You’ve worked hard to save $5 million. Now imagine the ghost of Christmas future comes right when you retire and shows you writing checks to the IRS for $13.6 million. If you’re not careful, I’m going to show you how that could happen.
When I work with people that have saved $5 million, typically they don’t feel super wealthy. If you’re in this position, you’ve probably done all the right things throughout your accumulation phase. You’ve worked very hard, you’ve been diligent at saving, and you’ve invested wisely. Now that you’re at retirement, more than likely, you’re not going to start spending frivolously. You feel secure, but at the same time, you may not know all of the financial challenges that still lay ahead. I’m going to go through four significant tax challenges that should be on your mind when you start to think about retirement planning, and also we’re going to get into one potential solution. When you have $5 million, there’s a bunch of different solutions, but we’re going to keep it simple today and show you how to save a lot of money in taxes.
The Base Parameters of this Scenario
If you follow this channel, you’ve seen this screen before. This is where we do the income tax analysis on your planned spending in retirement. Before we get there, I want to lay out the base parameters. Husband and wife, 60 years old, $5 million. Of that, $4 million is inside the retirement account. $1 million is in non-qualified or outside of the retirement account. The planned base spending is $120,000 a year throughout retirement. During the first 10 years, an additional $50,000 per year in what we call the go-go years.
This is when you want to have a little extra money, maybe take the family on a vacation, maybe the kids, the grandkids, pay for everyone. Maybe you want to travel to Europe, do a cruise around the world. Whatever it is that you want to do, you’ve earned it. Let’s plan for you to have a little bit more money when you’re active and younger and healthy and able to enjoy everything that you’ve accumulated.
Whether you have $1 million, $5 million, or $25 million, the Retirement Success Plan starts with your allocation. Because we’re talking about Step 3 here, tax planning, we’re just doing a standard allocation. We’re not going to get into the different options of how we can invest this money. Now, Step 2 is income planning. We talked about spending $120,000 as the baseline income and then $50,000 per year for the first 10. The question is, where do we get that income from? We have $4 million in IRAs. We have $1 million in non-IRAs. So step 2 of the retirement success plan is building that income strategy.
The First $6 Million in Taxes Due: Income Taxes
We have conventional wisdom here, which assumes that we defer the retirement accounts as long as possible, and we live off that non-IRA money. Typically, when you’ve accumulated this much money in a retirement account, that’s going to be the exact opposite of what you should be considering doing.
Here we have a dynamic, multi-account with, Roth conversion distribution strategy. so high level. Total taxes paid with the optimized distribution strategy, income and tax strategy, $2.3 million in taxes, versus over here, an estimated $5.9 million in taxes. We’re looking at, following conventional wisdom, off the bat, an additional about $3.5 million of income taxes, and this is just federal. If you live in a state with income tax, add on to that. Estimated ending balances here, $21 million, 21.7 versus 18.4. Roughly, the amount of money that we’re saving in taxes is going right to the bottom line when we look at the potential ending value.
In the beginning of this video, I said that you could potentially be on the hook for $13.6 million in taxes. If you follow the conventional wisdom distribution strategy in retirement, which many financial advisors recommend and have so for decades in this country, we just found where approximately $6 million of those taxes are going to come from. This is very important. I want to show you this before we get into where the rest of the taxes come from, and then one of the potential solutions to solve this big mess.
This is why conventional wisdom, deferring those retirement accounts when you’ve accumulated a significant amount of money inside your retirement account, can be very, very bad, where it can backfire. We see here, this is your estimated required minimum distributions. Again, this is if the accounts are growing around 5% to 6%. If you’re a more aggressive investor, and you’re earning on average a higher interest rate, the accounts will grow more, you’ll be forced to distribute more than what I’m showing here.
On the Y-axis, we see $200,000, $400,000, $600,000. Once RMD starts, so in this case, it’s at age 75, because this couple is 60 years old today, and the Secure Act 2.0 pushed those RMDs out to age 75 for someone that’s 60 today. We see the first RMD is estimated at $364,000. Now, the spending parameters for this plan in the beginning, remember, it was $120,000 as the baseline spending, with an additional $50,000 for the first 10 years. This is 15 years into retirement. Now, on top of Social Security, on top of any dividends and interest, if we don’t tackle the tax-infested IRA, you’re going to be forced to distribute $364,000 roughly and pay income tax on all that money. Then you see the severity of the slope of your future RMDs. When we start income planning and tax planning, one of the most critical steps is to create visibility into what the future looks like from a financial standpoint, if you continue down the path that you’re on. Then we need to create some alternative paths to follow and then analyze the pros and considerations for those different directions. Then we just simply try to take all that information and make the very best decision that we can each and every year.
These RMDs get up to be $728,000 at age 84 or 85. This is insane, right? This is a ridiculous amount of distribution that you’re paying income tax on. Two things to take into consideration here. One, what will income tax rates be in the future? We talked about this in the livestream recently, where we’re spending as a country, $2 billion per day on interest payments on the national debt. We’re adding $800 million an hour to the national debt. The spending in this country is astronomical. The debt is over $33, I think, $34 trillion right now.
If we were to start to count to $1 trillion, when one, $1,000, two, $1,000, it would take us more than 32,000 years to actually get to a trillion. That’s just how massive a trillion is. Now, with the rate we’re spending, it starts to come into perspective. We know taxes will be higher in 2026 because the Tax Cuts and Jobs Act, otherwise known as the Trump tax cuts, they sunset after 2025. That this software is taken into consideration that analysis. The question becomes, will taxes be even higher than that in 10, 15 years because of the amount of money that we’re spending and the massive amount of national debt?
Second thing to consider here, if one spouse predeceases the other, you go from the married filing jointly brackets to the single brackets. In the single brackets, you can have roughly about half the amount of income before you’re already in the same tax rate and tax bracket. If one spouse were to predecease the other one at some point, either unexpectedly or just in your 70s or 80s, you have another massive tax problem to consider.
I wanted to stress how important understanding what your RMDs are in the future, because that’s where the difference between what we call a multi-account Roth conversion income and distribution strategy is that we would recommend, that we would want to go down that path, at least start down that path, and then adjust as needed when the time occurs in the future versus following this.
That’s the first challenge that you face if you’ve accumulated $5 million. It’s the potential income tax liability from your distribution strategy. You may be sitting there thinking, I had no idea that even though I’ve accumulated $5 million, that I could potentially owe $6 million just in income taxes because of the distribution strategy that I choose. The next challenge we have to consider is extrapolating those account values out into the future to understand what a range or a potential future amount of money that you have could potentially be when you take into consideration the amount of money that you’re going to spend and taxes you’re going to pay in retirement. How much is left at the end of the rainbow?
Now the second planning consideration is out of this, if we go down this path, we’re going to contrast these, but if we go down this path, out of this 18 million, what is the composition of those accounts? Meaning, okay, I’m not worried about running out of money. Yes, I’ve paid $6 million in income taxes and possibly you didn’t have to do that, but you still have $18 million when you pass away here. Maybe you shouldn’t worry about crying over spilt milk, but there are other considerations, and it starts with, what is the composition of your accounts in the future?
Because you’re going to pass this money on to someone, assume you have children or grandchildren you want to pass this money on to. If you’re just giving it all to charity, this doesn’t really matter that much, but if you want the money to stay in your family, this is super important.
This is the composition of your accounts. The green is IRAs retirement accounts. The blue is non-qualified. The composition is we have about nine and a half million out of that 18 or so in retirement accounts. You may be asking, well, if I have nine and a half million in IRAs, how did I get so much in non-qualified accounts? When I retired, I only had 1 million in non-qual. It’s those massive required minimum distributions that you were forced to take out and pay income tax from 75 onward. You’re not spending that much money in retirement. What do you do? You pay tax on it. The leftover goes into
your savings account or your investment account. Over time, it accumulates, and that’s how you get $8 million or so in non-qualified. This next one we’re looking at, this is the multi-account distribution strategy where we’re taking advantage of the higher tax brackets today, the lower tax rates from the Trump tax cuts, and we’re doing Roth conversions. The gold represents Roth IRA money. We’re going to pay tax as we convert that money in the first few years of retirement and even past the expiration of the Tax Cuts and Jobs Act.
We see here about $19 million in Roth IRAs, so we’ve paid some taxes up front, but this money has now grown income tax-free forever. Like Paul Harvey used to say, now for the rest of the story. We’ve passed away with $18 million. If you start with five, with what we were planning on spending there, this is a very reasonable calculation. This assumes, again, about 5% to 6% growth.
Most people who have accumulated $5 million probably aren’t thinking it’s likely that they’re going to have $18 million. The composition of accounts is important, and so is the estate plan. If we pass away with $18 million and $9 million is inside IRA, $9 million is non-qualified money. Well, we have to be concerned about estate taxes. The current estate tax exemption is $25 million, meaning if you pass away as a married couple, you can have up to $25 million or so, and not pay any estate taxes.
We’re projecting out into the future, 20, 25, 30 years. We have no idea what the law will be at that time. We do know in 2026, when the Tax Cuts and Jobs Act expires, that the estate tax exemption is going to be cut roughly in half to about, let’s say, $12.5 million. Looking out into the future, given the debt that we have, the amount of money that we spend, it’s not unlikely that we have a smaller lifetime exemption.
The Next $4 Million in Taxes Due: Estate Taxes
It wasn’t too long ago, about 20, 25 years ago, in the Clinton years, 1999, or 2000, I believe, I think it was 1999, where the estate tax exemption was $600,000. Anything that you had above $600,000 was taxed at 50% when you passed away if you weren’t planning. For purposes of this, I’m assuming we’re doing the math based on a $10 million estate tax exemption in, let’s say, 30 years.
You take what you die with 18, minus the estate tax exemption, to get $8 million. Assuming the tax rate is 50%, that’s about a $4 million estate tax rate. Again, I’m making an assumption here with the estate tax rate. It has been that high before. It has been even higher, significantly higher before. Right now, it’s currently 40%. We’re making some assumptions, but we have to. This is part of the art of being a financial planner.
Now, in the real world, what we would do is we’d create some type of range analysis here, or sensitivity analysis, and then have a conversation with you. How do we want to plan for this? That’s what I’m about to get into.
For this video, we’re assuming a $10 million exemption, 50% tax rate. We subtract, so we have a $4 million estate tax. $6 million in income taxes from following the conventional wisdom distribution strategy. Now, another $4 million in estate taxes, but you have to pay the estate tax within nine months of the date of death. Where are you going to get that money from?
Most kids that inherit money are going to say, ah, you know what, I’m probably going to go over here into this non-qualified account because it gets a step-up in basis when you pass away. There’s no income taxes or capital gain taxes when that is inherited and leave the IRA alone. We have $9 million in that account. We pay Uncle Sam $4 million in estate taxes. This account is left with $5 million. Now we have $5 million and $9 million. We have $14 million.
Another $3.6 Million in Taxes Due: The Secure Act 2.0 on Inherited IRAs within 10 Years of the Original Owner’s Death
This retirement account, it’s still infested with taxes. The SECURE Act says that it has to be 100% distributed within 10 years. If this account gets fully distributed, guess what? We’re going to have to pay income taxes on that. If your children are working, this $9 million gets distributed. It goes on top of any income that they have. It’s not unreasonable to assume that account’s going to be taxed at the top marginal tax rate, making an assumption here of 40%. Again, not an unreasonable assumption.
To make the math simple, that’s roughly another $3.6 million in income taxes because the SECURE Act forces the distribution of that account within 10 years. The total taxes, $6 million in income from a poor distribution strategy in retirement, $4 million in estate taxes, $3.6 million in income taxes once that IRA is fully distributed for a total of $13.6 million in taxes.
The end result for your children, $5.4 million from the old IRA because it was $9 million. $3.6 was the 40% income tax once it’s fully distributed. $9 million minus $3.6 is $5.4. And then $5 million from the non-qualified account. Again, that was $9 million, but we had to take $4 million and pay the estate taxes, so 5.4 and 5, $10.4 million, and you passed away with $18 million in this example. They’re still going to be okay, but did you optimize? Did you have a strategy? Did you necessarily need to pay over the course of your retirement and passing the money on $13.6 million in taxes? No, you didn’t.
A Few Key Strategies to Avoid Owing $13.6 Million in Taxes
As a retirement planner who specializes in working with high-net-worth families, this is a potential solution that we would have a conversation that would solve the challenges that you face. We’ve already talked about the income tax problem from the distribution strategy in retirement, getting you your income once you retire all the way through retirement. If you remember, that Roth conversion strategy puts a significant amount of more money inside the Roth IRA.
That tax strategy for retirement income was going to cost about $2.3 million in total taxes throughout retirement. Significant savings there. If you think back, it was about $3.5 million or so in potential savings, just from income taxes on your retirement income distribution strategy, which left us with about $18 million in Roth that we’re passing on. That income strategy where we were converting to Roth, it also solves one of the tax problems you have later with the SECURE Act, enforcing the IRA. If you left all that money inside the IRA, that Roth conversion strategy is knocking two birds out with one stone.
Plus, we’re passing on $18 million. That Roth IRA, it still has to be distributed within 10 years, but all of that growth is going to be income tax-free. Now, it is still subject to estate taxes. How do we go about that? Well, there are a lot of ways to address it. We’re going to look at one of the most common ways and also one of the most simple. I am a fan of simple. Some estate planning strategies can be tremendously complex, where you have multiple trusts or family-limited partnerships and entities, and you have different accounting and tax returns, and a lot of complexity. Whenever possible, I prefer to have my clients go a more simple route because it’s easier to follow. There’s less opportunity for mistakes. If you make mistakes and get audited down the road, your children get audited on the estate, well, it’s very possible, even likely, that the IRA says your planning strategy is voided and you owe $6 million, $8 million, whatever that number is. Simple, in my opinion, is always better.
Same challenge. Now we die with $20 million, $10 million exemption. We would owe 40% on $10 million. We would owe about $4 million, so how do we solve that? A simple strategy is to create a trust outside of your estate. This is called an eyelet. It’s an irrevocable life insurance trust. We have the $20 million inside your estate here. We would simply make gifts. This is a rough number here of about $100,000 a year to the children in the form of this trust. Now, the money actually has to go into a trust bank account. This is important. Then the trustee pays the premiums on the life insurance policy, but it’s building cash value.
If the trustee needs to make a distribution of that money for your kids while you’re living, they can do that. Crummy letters need to be sent to the children. This is what gives the gift into the trust. It’s what creates what we call a present interest, which means we can use our annual exclusion to gift money into this trust without gift tax. Gift tax becomes a problem when you’re starting to gift money outside of your estate or to your children.
You don’t want to give so much to where you use your lifetime exemption because that brings it down, although it may be the only choice you have. We also want to make sure that we are falling within the annual exclusion amount. Now, that was a mouthful, but what that means is as long as we have a present interest in this gift into the trust, which means the kids, if they want, they can withdraw it through the trustee if they need it for health, education, maintenance, support, whatever it may be. Husband and wife can do $17,000 per year each. That’s $34,000. If you have three beneficiaries of this trust, husband and wife can give each one essentially $34,000. It’s just going into the trust, so $34,000, $68,000, $102,000. We can gift into that trust using your annual exclusion. No gift tax. As long as you have the letter, which essentially notifies the children that money has been given to them and they can access it if they want. Typically, they won’t because they want the death benefit, which I’m estimating to be around $4 million here. We’re just going to do that for about 10 years. We’re just repositioning money, essentially from your right pocket to your left pocket. It’s going to grow inside this life insurance policy, tax-deferred. If they need to access it, they can take a tax-free loan, but they’re just typically going to let it sit in there because the death benefit, roughly $4 million, is going to pay out income tax free and estate tax free.
Final Numbers on How Much You Can Potentially Save in Taxes, and Leave to Children With These Strategies
Went through a lot there, just helping you understand some of the nuances of the strategy. It really is simple. You set up a trust outside of the estate. You gift the money into the trust bank account. The trustee pays the life insurance premiums. The four million dollar death benefit pays out income and estate tax free. You pass away, you have 20 million in your estate, 18 million of it is Roth. Again, income tax free. You still owe the four million in estate taxes, which we talked about. We call it using pennies to buy dollars, right? We put a million dollars into the trust. It created a roughly four million dollar death benefit. That four million dollar death benefit pays out, pays the estate taxes, or they pay the estate taxes from the estate.
Either way, 20 million is the amount of money that goes to your children. You paid a million dollars for the life insurance policy, 2.3 million on income taxes for the conversion. You saved over 11 million dollars with this strategy. Very simple. The kids still get 20 million dollars of which 18 of this is in a Roth IRA, and it can grow tax free for 10 more years.
➡️ Do you need a Retirement Success Plan that goes beyond allocating funds to truly fit your needs? We can help you create a retirement life plan customized for your retirement vision and legacy. Call us at (877) 404-0177 or click here to fill out this form for a free consultation.