be wondering how to avoid some of the above-mentioned tax hits. One method we consider for our clients is building up Roth accounts, through contributions* and/or conversions. Taxes are paid upfront for Roth accounts, and withdrawals are tax-free. Roth accounts have no RMDs, and distributions do not impact your tax bracket or your Medicare premiums. For those still earning income and saving for retirement, contributions can often be made to Roth accounts, such as Roth 401(k)s and Roth IRAs.

For those nearing or in retirement who have mostly tax-deferred savings, it’s not too late! Roth conversions can also allow you to decrease some of the above-mentioned taxes on sizeable tax-deferred accounts. Any conversion of tax-deferred assets into Roth assets will be taxed as ordinary income in the year of conversion. There are certain times when this strategy is most effective: when assets are down and when your tax rates are down. Converting assets when your tax-deferred savings are down results in paying tax on a discounted value of these assets (less tax!). Converting assets when your tax rates are lower, such as when marginal rates are lower, or your income is lower, means paying tax at a lower effective tax rate (less tax).

For some of us, though, the traditional method of tax-deferred savings is still the best way to lower taxes throughout our lives. We at Madison ensure you are informed and comfortable with financial decisions made for your unique situation. Taking control of your tax planning can allow you to prioritize what means the most to you. We wouldn’t want you looking at your tax bill the same way you looked at your first paycheck.

If you have questions or want to discuss your situation in more detail, contact your advisor, and we will work together with your tax professional.



*Contributions to Roth IRAs have income limits. Speak with your advisor or CPA for more information about contribution rules.

Important Note: This material is for informational purposes only and is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment product. The opinions expressed herein are those of the named advisors at the time written.  Actual economic or market events may turn out differently than as presented. Any reference to an index is included for illustrative purposes only, as an index is not a security in which an investment can be made.  Indices are unmanaged vehicles that serve as market indicators and do not account for the deduction of management fees and/or transaction costs generally associated with investable products. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. As always please remember investing involves risk and possible loss of principal capital and past performance does not guarantee future returns.   © 2023 Madison Wealth Management