Social Security, employer pensions, and private savings are the three legs of the stool that make up retirement in the U.S. Social Security still makes up the bulk of income for most retirees, although its long-term solvency has economists and politicians alike sounding alarms (see “Is Social Security Secure?”).

Employer pensions have dwindled as they face a similar conundrum of funding waves of employees’ retirements possibly longer than expected. Since the early 1980s, the U.S. government has encouraged private savings to pick up the slack, primarily through IRAs (individual retirement account) and employer-sponsored defined contribution plans, such as the 401(k).

IRA History and Funding

The Traditional IRA was invented in 1974 as part of the Employee Retirement Income Security Act of 1974 (ERISA). Its primary draw in the goal of boosting private savings were its “tax advantages.” The IRA allows savers to make a tax-deductible contribution which can then grow tax-deferred. For 2024, the IRA contribution limit is $7,000, and a catch-up contribution of $1,000 is allowable for individuals over age 50. 

IRAs don’t just grow organically. They grow solely from contributions and market gains, but they are often the receptacle of “rollovers” as well.  Most employers offer some form of workplace retirement plan — 401(k) at for-profit companies, 403(b) at nonprofits and teaching institutions, Thrift Savings Plans (TSP) for the federal government, and 457 plans.

In 2024, employees can contribute $23,000 annually with a catch-up contribution of $7,500 for those aged 50 and over, with similar tax deductions as the IRA mentioned earlier. Between these higher employee contributions and possible employer matches, these balances can grow much quicker than standalone IRAs.

When employees retire or separate service, they are allowed to rollover their vested plan assets into an IRA with potentially greater investment decisions and control, while continuing to defer any taxes.

IRA Tax Concerns

So far, tax-deductible contributions and tax-deferred growth sound like “tax advantages.” However, it’s critical that retirement savers recognize their contributions not as a tax-savings, but more accurately as a tax postponement.  There are two concerns in this postponement. 

First, as a saver’s retirement investments compound over decades of their career, the income tax liability may be on a much larger pool of assets than the initial contributions they received a tax deduction on. This is obviously what investors hope for, a future sum of money much greater than their initial investment. But, a retiree may find it trickier to pay the taxes on $1 million in the future versus say $100,000 of contributions spread over the course of their career.

Second, the income tax rate a retiree will face may be as uncertain as the value of their assets decades from today. The U.S. government has sought to alleviate the dependence on Social Security and underfunded pensions through incentivizing “tax advantaged” private retirement plans, but the incentives of pre-tax IRAs focus more on the front-end than on the back-end.

According to the Congressional Research Service’s report in 2023, there are $11.5 trillion of assets in IRAs. There are an additional $26.3 trillion in employer-sponsored retirement plans, much of which may find its way eventually rolled over into IRAs. As the U.S. government grapples with over $34 trillion of debt, politicians will stay aware of the tax revenue coming from nearly $38 trillion of retirement assets.

This second point regarding the federal government, and state and local governments for some retirees, determining the income tax rates on future retirement distributions brings to light other caveats regarding qualified retirement plans. Most pre-tax retirement assets cannot be accessed prior to age 59.5 without being subject to income taxes and a 10% premature distribution penalty (some exceptions can apply).

Hopefully the retirement saver is prudently planning for retirement, and this would only be a concern in niche cases. The greater concerns again occur on the backend. Traditional IRAs are subject to Required Minimum Distributions (RMDs), which essentially begin forcing the money out of the plan and triggering income taxes. These start at age 72, or age 73 if you reach age 72 after December 31, 2022.

Some retirement savers may find that between Social Security, an employer pension, rental income, portfolio interest and dividends, or other income sources that they do not want to use their IRA and would prefer to leave it to future generations. In the past, such individuals might defer their taxes as long as possible, only taking RMD’s until they pass away, enabling their beneficiaries to “stretch” IRA distributions over their lifetimes.

But, since the SECURE Act of 2019, most non-spouse beneficiaries of inherited IRAs must take all of their RMDs within 10 years of the owner’s death.  One can imagine the tax nightmare this could create for a high-earning couple in their peak working years who inherit a very large IRA.

IRA Maximization Strategy

For high-net-worth individuals nearing retirement or still young in retirement, options may exist to help maximize their wealth while mitigating taxes. Whereas they used “tax advantages” on the frontend during the accumulation phase of their career, they can now use “tax advantages” on the backend through the unique benefits inherent to life insurance. 

The IRA owner can use a combination of IRA distributions and other assets to fund a permanent life insurance policy. There are various types of policies that can be utilized which goes beyond the scope of this article (see “Making Sense of Life Insurance Lingo”), but I prefer Whole Life insurance as the most secure option.

So long as a life insurance policy is structured appropriately and does not qualify as a Modified Endowment Contract (MEC), its death benefit can be distributed 100% income tax free. The IRA Maximization Strategy entails steadily converting an asset subject to income and estate taxes (the IRA) to one received tax free (life insurance). The life insurance policy may be put into an Irrevocable Life Insurance Trust (ILIT) to avoid estate and generation skipping taxes as well.

The younger and healthier an individual starts this strategy, the greater the benefits can be as life insurance premiums naturally go up with age and adverse health issues. There are many factors to consider in all retirement planning scenarios, but for high-net-worth IRA owners who plan on leaving much of their assets to their heirs, the IRA Maximization Strategy can be a great approach to keeping Uncle Sam at bay.

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Bryan M. Kuderna is a Certified Financial Planner™ and the founder of Kuderna Financial Team, a New Jersey-based financial services firm.  He is the host of The Kuderna Podcast and author of ,"WHAT SHOULD I DO WITH MY MONEY?: Economic Insights to Build Wealth Amid Chaos".